How Do Retirees Earn the Income They Need?

Eric Linser, CFA | July 30, 2009

If you listen close enough, you might hear the stampede of retirees running down to Wal-Mart for the newly opened "greeter" position. I hope it doesn't come to that, but it is tough to make ends meet, especially when expenses are up and income is down.

Those just retiring or looking to retire definitely know there is risk in their investment portfolios. They face risk from outliving their savings and from inflation which erodes the purchasing value of their money, which is why it's to take a look at several basic strategies for generating and managing income in retirement.

The financial aspects of retirement are neither new nor unfamiliar. A multitude of retirees are currently managing a variety of income sources, including Social Security, pension payments, and investment income.

Right now, about 1/3 of Americans age 65 or older are receiving lifetime pensions from their employers. However, more and more retirees don't have these traditional defined benefit pensions. In their place, many employers are sponsoring defined contribution plans that lead to a lump-sum benefit at retirement. The challenge becomes how to translate this lump sum into a source of income that will last through the retirement years.

We review some common strategies for generating and managing income in retirement: portfolio-based approaches such as income investing and total-return spending. Investors should keep in mind some important principles as they assess the trade-offs associated with each approach. Then they can implement the strategy, or combination of strategies, that meets their personal goals.

The first thing to do is to take an inventory of your income sources. Some of the most common are Social Security, pensions, part-time employment, and rental income or trust income. The inventory should also include investment cash flows, such as any required minimum distributions from tax-deferred accounts (beginning at age 70 ½) and dividends, interest, and capital gains distributions from taxable accounts. Since cash flows from the investment portfolio will be subject to taxation, this money should be the first resource tapped to meet spending needs. That allows the assets that remain to be working for you.

Next up is to have your income flows directed to a “spending account,” which is typically a money market fund or bank checking account. The spending account is a convenient cash management vehicle, serving as a repository to which cash flows are directed and from which expenses are paid.

How much should be held in the account? This is an individual decision, but a good rule of thumb is to have enough funds on hand to cover at least 6, 12 or 18 months of anticipated spending needs. Investors who have specific short-term goals – for example, a home improvement project or a vacation – might opt to keep a higher balance in the spending account.

If the cash flows in the spending account suffice for the retiree’s needs, then there is no need for withdrawals from the investment portfolio. Any significant surplus in the spending account may be reinvested in the portfolio to help with periodic rebalancing when the target asset allocation needs to be restored.

But what if the cash flows are not sufficient? In this case, the investor will have to find ways to increase cash flow from the portfolio. I have highlighted a few of the most common strategies. It‘s important to note that these strategies are not “all or nothing” – investors can choose more than one and tailor them to a particular situation.

Income Investing

An approach to focus on income-generating investments. Basically, the investor spends only the income such as interest and dividends that the portfolio generates. Retirees who adopt this approach believe that by not touching the account principal is a safe strategy of not running out of money. In some cases this is an effective strategy. However, only investors who have very large portfolio balances or low spending needs will be able to do this while meeting their spending goals and keeping their portfolios diversified. Those wanting to increase current portfolio income may forgo diversification and turn to increasing the portfolio’s allocation to bonds or tilting the equity allocation toward higher dividend paying stocks. Those who follow these approaches have a goal of preserving principal but the value of invested principal and income will fluctuate with market prices, and income obtained may note keep up with inflation over the long term.

This income investing strategy has two fundamental draw-backs. First is concentration risk. A portfolio exclusively focused on income will be overweight fixed income investments or equity investments that generate high dividend payouts. Such a portfolio will lack sufficiently broad diversification and growth potential to generate income. A high dividend paying stock strategy typically is disproportionately invested in bank stocks and real estate investment trusts. In 2007 and 2008, the stock prices in this area got decimated and dividends were severely slashed. Secondly, there are tax ramifications in taxable accounts and distributions from income generating investments, such as taxable bond funds are subject to income taxation. Income is highly taxed – current marginal income tax rates go up to 35% (presently) and in some cases more when state taxes are included, especially California – so the impact on a retiree’s net income can be significant.

