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The Four Levels of Income

One word, several different investment experiences.

A Good Point Last Tuesday’s column discussed the Department of Labor’s “interim final regulation” that requires 401(k) plan administrators to translate participants’ current account balances into “lifetime income” streams. These calculations assume that 401(k) account balances are used to purchase a single premium intermediate annuity. Out goes the principal, in come monthly payments.

A reader disputes the DOL's nomenclature. He writes, "An annuity payment is not 'income.' And the series of payments is not an 'income stream.' Income, in the investment and trust world, is the coupon from a bond. The dividend from a stock. The DOL should not be using this term to describe the payment (which includes return of principal) received from annuitization."

I'm not certain about that last part, as the term "income" can be useful as a overarching concept, covering all forms of periodic payments. However, the reader certainly is correct about the general point. (Which I had overlooked when writing my column.) Investment income comes in various forms, which could benefit from separate designations.

By my count, there are four primary varieties of "income," to use the irony quote. I categorize them below, based on their effects on an investor's capital.

Growth Investments: Dividend-paying stocks, Treasury-Inflation Protected Securities Investor Control: Retained Capital: At risk, expected to rise

The Growth strategy comes from investing in dividend-paying stocks or TIPS. It is the only approach that features a likely increase in both the investor's principal and in the income that the principal generates.

If the portfolio is well constructed, the costs reasonable, and the equity markets friendly, dividend-paying stocks provide the strongest solution. For example, with its capital gains distributions reinvested, American Funds Capital Income Builder CAIBX has tripled its 1995 net asset value, and its current income payments are double that year's amount, even though interest rates have sharply declined during that time period. Win/win.

TIPS, of course, operate very differently. Their capital growth comes not from stock price gains but instead from the Treasury's commitment to increase the investor's principal by the amount of annual inflation, as measured by the Consumer Price Index. Conceivably, this promise could become a threat, as the Treasury would decrease principal in the event of deflation. Overall, though, one expects the redemption price for TIPS to be higher than the issuing price.

Each approach has a drawback, as the possibility of capital growth doesn't come for free. Owning dividend-paying equities means courting stock market volatility, which is much higher than that of income investments. Meanwhile, TIPS suffer from low initial yields. In fact, today's TIPS rates are firmly negative. When initially bought, TIPS don't deserve even the irony quotes. They are not income at all.

Preservation Investments: Bonds, notes, cash Investor Control: Retained Capital: Not at risk/slightly at risk

Preservation is the simplest investment strategy. Buy a fixed-income security that will redeem at par on the maturity date, while providing cash along the way. If the issuer's credit remains intact--meaning, in the vernacular, that the bonds are "money good"--the buy-and-hold investor faces no price risk when purchasing the bonds, notes, or cash directly. Every penny paid will be returned.

The matter is not quite so settled for those who buy indirectly, through funds. There is no guarantee that the exit price will match the entry price, or that a fund's yield will remain static. However, for funds that invest in high-quality securities that are of intermediate length or shorter, those risks are modest.

Preservation provides the surest approach among those strategies that permit investors to retain control of their assets. At times, the tactic also offers high payouts. However, today is not one of those times, as the yield on Vanguard Total Bond Market BND is below that of the company's Dividend Growth Fund VDIGX. The present selling point for bonds, notes, and cash is their safety, not their remuneration.

Such securities are protected nominally, but not in real terms. Should inflation resurface in a big way, their security will prove illusory.

Erosion Investments: Premium bonds, option-writing Investor Control: Retained Capital: At risk, gradually

All things being equal, Erosion strategies have higher payout rates than Preservation strategies, at the cost of gradually reducing their capital base.

One tactic is to buy premium bonds or notes, which provide above-market yields in exchange for the inevitability that those securities will eventually be redeemed at less than their current prices. Another approach is to write call options on portfolio holdings. The options proceeds are distributed as short-term gains (often regarded as income by their owners). This tactic gradually erodes principal, because the portfolio's winners are called away, while its losers are retained.

There's nothing intrinsically wrong with Erosion strategies, as their total returns can match those of Preservation strategies, with similar volatilities. Unfortunately, most mutual fund shareholders who possess Erosion holdings do so unknowingly. They believe that their relatively high-paying funds provide them with something for nothing. Not so.

Exit Investments: Social Security, annuities, pension plans Investor Control: Conceded Capital: Conceded

With the Exit strategy, the investor relinquishes his or her assets, in exchange for future payments. That something is lost during the transaction is immediately obvious when purchasing an annuity, but less apparent when receiving Social Security or pension checks, because those assets were previously committed to the deal. But the outcome is the same: Money that could be used for other purposes was spent. It will not be coming back.

Effectively, Exit-strategy payments provide not only income on the underlying assets but also return of the investor's capital. It was in that sense that our reader protested the DOL's terminology. Annuity payments are not akin to bond yields or stock dividends. Neither are Social Security and pension-plan receipts. However, the existing language about "income" does not reflect that distinction.

Perhaps it should. If you send me $100,000, I can commit to delivering 30 annual payments of $3,333 (with a $10 bonus on the final date) for a "yield" of 3.33% that almost triples that of the 30-year Treasury bond. All I need do is place the money into a safe-deposit box and withdraw that amount each year. For lack of a better word, most today would call that "income." It would be useful to possess that better word.

John Rekenthaler ( has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

The opinions expressed here are the author’s. Morningstar values diversity of thought and publishes a broad range of viewpoints.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

John Rekenthaler

Vice President, Research
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John Rekenthaler is vice president, research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc.

Rekenthaler joined Morningstar in 1988 and has served in several capacities. He has overseen Morningstar's research methodologies, led thought leadership initiatives such as the Global Investor Experience report that assesses the experiences of mutual fund investors globally, and been involved in a variety of new development efforts. He currently writes regular columns for and Morningstar magazine.

Rekenthaler previously served as president of Morningstar Associates, LLC, a registered investment advisor and wholly owned subsidiary of Morningstar, Inc. During his tenure, he has also led the company’s retirement advice business, building it from a start-up operation to one of the largest independent advice and guidance providers in the retirement industry.

Before his role at Morningstar Associates, he was the firm's director of research, where he helped to develop Morningstar's quantitative methodologies, such as the Morningstar Rating for funds, the Morningstar Style Box, and industry sector classifications. He also served as editor of Morningstar Mutual Funds and Morningstar FundInvestor.

Rekenthaler holds a bachelor's degree in English from the University of Pennsylvania and a Master of Business Administration from the University of Chicago Booth School of Business, from which he graduated with high honors as a Wallman Scholar.

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