Investing for income might not be the safest way to manage your retirement portfolio. Income investments certainly seem safe in the short-term. The income usually is secure. You can plan on it. The principal value doesn’t have the great gyrations you see in the stock market.
But retirement can last 20 or 30 years. In that time, inflation will eat into the value of your income stream. If you don’t reinvest part of the income or find a way to increase it to compensate for inflation, your standard of living will steadily decline. When people are in danger of outliving their income, they compound the risk by reaching for higher yields. They search out highly volatile investments such as emerging market bonds.
That’s why I say that my Income Portfolio is for those with a time horizon of 10 years or less. Even then, I have some stocks and real estate investment trusts in the portfolio.
There’s a better approach for those whose money has to last longer.
Instead of investing for the amount of income you need today, put together a balanced portfolio and invest for the long term. Take whatever income the portfolio generates, then sell stocks or other investments each year to meet the rest of your spending needs. Don’t focus on the yield of your investments. Instead, focus on the rate at which you withdraw money and how that compares with the growth of the portfolio.
I’ve examined a number of studies that compare the results of this type of investing for retirees with traditional income investing. The balanced portfolio of stocks and bonds clearly is better than income investing. The keys are your withdrawal rate, allowing for higher withdrawals over time to make up for inflation, and your asset allocation. The studies all show that your initial withdrawal rate should be no more than 5% of the portfolio value. Withdraw more than that and you might run out of money if you live a long time. Also, the lower your portfolio allocation to stocks is, the lower your annual payout ratio should be.
Another benefit of investing for the long term and focusing on the withdrawal rate is that you can make adjustments through retirement. When the market has a few great years (as it has recently), you might be able to spend more. Or you might decide to keep your withdrawal rate steady as a hedge against bad markets. Also, you have the option of spending more in the early years of retirement, realizing that people tend to spend less as they grow older. They travel less and generally are less active.
You also can change your asset allocation from time to time. After some good years in stocks, reduce your stock holdings for a year or two until you see what develops.
These studies used historic annual returns from stocks and bonds. They include that tough bear market of the 1970s and some even go back to include the Depression.
Another benefit of this strategy is that you can pay lower capital gains taxes on gains instead of ordinary tax rate on income. That reduces the amount of money you need to withdraw each year.
Remember that the key is not to ensure the number of dollars you receive, but to secure the value of those dollars. With interest rates falling long term and the economy continuing to be healthy, the safest approach to investing during your retirement years might just be to ignore the traditional advice of switching to bonds. Instead, maintain a balanced portfolio of stocks and bonds for many years.