Courtesy Portfolio Solutions, LLC
Greek mythology tells us that Icarus flew too close to the sun on wings made of feathers and wax. During Icarus’ escape from Crete, the heat from the sun melted the wax holding his wings together, and sent him plummeting into the sea where he drowned.
The story of Icarus is an allegory for the danger of hubris. Investors ready to fly into retirement should beware the hubris of trying to live off of only the income yielded from their assets to avoid touching their accumulated principal.
As a retirement investor, your goal is to transition your investment portfolio from a source of asset growth into a consistent source of income; however, by focusing on income while overlooking growth, you may fail to generate the cash you need for retirement expenses — as well as burn away your portfolio.
To illustrate, let’s see how an income portfolio matches up with a total-return portfolio.
Income Portfolio
An income portfolio predominately favors assets that yield income, typically dividend-paying stocks and bonds with high interest payments. Its purpose is to provide an income stream from your investments without having to tap your principal. Some believe an income portfolio has lower risk since you are not investing for growth, which can subsequently extend the life of your money.
For most investors, however, the ability to use only dividends and interest to fund retirement expenses is nearly mythological itself.
Consider the illusion of dividends. Dividends distributed to shareholders come from a company’s earnings. Typically, when a company declares a dividend its stock price drops by the same amount when the market opens the next day.
For example, you decide to invest $100,000 and buy 1,000 shares of a stock that sells for $100 per share. The stock pays a $1-per-share quarterly dividend. In reality, you would have your initial investment (all else equal), but now it is $99,000 in stock and $1,000 in cash. Spending the cash would be the same as spending from your principal.
A company doesn’t have to provide a dividend, and if it does, it chooses when and by how much. Therefore, you have very little control over this type of investment income.
Bond yields can be equally inconsistent and insufficient, especially during periods of low interest rates. According to a Vanguard report, the historical average nominal return for bonds was 5.5% from 1926 – 2012. Meanwhile, the median inflation rate from 1950 – 2012 was 3.1%. An all-bond portfolio would be highly subjected to the corrosive effect of inflation, decreasing your buying power. The small return is reduced further by investment costs and taxes. This explains why bonds are better risk stabilizers than income generators.
From a return perspective, at best, an income portfolio may work if you need a small income amount and have a large portfolio balance.
In addition to potentially inconsistent and insufficient cash flows, another disadvantage of an income portfolio is the loss of security provided by diversification. Broad diversification across several asset classes can reduce your portfolio’s vulnerability to a steep decline by spreading risk.
According a Dimensional Fund Advisor report, global companies offering dividends was around 60% in 2012. That means if you fill your portfolio only with dividend-paying stocks, you exclude nearly 40% of global companies.
Moreover, an all-bond portfolio is by definition vulnerable to the price movement of a single asset class. That means you could expect lower risk and higher return by adding stocks, even though it is a more risky asset class.
Total-Return Portfolio
Unlike an income portfolio, a total-return portfolio maintains a mix of assets for their growth potential as well as turning their gains into income. You use dividends, interest payments and your principal as a cash flow for retirement. A more balanced portfolio can provide greater flexibility, risk protection, tax efficiency and longevity.
Instead of chiefly relying on a corporation to decide when to distribute a dividend and by how much, you can generate the same amount of cash with a strategy known as making “homemade dividends.”
If you sell 10 shares of a $100 non-dividend-paying stock of which you own 1,000 shares, then you have the same $1,000 as in the scenario used above; however, what you also have is greater control over the amount you receive and when you receive it.
Investing in broadly diversified investments such as a total stock index fund or total bond index fund still gives you exposure to income-producing assets but with lower risk. Additionally, maintaining an exposure to stocks, because of their high growth potential, can provide a hedge against inflation that you lose by favoring bond yields in an income portfolio.
A total-return portfolio can also be more tax efficient than an income portfolio. Dividends are taxed at the same rate as long-term capital gains, which is typically around 15%; however, you are taxed for the entire dividend amount, whereas shares sold are taxed only on their gain. Further, a portfolio heavily tilted to bonds could increase your tax liability, depending on your tax bracket, as interest is taxed as ordinary income.
Although a total-return portfolio means tapping your principal, its growth potential has been shown to provide a higher probability to last over your retirement. In a published Trinity University study using historical stocks and bond returns spanning 1926 – 1995, researchers found that an all-bond portfolio had only a 20% chance of lasting over a 30-year retirement period at a 4% inflation-adjusted withdrawal rate. Meanwhile, a total-return portfolio split evenly between stocks and bonds had a 95% probability of survival.
Your investment portfolio should be a reliable source of income during retirement. With that goal in mind, dividends and interest payments are important, but so is growth. A total-return portfolio can help prevent you from trying to fund your retirement while perilously flying too close to the sun.
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