Retirees: If You Love Income, You Should Love Cash Flow Even More
You diversify your investments; why wouldn’t you diversify how you source your in-retirement living expenses?
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In the 1990s, wringing a livable income stream from a portfolio was eminently doable: The 10-year Treasury yield ranged from a high of 8% down to a low of about 5%. Those plump yields on safe securities, while down a bit from their sky-high levels in the inflationary 1970s and early 1980s, meant that income-minded retirees didn’t have to venture into lower-rated bonds to generate income for living expenses.
But the environment got more challenging for income-focused investors in the 2000s. Ten-year Treasury yields first dropped below 4%--often used as a benchmark for retirement-portfolio withdrawals--in 2003. During the global financial crisis later that decade, 10-year Treasury yields fell below the 3% mark as the Federal Reserve adopted its zero-interest-rate policy in an effort to get the economy back on track. That gave retirees who were determined to live on portfolio income a cruel choice: settle for less income or venture into lower-quality, higher-yielding securities to sate their income needs. Not surprisingly, many investors took the latter route, venturing into various types of income-producing securities: master limited partnerships, emerging markets bonds, and floating-rate loans, to name a few.
A decade and another (still unfolding) economic crisis later, conditions are more challenging than ever for income-minded investors. As of early June, the yield on 10-year Treasuries is only 0.66%, while Bloomberg Barclays Aggregate tracking index funds are yielding just over 1%.
To be sure, yields on lower-quality bonds have gotten more compelling than they were at the outset of 2020, in part because they haven’t fully recovered from the drubbing they took during the equity-market rout in the first quarter. For example, it’s not hard to pick up 6% on a high-yield bond fund, and floating-rate and emerging-markets bond funds have payouts in that same ballpark. Meanwhile, many high-yielding equities, as well as mutual funds and exchange-traded funds that invest in them, sport attractive yields of nearly 4% or even higher. But with the higher yields of all of those investments comes the potential for higher risk, especially if the economy doesn’t recover quickly and/or stocks take another nosedive.
Current conditions reinforce what has been growing apparent for the past several decades: Rather than chasing ever-shrinking income sources--and risk under-diversifying and courting extra volatility in the process--retirees should focus on generating cash flow in retirement instead. Whereas an income-only mindset limits retirees to subsisting on current yield, a cash flow approach enables the retiree to meet living expenses from a variety of sources: Social Security and pension payments, annuity income, rebalancing proceeds, withdrawals of principal, and yes, dividend and income distributions. And the broader the base of cash flow resources, the greater the diversification and flexibility to maximize the investment portfolio's risk/reward profile. If something changes with one type of cash flow source, you have other options in your tool kit.
If you’re laying the groundwork for your financial plan in retirement, or if you’re already retired, here are the key items that should be in your cash flow tool kit.
Non-Portfolio Cash Flow Sources (Lifetime)
This grouping includes Social Security, of course, as well as pension and fixed-annuity income. These cash flow sources are the most valuable part of any retirement plan. For one thing, they’re stable and not subject to market volatility. Even more important, they’re largely lifetime income streams, so they’ll be there even when a portfolio is dwindling.
That's why maximizing these non-portfolio cash flow sources is mission-critical for retirees. For example, while the increased benefit from delayed Social Security filing isn’t always as great as is touted, delayed filing still makes sense in many situations, assuming people can hold off on claiming. Run the numbers based on your own situation and earnings history; married couples with different anticipated retirement dates and earnings records may find that claiming benefits at different times makes sense. I’ve been experimenting with Mike Piper’s free Open Social Security calculator and have found it to be incredibly helpful; you can even factor in potential benefits cuts to Social Security in order to determine the ideal filing date.
In a similar vein, retirees and pre-retirees with pensions will want to give due consideration to whether they take their pension as a lump sum or an annuity. As Morningstar contributor Mark Miller notes, the lifetime income and lack of market risk makes taking the stream of payments attractive in many situations. At the same time, the economic effects of the coronavirus pandemic will put additional stresses on pension finances.
