I recently met with a prospective client who was unhappy with his portfolio. He had told his advisor that he wanted to "live off interest and not touch principal" and he wasn't making enough investment income. It had been a couple of years or so since I had heard anyone ask for that strategy. With interest rates as low as they are, I imagine many of you have not heard that request very often lately either.
If we had been having this discussion a few years ago, I may have said that if I had a dollar for every time I heard that, I'd be retired myself. That may be an exaggeration but the live-off-interest-not-touch-principal approach had been a common desire among prospective clients for virtually all of the first 20 years of my career.
The trouble is, living off interest and not touching principal (LOINTP) has never really been a very good approach, even if the allure of the perceived safety of the approach persists.
Most people who wish to live off interest reside on the conservative end of the risk tolerance spectrum. Preservation of capital dominates their thinking. Using one-month T-bills as a proxy for highly stable interest-bearing investments, it is clear the amount of interest generated can vary substantially.
If a household started retirement, collecting just enough or close to just enough interest to cover its expenses, the graph above depicts the variability of its income stream. In most periods, the income varies more dramatically than most highly conservative clients could stand. It is also more volatile than many methods that vary cash flow based on conditions such as those advocated by Jon Guyton.
Households starting retirement in the 1930s, '40s, and '50s would have seen a generally rising stream of income over a 30-year retirement. This might be OK if that initial amount of income was adequate for their needs.
However, a household starting retirement in such a manner in the late 1970s and early '80s would see their standard of living steadily decline. In recent years, both the 2000 retiree and the 2007 retiree would see their incomes plummet almost immediately.
Of course some retirees may have a specific spending amount in mind that differs from the first year's rate of interest. Today, many people are at least somewhat aware of the so-called "4 percent rule." Clearly, one could not have even initiated a LOINTP approach to that spending pattern between 1929 and 1965 because interest was below 4 percent on day one, tapping principal immediately.
What exactly is meant by "don't touch principal" anyway? Does the client mean that they never want to see the balance of their account below the original starting value or they never want to see their account go down at all, ever? Recent retirees that may have tried implementing a 4-percent-rule style spending pattern with an overly conservative portfolio have failed under either definition.
The 2000 retiree who tried it would have spent 4 percent, but received roughly 6 percent. Unfortunately, rates dropped so fast that the 2 percent excess interest that was reinvested could not help keep the spending on pace with inflation. A similar fate came to other retirees later in the decade. This dynamic is likely part of why the prospective client I mentioned at the beginning is unhappy.
We looked at a 1981 retiree (when rates were at their peak) with $1 million who wanted to spend $40,000 the first year and inflate that amount with inflation. After 30 years, the retiree's portfolio was still about $1.2 million. At that point annualized interest income would cover about a week's worth of expenses since monthly costs exceed $6,500. However, since as we completely ignored taxes and the fact that the balance would feel more like $400,000 in 1981 terms due to inflation, all is not well.
Ah yes. Let us not forget the impact of inflation and taxes as clients often do. They remember the high CD rates of 25-35 years ago but often forget that inflation ran high. Here are the returns from the first graph adjusted for inflation. Quite a different picture, isn't it?
Marginal income tax rates have been substantially higher than in recent years. The Kemp-Roth tax cuts of 1981 lowered the top rate from 70 percent to 50 percent over the following three years. T-bills, CDs, and other safe interest-bearing investments paid so much interest because the marketplace demanded such rates to compensate for the inflation and the taxes that applied at the time.
For the client who is willing to have his or her principal fluctuate in value to some degree, clearly more income is possible through, for instance, longer maturities, weaker credit quality or stock dividends. All of these, of course, present disadvantages.
Longer maturities present greater risk from rising interest rates and inflation. Lower credit quality typically means higher volatility of principal and higher risk of default, definitely a form of "touching principal." Reaching in these ways may not help much. Many studies show an all-bond approach has severe limitations. For instance, Cooley, Hubbard, and Walz, using high-grade corporate bonds from 1926-2009, put the success rate of a 100 percent bond portfolio over 30 years using a 4 percent initial withdrawal rate at a mere 35 percent (Journal of Financial Planning April 2011).
I think today's low interest rates have impressed upon people that the LOINTP approach is unlikely to work for them. More common today, is a general desire for more income. Someday, interest rates will rise and those stretching for yield via a longer maturities will suffer.
Increasingly common are people who want to overemphasize dividend-paying stocks in their portfolios. Many of these people are substituting these stocks for bonds. I think this is a potentially problematic substitution. The nature of dividend income is radically different than the interest income from bonds. Dividend income isn't guaranteed and only represents a small buffer against a bear market. Dividend-focused funds and ETFs typically plunged 50 percent to 60 percent during the recent credit market crisis.
Don't get me wrong. I think most portfolios should always have had meaningful quantities of dividend-paying stocks. They are naturally included in a broadly diversified portfolio. The issue should never be dividends yes or dividends no. That said, increasing exposure to dividend payers seems all the rage these days. That alone is a red flag. You might not want to get too caught up in the hype. Here are four quick reasons.
First, roughly 80 percent of all listed U.S. companies pay no dividends. Most that do are larger more established companies. That is good but we also want to invest in other kinds of companies, like the dynamic upstarts or those investing in innovations or expanding markets. Overemphasizing dividend payers means avoiding a lot of worthy and smaller companies.
Second, for many great companies it is not just that they don't pay dividends. It is that they won't and shouldn't. They wish to use cash to invest in things that will grow profits and thus increase firm value. The corporate tax structure favors making these investments over making dividend payments.
Lastly, speaking of taxes, until recently, dividends were taxed at higher rates than capital gains. We emphasize after-tax returns so we see the location of the dividend-paying stock holdings as an issue to manage in order to keep our clients' taxation down. The threat of an increase in the tax rate applied to dividends only reinforces our opinion about this point.
The prospective client that started me on this discussion can be forgiven for wanting to live off interest and not touch principal. It is an extremely appealing idea. However, it is more likely that seeking an adequate total return from a well-balanced, diversified portfolio, implemented and managed appropriately, will be more successful at generating what clients really need -- cash flow. It shouldn't matter much from where the cash flow comes.
A simple way to make this point is to show interest-obsessed clients how many zero coupon bonds have better yield to maturities than corresponding traditional bonds. If they get that, they may understand the bigger picture quicker.
I'm less apt to cut the "advisor" much slack. I use quotation marks because he didn't really advise his client. He simply took the client's order like a waiter in a restaurant. That may have seemed like the path of least resistance but it does not serve the client.
Sometimes we need to tell people what they need to hear rather than what they want to hear. This does not have to be an unpleasant experience for clients. To the contrary, it can be an illuminating and empowering experience for clients to get a good grasp on what it really takes to succeed financially.
Dan Moisand, CFP, has been featured as one of the America's top independent financial advisors by most leading financial advisor publications. He has spoken to advisor groups on five continents on topics such as managing investments and navigating tax complexities for retirees, retirement readiness, and topics relating to the development of the financial planning profession. He practices in Melbourne, Fla. You can reach him at (321) 253-5400 or [email protected]