Holistic Income
Today’s interest rates are low. For those of us saving for retirement, that is typically not a big concern since we are growing our assets and allocating a fair portion of our portfolios to stocks. We have bonds (preferably short to intermediate term government bonds) in our portfolios to mitigate the volatility of stock returns. This stage of investing life is often called the accumulation stage. When we reach the decumulation stage (retirement), taking money from our portfolios to live on, we are often very concerned with the level of interest rates. We want to preserve our principal and live off of the dividends.
A Vanguard paper by Jaconetti, Kinniry, and Philips addresses the dilemma faced by retirees in this low-interest rate environment. It notes that today’s retirees are faced with three primary choices:
- Spend less
- Reallocate their portfolios to higher-yielding investments
- Spend from a well-diversified portfolio’s total returns
Spending less is an option for discretionary spending (i.e. travel, dining out, gifts, hobbies, charitable donations, economic outpatient care for adult children, home remodeling, etc.) and gives a retiree the best control over the risk of running out of money. Many retirees haven’t saved enough to have significant discretionary income. All of their income must go to meeting necessary expenses such as food, housing, medical expenses, insurance, and utilities. Spending less is not an option for them.
Reallocating to higher-yielding assets is another option. To do this, an investor has to depart from a well-diversified portfolio and heavily weight asset classes such as high-yield (junk) bonds, longer-term bonds, emerging market bonds, and high dividend stocks. Jaconetti et al. analyze the risks of this approach in detail. The bottom line for investors who overweight their portfolios to “stretch for yield” is that they increase the risk of greater volatility and default in their portfolios. Most retirees are risk averse, so this strategy conflicts with their desire for safety. In fact, many may not be aware that they are adding significant risk of running out of money by stretching for yield.
The third option, the total return approach, is relatively simple. Develop a well-thought out plan for retirement, build a well-diversified portfolio that supports the plan, and take income from the portfolio in a tax-efficient manner. The authors note that the total return approach offers advantages over the “stretch for yield” approach in the following ways:
- Maintains a portfolio’s diversification (risk exposure)
- Allows the portfolio to be more tax-efficient
- Increases the portfolio’s longevity
An advantage not noted by the authors is that a well-planned total return approach to investing, the investment policy is consistent throughout the retiree’s lifetime. He or she doesn’t have to search constantly for the next big thing in high-yield investing. One can enjoy the comfort of knowing that by following a well-designed total return approach they are using the best strategy known to finance their retirement.
