How to Create Cash Flows in Retirement

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It’s something that even casual market observers know well: Yields on bonds and cash have been going down, largely unabated, for almost three decades. Just when it seemed they had reached their nadir, payouts have taken another leg down. The yield on the 10-year Treasury was just 0.51% on August 4, its lowest level since the equity-market panic back in March. Yields on lower-quality U.S. bonds spiked during the equity-market duress in the first quarter, but they too have drifted back down more recently.

U.S. equity dividends have been more stable, but they’re pretty low right now, too--well under 2% for the broad market today. Equity dividends can also be subject to cuts when business conditions worsen. Thus far in 2020, for example, a broad swath of companies in the energy, banking, and travel sectors have cut dividends, to the tune of a net $25 billion in dividend cuts in the first half of 2020.

Learning to Love Cash Flows In the face of very low yields, I've argued that retirement "income" deserves a fundamental rethinking. Rather than subsisting on organically generated portfolio income--which today entails jacking up risk to generate a sustainable level of portfolio--retirees should focus instead on "cash flows." A cash flow approach encompasses income production as well as gain harvesting through rebalancing appreciated positions.

Many retirees are positively allergic to the idea of ever selling anything from their portfolios to meet cash flow needs. They’d like to leave their portfolios behind for their loved ones. But a broader cash flow mindset allows them to build better-diversified portfolios than an income-centric mindset would allow, which in turn can improve the portfolio’s risk/reward profile. And if the portfolio is larger in the end, the retiree shouldn’t be concerned with whether his or distributions came from income or from selling chunks of the portfolio.

Moreover, employing a cash flow approach versus an income-only mindset enables the retiree to diversify the stream of actual payouts, thereby ensuring its stability. If one type of cash flow generation slows or is otherwise disrupted, the retiree can lean more heavily on the other. Even as yields have declined over several decades, for example, stocks have compounded at a decent clip, enabling retirees to rely more heavily on trimming appreciated securities instead of clipping coupons. In addition, a focus on cash flow builds in an element of ongoing portfolio maintenance and risk reduction into the plan. A cash-flow-driven approach may also allow for better tax management than would be the case with a strictly income-centric mindset.

Making It Work The big hurdle is implementing a cash-flow-driven approach to retirement decumulation. Subsisting on dividend checks is simple, whereas incorporating rebalancing into a cash flow generation plan is more complex. If you're sold on employing a cash flow system for generating living expenses in retirement, here are some key steps to take.

Determine your approach to income distributions. Even if you don't build your retirement portfolio and plan around income production, some, even most, of your portfolio holdings are still going to distribute income. Thus, one key decision to make before embarking on a "cash flow" system for retirement income is how you'll approach those distributions. Will you spend them to help meet your living expenses? Or will you reinvest them, either back into your holdings or to top up your liquid reserves?

There are pros and cons to both approaches. A hybrid approach, whereby the retiree uses income distributions for spending, then looks to rebalancing to make up any additional cash flow needs, will likely provide an agreeable balance for many.

Employ discrete holdings. Rebalancing in retirement entails trimming appreciated asset classes or securities and using the proceeds for living expenses. That underscores the importance of in-retirement portfolios incorporating discrete holdings rather than all-in-one funds like balanced funds. By holding at least a few core investments with targeted exposure to key asset classes--U.S. stocks, foreign stocks, and bonds--a retiree can pick and choose where to rebalance on a year-to-year basis.

My model "bucket" portfolios entail even more holdings than that, and in my bucket stress tests, that afforded more rebalancing opportunities. In most years--even ones when the broad stock market declined--something performed reasonably well. In 2020, for example, with the broad market clinging to positive but tiny gains, a retiree might prune large-cap growth stocks to help meet living expenses. In 2000 (which admittedly feels like a distant memory at this point), growth stocks fizzled while value enjoyed its day in the sun.

Outline your rebalancing thresholds and glide path plan. In addition to deciding whether you'll spend or reinvest income and holding distinct holdings to facilitate rebalancing, it's also important to outline what triggers you'll use to rebalance. Will you rebalance only when your portfolio's baseline allocations to stocks and bonds are out of whack, or will you rebalance when individual positions get too large, even if your total asset allocation to the asset class hasn't?

Of course, retirees will want to guard against overly complicated portfolio maintenance regimens, especially if they have multiple accounts with different tax treatments. But as noted above, I found rebalancing at the securities level to be particularly helpful in my model portfolio drawdown/rebalancing simulations. I used a rebalancing regimen whereby I trimmed securities that exceeded their starting values by 10%. In all but a handful of years dating back to 2000, that system enabled a hypothetical retiree to meet his or her living expenses.

In addition to rebalancing triggers, you’ll also want to consider how how--or if--you want your portfolio’s asset-class exposures to change over time. While classic rebalancing involves periodically adjusting the baseline asset allocation back to the target mix, you may not want your asset allocation to remain static throughout retirement; you may want it to become more conservative or even more aggressive. Knowing that at the outset can help you determine how you rebalance your portfolio and what you do with excess funds, above and beyond what you need for living expenses.

Hold a buffer.

Of course, there are those years when almost nothing performs especially well--2018 was a recent example--and when bond and dividend income alone may not be enough for a retiree to live on. That’s a key reason I like the idea of holding a cash “bucket” as well, providing the retiree with a buffer if nothing is ripe for pruning.

Yet even as such a buffer works well in practice, and provides peace of mind for many retirees, too, it’s important not to overdo it, especially given how incredibly low cash yields are today. In my bucket portfolios, I’ve suggested an allocation of one to two years’ worth of portfolio withdrawals in cash. Retirement expert Wade Pfau has asserted that retirees might also consider noncash buffer assets such as reverse mortgages and life insurance cash values in lieu of the drag of cash.

Factor in tax implications. Because rebalancing involves trimming appreciated securities, it's impossible to ignore the role of taxes when deciding how and what to trim. Once required minimum distributions from tax-deferred accounts commence at age 72, the taxes due on those withdrawals are what they are, regardless of whether you pull from holdings that have appreciated a lot since purchase, or those that haven't performed as well. But if your rebalancing program involves selling taxable assets, it makes sense to work with a tax or financial advisor to minimize the tax bill due on the sale of appreciated securities. For example, low-tax years--and 2020 is shaping up to be one such year due to the suspension of RMDs--may be a good time to consider trimming highly appreciated securities that might entail a bigger tax bill in other years.

Tie it all together in a once-yearly review. Finally, I like the idea of skinnying down in-retirement portfolio-management responsibilities, including rebalancing, into a single, once-annual review. At that time you can survey your plan in totality: Assess your withdrawal rate, determine whether you need to take RMDs, consider charitable giving, mull tax-loss selling and/or IRA conversions, and set aside your cash flow needs for the year ahead. You can then assess whether rebalancing can help you achieve those aims.