What Higher Yields Mean for Retired ‘Bucket’ Investors

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Thanks to higher interest rates, a balanced portfolio of stocks and bonds is once again offering a reasonable yield. Joining me to discuss what that means in practice for retirees using a Bucket strategy for their retirement income is Christine Benz. She’s Morningstar’s director of personal finance and retirement planning. Nice to see you today, Christine.

Christine Benz: Hi, Susan. Great to see you.

Retirement Asset Allocation

Dziubinski: Let’s talk about the prevailing interest-rate environment, and if someone has that balanced 60/40 portfolio, what kind of income is that generating and throwing off today?

Benz: It’s gotten much better due mainly to the fixed-income piece. So, if we look at a very plain-vanilla U.S. stock/bond portfolio today, it’s yielding about 2.7%. If we look at my minimalist Bucket portfolio, which would just include a dash of cash, as well as a dash of international equities, you can nudge that up to closer to 3.0%, like 2.9% for a portfolio that’s slightly more diversified. That is miles ahead of where we were a couple of years ago, where you were lucky to wring like 2% from your balanced portfolio.

Bucket Strategy

Dziubinski: Right. What do you suggest investors do with these now higher income distributions they are receiving? Should they be reinvesting those or should they be spending them?

Benz: I like the idea of retirees coming into the process with a formulated strategy about how they will deal with this. Really there are two ways to think about it, and if I’m thinking about the Bucket portfolios that I often talk about, you could either maintain what I think of as a pure total-return strategy, where you’re reinvesting all of your income and dividend distributions right back into the portfolio and then periodically you’re taking, a look at whether your portfolio needs rebalancing. So, in a period like 2019 through 2021, for example, most portfolios had appreciated equity holdings that retirees could use to fund their cash flow needs. That would be sort of the pure total-return approach. I think if we were to ask our more academic colleagues around here, that’s probably what they would recommend.

Another strategy, though, that you could use is to pull those income distributions that are coming off of your stock and bond holdings, and just have them spilled over into your cash bucket, if you’re using this Bucket strategy, you’ve got a cash bucket that you’re spending from on an ongoing basis. Your portfolio’s income distributions will help refill that cash bucket, as you’re spending from it. That’s an alternative method if you need additional sources of cash flow, you could use rebalancing to help make up the difference. So, if you think about that 60/40 or sort of minimalist Bucket portfolio that’s getting you about three fourths of the way to like a 4% portfolio withdrawal with that 3% organic yield. That’s another strategy. I think of it as kind of a hybrid strategy.

Dziubinski: What are the pros and cons of these two approaches, reinvesting all that income or using it to help provide some of the cash flow.

Benz: Sure. If you think about the pure total-return strategy, the beauty of that is that you are periodically reviewing your portfolio’s asset allocation, getting it back in line, and using the selling proceeds to fund your cash flows on an ongoing basis. The downside is that there may be years when there’s nothing to rebalance, right? Think about 2022, there was not a great source of rebalancing proceeds in most of our portfolios. So there will be those dry years. And then the other downside of that strategy is that your portfolio is not supplying you any income distributions whatsoever. You have to go in and do the work to get the cash flows out of the portfolio. Those are the major pros and cons of the pure total-return strategy.

In terms of the hybrid strategy, I think there’s a lot to like about it. And when I talk to retirees using this Bucket approach, they often tell me that they’re using some version of that approach where you are getting that source of cash flows on an ongoing basis coming from the portfolio. I don’t know that there’s a major downside, I suppose a big one would be if you’re automatically harvesting the income distributions. You’re not putting money back to work in your portfolio in a year like 2022 when ideally you would be reinvesting your income distributions right back into the portfolio to put more money to work in a declining market.

Dividend Stocks

Dziubinski: Let’s talk about dividend stocks as an option. We know that’s a popular source of income, particularly among a lot of readers of your content on Morningstar.com. How reasonable is it to be using dividends to supply your living expenses in retirement?

Benz: I think it’s perfectly reasonable. In fact, I think it’s fine if retirees want to nudge up the focus on income production within their portfolios. I’ve not really done that when I’ve created the model portfolios, but I don’t see that there’s anything wrong with someone using like a Vanguard High Dividend Yield for their U.S. equity exposure. I would tend to want to augment that with a little bit of total stock market exposure because it’s going to give you exposure to other parts of the market. But if retirees want to kind of dial up the dividend production, I think there’s nothing wrong with that. I would also note that international dividend payers tend to have higher yields than U.S. today. I wouldn’t just focus on the U.S. component in terms of nudging up my dividend yield. I’d also look overseas.

Cash Yields

Dziubinski: And then lastly, we’ve talked a little bit about cash yields being very attractive and we’ve also seen indications in the market that investors are actually increasing their cash holdings. Is that a defensible strategy today? Are you going to be able to generate enough cash for your income needs through an approach like this?

Benz: Well, the risk is that current cash yields as attractive as they are may prove ephemeral, especially if we do head into a weakening economic environment, the Fed will probably step off the gas in terms of these interest-rate increases and may even cut interest rates. Well as a short-term investor, as a cash investor that is not your friend, right? You’re having to put your money to work in lower-yielding securities, typically. So, even though it might provide some peace of mind to know that more of your cash flows are just coming from your cash yields today, just know that the good times that cash investors have may not last. And also bear in mind the role of inflation, which is the natural enemy of anything with a fixed payout attached to it.

Dziubinski: Well, Christine, thank you for your time today and for talking us through retirement income, against today’s backdrop. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch “Can You Recession-Proof Your Portfolio?” for more from Christine Benz.