Consider two phases of wealth management: the accumulation phase and the distribution phase. In the accumulation phase the top concern is to grow retirement assets to meet future income needs. In this phase, income from employment provides for both current spending and retirement investing. Investment decisions focus on building a high confidence plan that ensures future needs will be met. In the distribution phase, we add the additional goal that the investment portfolio needs to generate enough cash to fund retirement spending. In practice, the accumulation phase and distribution phase can overlap. For example, we may take funds from investment accounts to fund college expenses or make large purchases.
In this article we’ll start by discussing the goals for the distribution phases and outline various investment strategies available to meet retirement income needs.
Distribution Phase Goals
As noted above, the overarching goal for wealth management is to build a high confidence plan that meets future spending and distribution goals (including charitable giving, gifts and estate distributions). In retirement we move into the distribution phase with the added goal that living expenses need to be generated from one’s investment portfolio. Finally, we want to accomplish these goals in the most tax efficient manner possible. Tax advantaged retirement funds require that distributions must be considered. Tax on investment income must also be considered. Tax on investment returns varies by type of investment and the account type containing the investment (we refer to this as ‘tax location’). As a general rule, we take funds from taxable accounts before withdrawing from tax deferred retirement accounts. Next, we’ll explore the broad categories available for investment in the distribution phase. We’ll discuss these strategies in light of the goals we have just laid out.
Starting Point
The initial step in planning includes identifying all sources of income and needs. Sources include retirement accounts (taxable and tax deferred), social security, rental income, pensions and so forth. Retirement spending needs can be estimated from existing spending levels or by using ‘affordability estimates’, where we use accumulated wealth to determine the maximum sustainable spending levels. This gives us a starting point to determine how much additional cash we need to generate.
Income Investing
Income investing strategies focus on generating cash from investments that generate current income. The basic idea is to find a solution that preserves capital while spending only as much as generated by income. This income is typically provided by interest on CDs, bonds and possibly dividend paying stocks (or stock funds). There are several drawbacks to this approach:
Concentration risk. The income investing strategy may concentrate assets to heavily in one asset class, such as bonds. The diversification benefit of stocks could be lost.
Inflation risk. Inflation needs to be considered. Bond interest may be sufficient to meet current needs, but over time inflation increases the spending needs and reduces the real income provided by a fixed-income heavy strategy.
Taxes. Ordinary dividends are taxed as income. The maximum marginal rate at the federal level is 39.6%. Qualified dividends are taxed at lower rates. After considering taxes, the most efficient plan may not be an income heavy approach.
Total Return Approach
In this approach, the emphasis is on building and maintaining a long-term plan to meet spending needs including adjustments for inflation. Diversification and managing overall portfolio risk are maintained. But how can we meet income needs with investments that don’t have an income focus?
First, we take income produced by interest and dividends. Second, any income needed in excess of this can be created by liquidating a small portion of portfolio holdings. Over a long period of time, maintaining a portion of the portfolio in equities should help to grow the portfolio at rate greater than or equal to inflation. The rate of portfolio liquidation is kept low to ensure that the total return provided by the portfolio will meet all future spending goals.
What about stocks that pay dividends, aren’t they better than stocks where no dividend is being paid? Not necessarily. The value of a company comes from its earnings potential. The distribution of earnings to shareholders can come in several different ways. A company can pay out earnings in the form of a dividend. If the company doesn’t pay a dividend but reinvests the earnings and generates additional returns, the price of the stock should appreciate. Alternatively, a company could buy back shares, increasing the earnings per share. Absent taxes, we should be indifferent to how we are compensated. If the company does not pay a dividend, we could simply sell a few shares each year and create our own dividend. We generate the same level of return through capital gains on the stock price.
Guaranteed Income/ Immediate Annuities
The basic idea with income annuities is to convert a lump sum of money today into a future income stream. There are many forms of annuities. Some payout a fixed amount, others payout based on a formula derived from investment returns. Payouts may be based on a fixed term or as long as you and/or a surviving beneficiary are alive. Annuities are complex and generally come with very high fees and expenses. Analyzing an annuity to determine the actual return you will receive is difficult.
In most cases, once you have purchased an annuity you give up your future principal. Think of an annuity as a form of insurance where you are managing the risk of outliving your assets (longevity risk). Income annuities are usually irreversible (or very costly to reverse) and are illiquid. Analyzing how income annuities can be used in an overall investment strategy requires complex simulation tools. In some scenarios, holding up to 15-20% of your portfolio as an annuity may reduce risk of a portfolio shortfall.
Annuity payments are treated as ordinary income for tax purposes. This makes them less attractive to those in higher income tax brackets.
In short, there are a significant number of issues with annuities and I would recommend that anyone considering one get professional help to analyze the annuity based on one’s overall financial plan and investment portfolio strategy. (Brightwood Ventures, LLC does not sell annuities. We do not receive any compensation based on annuity products. Given the complexity of annuities, the number of drawbacks and the current low interest rate environment we do not believe annuities are appropriate in many cases.)
Conclusions
We hope this article has provided a good introduction to the retirement income investment strategies. We outlined the overarching goals that the income investment strategy should: 1) provide for a high-confidence long term plan to meet spending and distribution goals, 2) provide cash flow needed for current living expenses, and 3) that the plan be efficient from a tax perspective. We introduced three broad categories of investment strategies including: income investing, total return approach and guaranteed income approaches. We believe that the total return approach should be the core strategy for meeting needs of the distribution phase of wealth management.