For many investors there is an intuitive appeal to owning income-producing investments and the idea of living off the cash flow (coupon payments, dividends, etc.), while leaving the principal to grow undisturbed.
For investors looking to fund living expenses through retirement though, we’ve found the better approach is to seek the best overall return possible consistent with their risk tolerance, then to use that return as the source of funds to meet their spending needs. Below we walk through specific reasons we believe a total return approach is the best option for funding living expenses and discuss how we work with clients in the withdrawal phase of their investment lifetimes.
Why “Living on the Income” Won’t Work
For those without a very high ratio of assets to required spending there just isn’t enough income for that approach to be successful. For most investors seeking income, the goal isn’t just to fund living expenses, it is to have enough money to last the rest of their life while keeping inflation from eroding the value of their principal. Especially in today’s environment of historically low yields, a portfolio limited to investments that generate current income all but guarantees they won’t achieve those goals. Here’s why:
There are no free lunches in investing. Every investment needs to be evaluated in a broader portfolio context that takes into account your goals and risk tolerance as well as other investment opportunities available at the time.
What’s Better About a Total Return Approach?
The bottom line for most income investors is that they need to have a sustainable withdrawal plan to fund living expenses. The investments they own as part of this plan are a key component in determining how much they can realistically take out over time.
In a total return approach, a portfolio can be more diversified and own all kinds of investments: domestic and international equities, smaller-cap stocks, both high-yield and investment-grade bonds, and so on. In contrast, focusing solely on income-oriented investments casts a narrower net and offers fewer options from which to choose.
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 could be sold with the least onerous associated tax consequences. This could include investments with long-term gains (taxed at a lower rate than income), or possibly even investments that are underwater and generate tax losses that can be used to offset gains elsewhere in the portfolio. In a diversified, total-return-oriented portfolio, an investor has more control and greater potential to maximize after-tax returns.
Our approach has always been to try to generate the highest total return without exceeding a client’s risk tolerance. Seeking the best return for a given level of risk lets us build more diversified portfolios, which is our primary focus in building portfolios. We work hard to get a sense of probabilities and downside severity, but good diversification lets us build portfolios better suited to a variety of outcomes. An investor who is regularly withdrawing living expenses needs a portfolio that will provide far into the future. Inflation steadily erodes the value of those dollars. Trading return potential for the sake of current income makes the challenge of meeting financial goals even tougher.
Managing Portfolios in the Withdrawal Phase
Our Conservative Balanced portfolio is often the starting point for an investor in the distribution phase. We also offer an even more conservative strategy, the Defensive Balanced portfolio, which has an 80% bonds/20% stocks target allocation. Both strategies are tilted toward income-generating investments, but the overall portfolio for each is constructed to maximize total return within the stated level of risk, which we define as a 12-month loss threshold (a 5% loss for Conservative Balanced; a 2.5% loss for Defensive Balanced). In trying to maximize total return, we own a mix of investments with different drivers of return and varying risk exposures. By combining them we seek to reduce overall portfolio risk and create a portfolio more likely to meet a given investor’s return objectives while keeping any potential losses within an agreed upon risk tolerance.
The reality is, of course, that these portfolios will likely own a lot of bonds due to their lower risk profiles. (Even with their vulnerability to rising rates, bonds are far less risky than stocks.) But even in our strategies with large strategic allocations to core bonds, we hold other investments that have the potential to generate more attractive returns without undue risk.
We currently own a number of flexible and absolute-return-oriented bond funds in these portfolios. We evaluated these funds’ potential contributions from a total return perspective and in the context of their overall investment strategy and targeted risk levels. Given the portfolios’ total return mandate, we are also able to incorporate small allocations to riskier investments we think have higher return potential. This is only possible in a broader portfolio context where we are able to offset this risk with lower risk holdings and with positions that have low correlation with one another. Emerging-markets stocks is another example of an asset class we hold as a source of long-term return opportunities even within our conservative strategies.
The Importance of Risk Management
Our risk discipline is paramount in managing short-term volatility, which is of particular concern to investors reliant on their investment portfolio to supply living expenses. Other investors may have a large financial obligation coming up in the near future (such as a down payment on a house, a new car purchase, or education funding for their children), and would be negatively impacted by a short-term drop in their portfolio’s value.
These investors need to own a portfolio that is unlikely to perform poorly if the stock market takes a spill. Otherwise they could be in the unfortunate situation of having to sell equities right after suffering a big loss. That can be harmful in the long run because it depletes the portfolio’s capital at the worst possible time. Because bonds generally are not very volatile, they provide investors with an asset likely to hold up at least fairly well, even if their equity holdings get hammered by a bear market.
When we do take on risk, we undertake extensive stress-testing as part of our evaluation process. We want to have very high conviction that the return potential warrants taking on the risk and that we are managing the overall portfolio to stay within its loss thresholds in most market environments.
Capital Sufficiency—Not Everything Lasts a Lifetime
The other essential part of investing during the distribution phase is truly understanding investors’ income needs and evaluating their resources for meeting them. In our private client business, we undertake capital sufficiency analysis to assess sustainable retirement income withdrawals. (The term “capital sufficiency” refers to how long a portfolio will last at a given return and withdrawal rate.) In what we believe is likely to be a lower return environment for some time to come, 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. While reassessments over time can generate confidence that higher withdrawals may be taken safely, getting the trajectory wrong early on can create lasting problems. Therefore, opting for a realistic, conservative withdrawal rate is essential.
A Final Word
Letting go of the idea that cash flow needs can only be funded from investment income creates the opportunity to build a more diversified, more durable, potentially higher-returning portfolio strategy. We believe that whether investors achieve investment objectives and maintain adequate capital to meet their spending needs is ultimately driven by overall return.—Litman Gregory Investment Team
Alice Lowenstein Earns CSRIC™, Sustainable, Responsible & Impact Investing Designation
We are pleased to share that Managing Director Alice Lowenstein has obtained the Chartered SRI Counselor designation, the first major financial credential dedicated specifically to sustainable, responsible and impact investing. This designation demonstrates Alice’s knowledge of SRI principles and best practices.
As 2020 comes to a close, we join in the enthusiastic farewells to this truly unique year, and also reflect on what we achieved with our clients through it all. Our colleagues worked against the grim tide of news and unprecedented events to support one another, discover our resilience, and ultimately deliver on our ongoing commitment to our clients.
Barron’s Article Featuring Gretchen Hollstein: 5 Tax Moves to Consider for an Unusual Year
Litman Gregory Senior Advisor Gretchen Hollstein was quoted in this recent Barron’s article, which offered ideas to consider before year-end. She describes some common planning strategies we utilize with clients, such as considering Roth IRA conversions and managing IRA required distributions in a unique tax year.