Note: This article is part of Morningstar's September 2016 Retirement Matters Week special report. A version of this article appeared on Jan. 29, 2016.
Retirees often obsess about generating income from their portfolios, conflating their need to replace the income they once earned from their salaries with a need to invest their whole portfolios in income-producing securities. This phenomenon probably has its roots in a more favorable yield environment: When bond yields were higher, many retirees could readily generate the cash they needed from their portfolios, even with money markets and bonds.
Yet, as appealing as it might seem to live off of a portfolio's income and never touch principal, it's not the only way--or necessarily even the best way--to extract cash from an in-retirement portfolio. Because there's more than one way to get the job done, I've argued that retirement terminology should ditch "retirement income" in favor of the more inclusive "retirement cash flow." In some years, like several of the ones we've experienced so far this decade, selling highly appreciated securities is arguably an even more defensible way to meet living expenses than is scrambling for yield.
Here's an overview of some of the key strategies for cash flow from an in-retirement portfolio. There's no single "right" way to do it, so I've described each strategy, as well as its pros and cons.
The Income-Only Portfolio Approach
Using this strategy, a retiree subsists on whatever income the cash, bond, and stock holdings kick off.
Pros:Because it doesn't involve tapping principal, this approach provides some insurance that a retiree won't outlive his or her assets; there may also be principal left over for heirs or for in-retirement splurges.
Cons: From a lifestyle standpoint, most retirees generally prefer a predictable stream of income, much like they had when they were earning a paycheck. That's why spending rules like the 4% rule assume that a retiree would prefer a static dollar withdrawal per year, adjusted for inflation. But by relying only on income distributions to supply living expenses, a retiree is apt to find that income stream is buffeted around by the prevailing yield environment. Moreover, given how low yields are currently, the income-generating securities in a portfolio may have trouble generating a livable yield at various points in time (like right now), leaving the retiree with no choice but to withdraw principal or invest a lot in higher-risk higher-yielders. The higher risk the income-focused portfolio is, the greater the risk the retiree will have a loss over her holding period.
The Reinvest-and-Rebalance Approach
Under this strategy, a retiree reinvests all income, dividends, and capital gains back into his or her holdings. The retiree then rebalances on a regular basis, periodically scaling back on those holdings that have performed the best, whether stocks or bonds, to bring the total portfolio's asset-class exposures back in line with targets. (Those targets may gradually grow more conservative over time, depending on the asset-allocation glide path the retiree is using.)
Pros:The big advantage to the total-return approach, in contrast to an income-focused strategy, is that it's extremely plugged in to market movements and valuation, forcing the investor to sell appreciated assets on a regular basis while leaving the underperforming assets in place or even adding to them. An investor using this strategy during the bear market, for example, would have been trimming high-quality bond holdings to meet living expenses (or to refill her liquidity bucket/bucket 1), leaving potentially undervalued equity assets intact. More recently, the investor would be selling stocks to meet living expenses and/or refill bucket 1.
Cons:Rebalancing too often may prompt a retiree to prematurely scale back on an asset class, thus reducing the portfolio's total return potential. That argues for holding at least two years worth of living expenses in a liquidity bucket (bucket 1), thereby giving the retiree more discretion over when to sell assets for rebalancing. Rebalancing can also trigger tax costs if it involves selling from taxable accounts, but so does harvesting most types of income within a taxable account.
The Income-and-Rebalancing Approach
Under this strategy, a retiree relies on both income distributions and rebalancing to meet living expenses. Income distributions from cash holdings, bonds, and dividend-paying stocks are spent (or transferred to bucket 1). If those distributions are insufficient, the retiree can look to rebalancing proceeds to supply additional cash flow needs.
Pros: By relying in part on current income distributions, this approach provides a baseline of income for living expenses. Those income distributions may also trend up in periods of market distress, as yields often move in the inverse direction of prices. That extra income, in turn, could help the retiree avoid tapping principal during a market downturn, while also providing valuable peace of mind.
Cons:Securities' income production often trends up when their prices are depressed; in such instances, the retiree may improve the portfolio's long-term returns by reinvesting those income distributions rather than spending them.
While the previous strategies all relate to extracting cash flow from a portfolio, an annuity is an entirely different animal. With the most basic annuity type, a single-premium immediate annuity, the purchaser receives a stream of lifetime income in exchange for a chunk of her cash.
Pros:Many annuities are set up to supply a lifetime income stream, which is unavailable with traditional investment products; such guaranteed lifetime income may be especially appealing for individuals without pensions. And because annuities offer longevity-risk pooling--that is, the assets of those who die prematurely stay in the kitty--that tends to boost their payouts relative to investments.
Cons: The big negative with any sort of annuity is a loss of liquidity--assets that were once under the retiree's control are no longer accessible for spending. Many annuity types also carry high costs, which can erode at least some of their benefits. The creditworthiness of the insurer is also a potential risk factor. Finally, the payouts on the most basic annuity types are keyed off of current interest rates, so payouts are currently low relative to historical norms.