One of the biggest questions for people entering retirement is how to generate income from their hard-earned savings. Moving from accumulation to withdrawal mode is an uncomfortable transition for many. Setting aside the emotional and behavioral component, what are the logistics involved in creating your own paycheck? From which accounts should you draw and how does this affect your investment strategy?
The belief that income and dividends should provide enough to fund your living expenses without having to touch the principal amount of your portfolio is a popular one. While this is a reasonable point of view, it often results in accepting lower expected return for the same level of risk when compared to a total return strategy.
What do we mean by a total return strategy? Glad you asked!
A total return strategy often involves building a diversified portfolio of equity and fixed income securities (stocks and bonds) and using a combination of income (interest and dividends) AND capital gains (increase in value of the securities in the portfolio) to fund your income needs.
The benefit of a total return strategy is the potential for larger and steadier returns over time, which means you could have more money in the pot over the long-term. It also allows you to maintain a consistent risk profile, so you’re not dramatically altering the portfolio at an inopportune time or incurring excessive trading costs.
We know that focusing on income generation and preservation of principal can provide peace of mind because it creates more tangible limits on the amount you can spend. However, focusing solely on income can lead to unintended risks.
Here are a few pitfalls to consider with an income-only strategy:
- Miscalculating risk
If your desire for income leads to a chase for yield, this often results in purchasing fixed income instruments with either longer maturities or higher credit risk. Or, maybe you choose high yielding mutual funds that hold risky underlying securities, charging higher fees. It might not sound intuitive, but you are often better off from a risk/return perspective by owning equities and lower risk fixed income instruments than chasing higher yielding securities.
- Concentrating equity holdings
Another pitfall of chasing income is holding large positions in a few stocks that pay high dividends. The number of high dividend paying stocks is fairly limited, which means you would need to own large positions in order to generate a decent amount of income. When a few stocks make up a large percentage of your portfolio, you may not enjoy equity market gains if one or more of the stock’s value falls.
- Investing in non-traditional asset classes
For sophisticated investors, diversifying beyond traditional asset classes may be worthwhile. However, if you are an average investor, you should avoid taking on risks you don’t understand by investing in funds that offer high dividend yields solely for the purpose of achieving an income goal. These funds often carry unique risks that are generally not appropriate for most investors.
The interest rate environment in recent years has caused many investors to participate in the chase for yield as a means of funding retirement. Most don’t realize that this chase creates additional risk at a time when most people intend to be conservative in their investment strategy. While it may feel right to plan your retirement around the income generated by your portfolio, the expected return for a given level of risk is likely to be higher by building a diversified portfolio around a total return strategy.