Finally, the decision about whether to purchase additional guaranteed income through some type of an annuity is an incredibly complex one. In general, the academic literature indicates that adding a very simple, low-cost income annuity can help improve the longevity of a retirement plan. If you're venturing beyond these product types, it's crucial to understand what you're buying and what it will cost, and any trade-offs associated with the product.
Other Non-Portfolio Cash Flow Sources
In this idiosyncratic category of cash flow sources I’d include income from working, to the extent that you care to do so in retirement, as well as income from passive non-portfolio sources such as property rentals or royalties. Of course, whether you count on any of these cash flow sources depends completely on your situation and your personal preferences.
Additional non-portfolio cash flow sources may include cash values on life insurance as well as reverse mortgages. Retirement researcher Wade Pfau calls these “buffer assets," meaning that they’re most advantageous in periods when pulling from a portfolio is a bad idea because the holdings are depressed.
Portfolio Cash Flow Sources
The last big category, portfolio sources of cash flow, can be divided into three few main sections: income distributions, rebalancing proceeds, and withdrawals of principal (separate from rebalancing).
Income distributions: This is any income organically generated from the portfolio, including bond income and dividend distributions. As noted above, the extent to which retirees will be able to rely exclusively on income from their portfolios is incredibly time-period-dependent. In 2005, a portfolio consisting of 60% in a total stock market index and 40% in a Bloomberg Barclays Aggregate index would have yielded 2.9%; in 2010 the yield on such a portfolio dropped to 2.7%. Today, it’s about 1.7%. Dividend yields have remained fairly constant over that stretch, but bond yields have forced the portfolio’s yield down. Of course, it’s possible to boost that yield by emphasizing high-dividend-paying stocks and/or venturing into riskier bonds, but that tack can bring risks and also has the potential to reduce the portfolio’s diversification. High dividend-yielders tend to cluster in certain sectors, some of which have been hard-hit during the recent economic weakness--financials and energy stocks, especially.
Rebalancing proceeds: Rebalancing may be in the category of “nice to have” during the accumulation years, but it’s mission-critical during retirement. Scaling back appreciated positions by periodic selling achieves a few key objectives: It reduces risk in the portfolio (the main benefit of rebalancing during accumulation) and it also supplies a source of cash flows on an ongoing basis. Once required minimum distributions commence at age 72, rebalancing appreciated positions can help serve as a source for RMDs, too.
If there’s a drawback to using rebalancing for cash flow, it’s that rebalancing proceeds will be lumpy depending on how the market has behaved. Yet rebalancing not just at the asset-class level but at the position level can help address that. In 2020, for example, retirees looking to rebalance for cash flow might harvest appreciated positions in growth stocks and funds, which have dramatically outperformed the broad market and especially value names over the past decade.
Withdrawals of principal: Of course, rebalancing is a withdrawal of principal, too. But what if rebalancing proceeds are insufficient, and withdrawing portfolio income isn't enough? After all, income can ebb and flow based on market conditions, and rebalancing proceeds can be lumpy. (The year 2018 was one such year when having cash for portfolio withdrawals would have come in handy, and 2020 is shaping up as another.)
That’s why the third component of retirement cash flow sources is withdrawals of principal, separate from rebalancing. To the extent that you withdraw principal, it's wise to ensure that you're pulling from safe assets rather than disrupting your long-term portfolio. In the bucket strategy that I often talk about, cash is there to provide liquid assets for living expenses on an ongoing basis. In years when income is low and/or rebalancing opportunities are scant, the cash is there to tide a retiree through. Alternatively, some retirees use ladders of bonds and CDs in this context. No matter the specific approach, it's wise to maintain a source of liquidity on an ongoing basis to serve as backup in periods when the above cash flow sources come up short.