When my grandfather passed away, my grandmother was managing their remaining money and ensuring it would provide enough income to last her lifetime. She would call up all of the local banks and haggle over CD rates. If one offered a hundredth of a percentage point higher in rate, she’d use it to beat up all of the others until one of them upped the ante. She’d have been a master in a Turkish bazaar! Due to her diligence, she was successful, and hasn't yet run out of money more than 20 years later.
I don’t know that my grandmother’s approach would work as well for those just reaching retirement. There is a great temptation today to put everything into “safe” investments and live off of the income. Loss of enough principal can be devastating, and fear of that loss has caused investors to pile into bonds for the income as well as for the principal protection.
For many retirees and for those approaching retirement, their portfolios, if invested entirely in bonds, may not throw off enough income to live on. A recent paper from Vanguard’s Colleen Jaconetti, “Spending From a Portfolio,” (via Dr. Wade Pfau) discusses some of the downsides to that approach, concluding that continuing to invest for income, dividends, and capital gains may be a better one.
Let’s look at three typical reactions of investors whose investment income doesn't provide enough to meet living expenses, and what the pitfalls of those reactions are:
Reaction #1: Go all-in on bonds. Put the entire investing portfolio in conservative bonds such as treasuries or municipals.
Pitfall: Such a strategy can decimate purchasing power and, eventually, the portfolio itself. With inflation higher than the interest rates on treasury bonds and with interest rates on treasury bonds lower than safe withdrawal rates, investors will eat into their principal and erode the portfolio.
Reaction #2: If treasury bonds don’t yield enough income, investors chase yields with higher yielding corporate bonds and longer-term bonds.
Pitfall: This strategy introduces more default risk and interest rate risk into the equation. Corporate bonds, particularly high-yield bonds, are riskier because there’s a higher chance that the issuer cannot pay back the bond. If the U.S. government needs to pay off bonds, it can always print money to pay them off. Corporations (and municipalities) do not have that option.
Secondly, by increasing the term of the bond, investors are increasing the duration of their bond portfolio. The risk of longer duration is an increased sensitivity to interest rates. For bonds, when interest rates go up, the value of the bond goes down, as the purchasing power of the subsequent interest payments decreases. In the current economic environment, interest rates are unlikely to go down much further, and an increased duration simply puts more principal at risk if the investor needs to sell a bond later to meet living expense needs.
Reaction #3: Invest in dividend yielding stocks.
Pitfall: This strategy may seem inherently practical at first—get a dividend and participate in capital appreciation. However, there are two downfalls to the approach. First, a dividend payout is simply a reallocation of corporate capital to the shareholder. In general, companies pay dividends when they have no higher yielding investments as alternatives. The share price of a company usually decreases by the dividend amount at the ex-dividend date. Therefore, there is no net gain as a result of the dividend. Furthermore, with 2013 tax law changes, dividends may no longer receive preferential tax treatment and are counted as ordinary income. Secondly, according to Vanguard, the total return between 1986 and 2006 of higher yielding equities was lower than the total return of lower yielding or non-dividend equities.
What is an investor who needs to live off of their portfolio to do?
It’s a scary proposition to feel like you need to tap into principal to meet your living expenses in retirement. However, the alternatives to a total return approach to investing present their own risks and challenges and may leave you worse off than if you had stayed the course with appropriate asset allocation.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.