In a few weeks the calendar will turn to 2018, marking almost eight years since the 10-year Treasury bond last provided a 4 percent yield. The subsequent period of low rates has created a near impossibility for most retirees to “maintain principal” and the associated challenge for advisors to reorient client thinking. The dangers of “stretching for yield” have been well documented and the old axiom “if it’s too good to be true, it probably isn’t” has been regularly repeated. Despite these and other warnings, retirees’ demand for income is as robust as ever, along with the expectations they often place on their financial advisors, whether reasonable or not.  

One potential solution advisors might consider leverages the great insights of recent Nobel Prize-winning economist Richard Thaler. Perhaps best known for his work on nudge theory, Thaler is also credited with illuminating the behavioral tendency of “mental accounting.” Thaler explains that people treat money differently, depending upon origin and intended use. While advisors are in the business of constructing efficient portfolios that maximize return per unit of risk, most individuals view their wealth in buckets or pots. In other words, while our industry creates holistic plans using the fungible asset of money, clients are often thinking in terms of “my retirement funds,” “my rainy day reserve” and “my vacation stash.” Success from the client perspective is often determined by whether there are sufficient funds available in a bucket to satisfy its intended use.

Having a better understanding of how people think, matching client objectives to various sources of income can help shift the discussion away from yield and toward cash flow. In our framework there are three tiers of income: anchor, cushion and yield. For most people, anchor income will include Social Security benefits and employer pensions. Depending upon the client, other sources may include royalties, rental income and annuity payments. Ensuring that anchor income will sufficiently cover essential expenses such as housing, utilities, food and insurance premiums can provide clients peace of mind that their most pressing needs are accounted for. If projected anchor income is short, converting a portion of the client’s portfolio to a guaranteed income stream may be an appropriate course of action.

The next step is to account for the client’s discretionary expenses. Examples include travel, making charitable or family gifts or other expenses that can best be thought of as “wants” or “wishes” rather than “needs.” A cash cushion equal to two years of discretionary expenses should be set aside to meet these expenses as they arise. Typically, cushion income is invested conservatively, generating some return, but with a primary objective of preserving principal. The reason why we believe it is important to set aside two years of cushion income is because it may help curb some clients’ tendencies to sell some investments, such as stocks, immediately after they have gone down in value.

One year into the program, approximately half of the cushion will be left. At this point any combination of portfolio balancing, tax-loss harvesting or satisfying required minimum distributions can be used to add another year’s worth of discretionary expenses to the cushion income tier. Further, retirees that have been able to comfortably satisfy their first year’s income needs, consisting of both essential and discretionary expenses, should feel satisfied that their income plan is off to a successful start. 

The third tier of our retirement income framework is yield. This category of investments will generally pay competitive interest or dividends; but remember, typically carry greater risks. For this reason, we believe in using anchor and cushion income to meet anticipated essential and discretionary expenses, while earmarking these higher-yielding investments for longer-term time horizons, similar to stock investments.

So, what does one do with the interest and dividends these investments generate, if essential and discretionary expenses are already satisfied? There are several options, depending upon the investor. In our framework, we try to set aside adequate sources of income for anticipated essential and discretionary expenses, but sometimes events occur that are unexpected. Interest and dividends can be used if and when these unexpected expenses arise. Alternatively, interest and dividends can be used to consistently replenish the cushion income tier throughout the year, rather than waiting until year-end. Finally, dividends and interest that are not immediately needed may be reinvested, thus offering the potential to generate additional income later on.

The most important takeaway from our framework is that investors are not using their dividends and interest to meet their immediate expenses. Instead, we are suggesting a systematic and reliable approach that matches income needs with all income sources, including Social Security and pensions. What’s more, we successfully shift the conversation away from those investments that offer the highest yield, to a more helpful discussion about generating sufficient cash flow depending upon each client’s unique set of circumstances. 

Matt Sommer, CFP, CPWA, CFA, is director of retirement strategy at Janus Henderson and leads the Defined Contribution and Wealth Advisor Services team.