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How to extract income from a retirement portfolio

Christine Benz  |  20 Mar 2018Text size  Decrease  Increase  |  
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Because yields and market returns often move in different directions, I think it's advisable to take a flexible approach to generating cash flow for retirement.

When the yield gods are cooperating, a portfolio's income may provide all of a retiree's cash flow needs and then some. But when yields are meagre, as they have been for the past decade, pruning appreciated positions to meet living expenses is a way to raise cash while also reducing a portfolio's risk level.

Holding a cash "bucket" and/or employing a simple annuity product are other tools that can help stabilise a retiree's cash flows.

Here's a look at the pros and cons of various cash-flow generating strategies that retirees might employ.

An income-centric strategy

This is the old-fashioned way of generating income from a portfolio: building a portfolio with an eye toward income production, then relying on whatever income distributions that portfolio's stock and bond holdings kick off.

On the plus side, such a strategy allows a retiree to leave his or her principal untouched; that's one reason that retirees with a bequest motive often gravitate to income-oriented strategies. Subsisting on income alone also helps ensure that a retiree will never spend all of her assets in her lifetime, which can provide valuable peace of mind.

The big knock against an income-centric approach, however, is that income can fluctuate, often substantially, and many retirees are seeking stable cash flows in retirement. That leaves income-minded retirees with two choices: Make do on whatever income their portfolios serve up (which can result in dramatic changes in a retiree's standard of living) or attempt to keep their portfolios' yield production stable, even if it entails taking greater amounts of risk.

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As yields have trended down over the past decade, many retirees have opted for the latter strategy, venturing into higher-yielding stocks and bonds. Another risk of income-centric strategies is that they forego low-yielding securities that might bring diversification to the portfolio--growth stocks and short-term high-quality bonds, for example.

A pure total return approach

In contrast to the income-centric strategy outlined above, a retiree using a total return strategy doesn't focus on income as a going concern. Rather, he or she builds a well-diversified portfolio encompassing income-producing and capital-gains-producing investments, then reinvests all income distributions back into the portfolio.On a regular  basis, the retiree then harvests appreciated positions to help meet living expenses.

Rebalancing regimens vary: Retirees might rebalance only when their allocations to the major asset classes veer meaningfully from their targets, while others might trim individual securities that have appreciated, even if the total portfolio's asset allocation hasn't changed meaningfully.

A big positive of the total return approach is that because income isn't the overarching priority, a total-return-oriented portfolio is apt to be better diversified than an income-centric one, encompassing growth and value stocks, as well as high-quality and lower-quality bonds. Moreover, the process of rebalancing--periodically scaling back the total return portfolio's appreciated positions--can help reduce a portfolio's risk level. Of course, there's nothing stopping an income-centric retiree from rebalancing, either, but there's no built-in impetus to do so.

On the downside, there will be years in which a total return portfolio hasn't appreciated enough to warrant rebalancing; in such an instance, holding a cash bucket alongside the total return portfolio can come in handy.

Additionally, a too-aggressive rebalancing regimen can prompt a retiree to scale back on appreciating assets prematurely, and can also trigger heavy tax costs for retirees with large shares of their portfolios in taxable accounts. Of course, holding and spending income-producing assets in a taxable account also carries tax consequences.

Finally, retirees may derive peace of mind if their portfolios deliver a baseline of their living expenses via income distributions; with a pure total-return-oriented strategy, the retiree is reinvesting all of those distributions rather than spending them.

A blended strategy

This strategy brings together the two aforementioned approaches. A retiree builds a total-return-oriented portfolio with a mix of income- and capital-gains-producing securities, then funds living expenses with a mixture of income and rebalancing proceeds. If the portfolio's organically generated income is insufficient, rebalancing proceeds can make up the shortfall.

In many respects, this strategy melds the best attributes of the two aforementioned approaches. A retiree using a blended approach can receive a healthy share of his or her cash-flow needs via organically generated income distributions; that can provide peace of mind. But because the retiree isn't going out of his or her way to generate income, the portfolio is apt to be better diversified and more all-weather than the income-centric portfolio.

The key drawback of this approach versus a pure total return approach is that by spending, rather than reinvesting, income distributions, a retiree could starve the portfolio of some return potential. After all, yields on securities are often highest when their valuations are most attractive.

Annuities: A lifetime income stream

Discussing annuities alongside the aforementioned portfolio approaches is a bit like putting a pear in a bowl of oranges: Buying an annuity involves parting with a piece of your assets in exchange for guaranteed cash flows, whereas the previous three strategies revolve around extracting cash flows from a conventional portfolio.

In addition, annuities provide a baseline of lifetime income, whereas the other strategies may or may not supply income for life.

The lifetime income that one receives from an annuity is a huge benefit for retirees who are concerned about outliving their assets; it's one reason academic investment researchers like annuities so much.

Annuities may also offer a better payout relative to other "safe" investments because they allow retirees to pool their risks together; because an insurer knows that some annuitants will die early, it's able to boost returns for all.

Yet there are a couple of big drawbacks to annuities, too. One is complexity: While plain-vanilla immediate annuities are transparent and can be inexpensive, many other annuity types are opaque and costly. An insurer's creditworthiness is another potential risk factor.

Loss of control is a drawback, too, in that assets steered into an annuity are no longer part of the retiree's portfolio.

Finally, it’s worth noting that the current low-yield environment has depressed annuity payouts relative to where they’ve been historically.

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Christine Benz is Morningstar's US-based director of personal finance.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

is Morningstar's director of personal finance.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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