The purpose of this series of posts is to demonstrate why we believe a total return approach is a better option than a pure income approach when investing to fund living expenses, particularly in today’s low-interest-rate environment. We hope that convincing investors of this will pay them dividends in the form of better returns.
In parts 1 and 2 of 4, we considered some of the pitfalls of investing in investments that primarily cast off income. Part 3 considered the reasons to build portfolios with risk and return, as opposed to income, as a primary focus. Part 4 addresses how we tackle this ‘total return’ approach and address issues such as distributions, taxes, and perhaps out clients’ greatest concern, capital preservation.
DISTRIBUTIONS AND TAXES
In order to handle actual distributions from a practical standpoint, we recommend a couple of strategies. First, allow the investments to pay interest and dividends to cash instead of being reinvested, creating cash for upcoming portfolio distributions. Second, if there isn’t enough cash available for a distribution, rebalance the portfolio. For example, if stocks have done well in relation to bonds, they would likely be overweighted relative to their target allocation and can trimmed back to meet the investor’s withdrawal needs. Similarly, if stocks were down, the investor’s bond positions would probably be overweighted, so sell some bonds.
Admittedly, this is a bit more work than having a steady stream of income coming in all the time, but it has a couple of key advantages. As we discussed in Part 3, in a total-return approach, a portfolio can be more diversified and own all kinds of investments: domestic and international equities, small-cap stocks, both high-yield and investment-grade bonds, and so on. This diversification has advantages for distributions because it offers more options for rebalancing (it’s more likely that something is up—and something is down—in a more diversified portfolio). In contrast, focusing solely on income-oriented investments casts a narrower net and offers fewer options from which to choose.
Furthermore, focusing on income generation isn’t always very tax efficient. Obviously municipal bonds generate tax-exempt interest, but the yields on those bonds—and indeed most bonds these days—are not very high, so an investor would need to own a lot of them to fund their living expenses. A total-return approach enables investors to shift a meaningful portion of their tax liability to long-term gains. Whenever cash is needed to cover additional expenses, the portfolio can be reviewed for securities that can be sold with the least onerous tax consequences associated with them. This could include investments with long-term gains (which are taxed at a lower rate than income), or possibly even investments that are underwater such that selling them would generate tax losses. In a diversified, total-return oriented portfolio, an investor has more control, and greater potential to maximize after-tax returns.
CAPITAL SUFFICIENCY—NOT EVERYTHING LASTS A LIFETIME
The other essential part of investing during the distribution phase is truly understanding each investor’s income needs and evaluating their resources for meeting them. We suggest a retirement capital analysis to assess sustainable retirement income withdrawals. In what we believe is likely to be a lower return environment for some years ahead, it is critical to use realistic and conservative assumptions in determining what rate of withdrawal is possible over longer periods. But returns are only a guess, and ultimately, the only factor that can be controlled with any certainty is the investor’s rate of withdrawal and spending. We always hope to generate returns that are better than our assumptions, and reassessments over time can generate confidence that higher withdrawals can be taken safely. But getting the trajectory wrong early on can create lasting problems. Therefore, opting for a realistic, conservative withdrawal rate is essential.
A FINAL WORD
We encourage our readers to let go of the idea that portfolio distributions must by definition come from investment income (bond coupon payments, dividends, etc.). Letting go of this idea creates the opportunity to build a more diversified, durable, and potentially higher-returning portfolio strategy.
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