To address retirees’ needs we offer an Income approach – a globally diversified portfolio with a higher concentration of fixed income securities and other income producing securities than in our Growth & Income portfolio, along with some growth oriented securities to help offset degradation to the portfolio’s principal by inflation.

The Total-Return Spending Approach

The preferred alternative to income-only investing is a total-return spending approach, in which the investor spends the income and taps the principal when necessary. The income is used first; then, if it proves insufficient to meet spending needs, the investor liquidates some portfolio holdings. Here, the investor doesn’t base investment decisions on maximizing income, but rather maintains portfolio diversification, allowing for long-term portfolio growth.

The primary advantage of a total return approach is that it offers the potential to increase the longevity of the portfolio, reduce the number of times that it needs to be rebalanced, and increase overall tax efficiency. Investors can employ this approach through our Growth & Income portfolio, an “all-in-one” approach, or by creating a customized spending plan.

Our Growth & Income portfolio offers investor a diversified single-portfolio approach – providing professional investment management while transferring the complexities of portfolio construction to the advisor. Benefits for the investor include asset allocation and automatic rebalancing, diversification, convenience, and simplicity. An all-in-one approach provides a bundled approach by combining asset classes, sub-asset classes, and management style into one fund.

The Growth & Income portfolio can offer great convenience to retirees who are spending from their portfolios. For this purpose, investments can be generally be differentiated by how their payment mechanics work (income investing versus a total-return approach). An investor can select the type of approach that is best aligned with his or her goals and create a withdrawal program.

A Customized Portfolio Spending Approach

For investors who have taxable and tax-advantaged accounts, the biggest drawback of all-in-one funds is the inability to maximize tax-efficient portfolio construction and to implement a tax-efficient withdrawal strategy. By creating a customized spending program, investors can gain flexibility and greater control over tax liability.

Investors who create a customized plan should consider these guidelines:

• Asset allocation. As with any portfolio, the most important task is to establish a target allocation among asset classes including stocks, bonds, and cash reserves. The desired income level should not govern this target; rather, it should be based on the investor’s objectives, time horizon, and risk tolerance.

• Asset location. An investor who has both taxable and tax-advantaged accounts generally should seek to maximize the portfolio’s after-tax returns with appropriate asset location. From an asset location perspective, is preferable to hold tax-efficient stock investments (such as broad market index funds/exchange-traded funds, or tax-managed funds) in taxable accounts. Tax-inefficient investments (including actively managed stock and taxable bond funds) should be held in tax-advantaged accounts, such as traditional and Roth IRAs.

• Order of withdrawals. For investors who do not have taxable assets with large embedded gains or considerations involving specific bequests, it is generally most tax-efficient to spend from taxable accounts before spending from tax-advantaged accounts. This order allows the tax-advantaged accounts to keep earning, improving the likelihood that the portfolio will not be depleted prior to the planning horizon. (For an investor with larger retirement portfolio than his or her taxable account, it may make sense to deplete the retirement account at an accelerated rate, depending on circumstances)

• Rebalancing. It is always a good practice to monitor the portfolio for rebalancing on a semiannual or annual basis. When selling assets to meet spending needs, the investor should choose holdings that will help rebalance the portfolio to the target allocation.

For motivated investors, implementing a personalized spending program can be a manageable process that provides the most control over both portfolio holdings and withdrawals. However, as the complexity of holdings and account types increases, so do the management responsibilities. Some investors, especially those who have complex needs, such as estate planning and wealth transfer objectives, may benefit by working with a professional advisor. An advisor can help implement processes such as a tax efficient spending program. These benefits need to be clearly weighed against the costs, which can vary among advisors.

As you can see, managing a spending program is a process that needs someone in charge – you can either do it yourself or work with an advisor to do it for you. Over time, the advisor can adapt the investment and distribution program to meet the retiree’s own changing situation. The advisor also can help with balancing the individual’s current income needs and estate planning objectives, while providing for the portfolio’s long-term durability in dynamic, and uncertain, financial market and tax environments.

Give us a call, we’d be happy to assist you in making informed decisions.

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