Total Return Versus Income Only
So how can an investor get to that 4 percent figure in today’s low interest rate environment? Many investors may take the approach of reaching for yield in riskier investment instruments -- for example, high-yield bonds, high-dividend-yielding stocks and preferred stocks. But this practice has its own risks.
For instance, during the market crash of 2007-2009, the prices of REITs and preferred stocks (80 percent of which are financials) collapsed along with those of common stocks. When a company decides to cut a rich dividend, investors not only lose out on that income but also in all likelihood see the value of the share price tumble. In many respects, reaching for yield equates to reaching for risk -- and not necessarily the kind that reliably rewards investors in the form of return.
It’s not uncommon for investors to try to meet their withdrawal needs solely through income-oriented investments. Not only is this particularly challenging to do given the current yield environment without incurring excessive amounts of risk, but a pure income strategy leaves a portfolio vulnerable to inflation, which is generally the greatest risk to investors over decades of retirement. Especially in light of increasing life expectancies, investors often underestimate the corrosive long-term effects of inflation.
In contrast with bonds, equities have historically done a good job of keeping pace with inflation. For instance, from January 1, 1926, to September 30, 2013, the S&P 500 index returned 9.98 percent annualized, compared with 2.98 percent consumer inflation over the same period. An investor who reduces his exposure to equities in favor of bonds is, in effect, making a trade: acquiring higher current income in exchange for a higher risk to the purchasing power of their future income.
Rather than attempting to alter their portfolios by overweighting bonds, increasing bond duration, or loading up on income-oriented stocks, investors would be better served by employing a total return approach, which allows for spending both from portfolio cash flows and from any realized capital gains in the portfolio assets.
Using this strategy, income generated by the portfolio’s investments is typically the first source tapped to meet spending needs, and when this source is insufficient the investor liquidates some holdings to make up the shortfall, in conjunction with periodic portfolio rebalancing. Note that in situations when the total portfolio cash flow is more than the annual spending requirement (a 4 percent withdrawal rate and a 5 percent yield, for example), the total return approach is generally equivalent to the income approach.
Returning to the case of a 4 percent withdrawal rate, for the majority of years from 1926 through 2012, the yield on a 50/50 stock/fixed-income portfolio either approached or exceeded 4 percent. Another noteworthy observation is that typically, when yields are less than 4 percent, this is due in part to the fact that the market has done well and thus the price-to-yield ratio is high. In such a scenario, liquidating some of the portfolio’s equity holdings for cash to meet the total income shortfall should not be too difficult, and may be advisable to reduce the allocation the portfolio now holds in highly appreciated stocks.
Conclusion
Determining the appropriate withdrawal rate from a portfolio to cover a retiree’s living expenses (the amount needed in addition to what he or she receives in pension, Social Security or other benefit payments) is a challenging but important exercise. Research by Gerstein Fisher and others points to 4 percent as being a reasonable starting point for a withdrawal rate that can be sustained for the long term. Investors should also consider age, health and other individual-specific issues in determining whether their own withdrawal rate should in fact be lower than this, or possibly higher. While investors may be tempted, particularly in the current low interest rate environment, to reach for yield in high-dividend-yielding stocks or high-yield bonds, this approach entails excessive risk for most investors. When it comes to structuring a portfolio for retirement, a total return strategy may be a sounder alternative to an income-only approach.
Gregg S. Fisher, CFA, CFP, founded Gerstein Fisher, an independent investment management firm headquartered in New York City, in 1993. The firm uses a quantitative, research-based approach to investing that is grounded in economic theory and common sense. For more information, please visit www.gersteinfisher.com.