The myth about retirement income generation is that it relies primarily on the value of your assets throughout retirement – i.e., If asset values decline, so too will your income and your ability to outlive your assets. But that’s not the case if you own the right investments.
Unquestionably, this has been an unnerving time for investors. Even as the stock market appears to be clawing its way out of a bear market territory, the uncertainty going forward is palpable, especially for those near or in retirement. For many, there is nothing worse than watching their retirement account values gyrate wildly in step with the market, threatening their expectation of lifetime income sufficiency.
Except when it doesn’t. In fact, with the right portfolio structure, there isn’t any correlation between asset value and income generation. Meaning, regardless of how the markets perform, your income can continue unabated.
The Asset Value Myth
Much of the anxiety people feel about market values can be attributed to their lifelong fixation on accumulating assets as their primary source of future income. The fallacy with that is the belief that the amount of income they generate is based on the value of their assets throughout retirement. So, if asset values decline, so too will their income and their ability to outlive their income. But that’s not the case. Or, at least it doesn’t have to be the case if you own investments that pay naturally occurring income.
Sources of Naturally Occurring Income
Bonds
Consider investors who own bonds in their portfolios. Most bonds pay interest twice a year. If you pay $10,000 for a bond that matures in ten years, you can count on 20 timely payments occurring naturally over that period of time. The payment will be the same based on the bond’s coupon rate, regardless of what happens in the bond or stock markets.
The only thing that matters is the entity – government or corporation – that borrows the money from you in the form of a bond has a contractual obligation to pay interest to you. What does matter is the entity’s financial ability to pay that interest, which is why you should only invest in bonds backed by the U.S. government or high-quality companies.
Dividend-Paying Stocks
Stock dividends are another form of reliable, naturally occurring income. However, it wasn’t always that way. When companies began issuing dividends more than a century ago, they did so by paying out profits earned during a given period. During periods of profitability, shareholders received dividends. But, when profits were down, shareholders received smaller dividends or no dividends at all. So, as a source of naturally occurring income, dividends were not so reliable.
That all changed around World War II when companies started to utilize dividend payments as a way to increase shareholder value, which, in turn, increased their market value. A steady, reliable dividend attracts investors, which helps to maintain or increase a company’s market value. Instead of merely paying out their entire profits as dividends, companies paid out a portion of their earnings and retained a portion to reinvest in the company to grow its value and its dividends.
So, if a company earns $10 a share in a quarter, they might pay $3 as a dividend and retain $7. If earnings decline, they might still pay the $3 dividend but keep fewer profits. Why would they do that and not lower the dividend? Because maintaining and growing shareholder value have become paramount to high-quality companies to demonstrate sound management and financial stability. In fact, over the last six or seven decades, dividends have become sacrosanct, with most companies choosing to cut expenses elsewhere over lowering their dividends during tough times. These days, companies build up their cash reserves to ensure they can maintain their dividend.
Companies with a solid track record of paying and growing their dividends can be an excellent source of reliable, naturally occurring income. Many companies have never failed to make a dividend payment, and many of them have never decreased their dividends even as their earnings declined for some time. Therefore, if you receive a quarterly dividend payment from any of these companies, it doesn’t matter what happens in the stock market.
So, if you own bonds or dividend-paying stocks in your portfolio, you have sources of dependable, naturally occurring income you can’t outlive. And if your portfolio income, combined with other income sources such as a pension and social security, produces enough for lifetime income sufficiency, you should never have to worry about market turbulence or the value of your assets.
When There Isn’t Enough Naturally Occurring Income
However, many people can’t live off their naturally occurring income alone. It can be especially difficult during these times of historically low yields. That might not be a concern if the market continues to rise, because you can utilize that growth to capture gains to supplement your income periodically. However, if you are forced to sell stocks during a market pullback, you are potentially limiting your lifetime income sufficiency. Before taking that irreversible action, we recommend developing a deliberate strategy to preserve your assets during periods of market turbulence.
First, you need to ask yourself whether you need all of that income. Is your genuine need for income worth the tradeoff of selling assets for a loss? Are there things you can be doing to tighten your belt to live within your means until the market recovers in a year or so?
Second, if your situation is such that you do need to supplement your naturally occurring income, look to your bonds. Their relatively low yields are currently providing the least return on investment in terms of usable income. And, because the outlook for bonds over the next several years is not exceptionally bright, they would be the better option for liquidation. But, because bonds tend to be more resilient during stock market downturns, you wouldn’t necessarily be selling them at a loss. This would allow the stock side of the portfolio to recover and grow the portfolio to previous levels.
Finally, if you have to lean on your stocks for supplemental income, it’s essential to be strategic in determining which positions to tap. That’s much easier when you construct your investment portfolio with the potential for these kinds of market disruptions in mind. You can also use this opportunity for some strategic tax harvesting, which, when done right, can position the portfolio for more significant gains in the coming years. The point is, if you are very strategic when there is a need to invade your portfolio principal, you can still maintain lifetime income sufficiency.
