There is no shortage of information available for people to become educated about finances. Despite this, I hear the same misconceptions today that I heard 27 years ago when I first started working with retired clients. 

As the baby boom generation continues to retire, more and more financial planners will be dealing with the distribution phase of client’s financial lives. I thought I’d share some of the most common issues that are not understood by those in or approaching retirement. Today we’ll highlight some investment-oriented issues.

If I Start Spending X Percent Of My Money And Earn At Least X Percent On Average, I’ll Be Fine

Despite all the volatility in the markets, I still hear this frequently. Even if you can get x percent steadily, if you spend it all, inflation will erode your purchasing power and the sequence of returns can matter a lot.

A 5 percent or 6 percent rate, sounds modest. However, historically, a significant allocation to stocks has been required for a portfolio to compound at rates like that. Many retirees find that posture too aggressive for their liking.  

Mathematically, when volatility strikes, and distributions are made on top of the losses, bad outcomes can result. Even if you correctly predict the compounding rate over a prospective retirement, spending that percentage of the initial portfolio and increasing each year for inflation produces a significant chance of failure.

Most sustainable withdrawal studies I’ve seen would put the success rate over 30 years for a 6 percent initial withdrawal rate with an all S&P portfolio in the low 60 percent range. This despite the worst 30 year annualized average return for the S&P500 being just under 7 percent  (starting September 1929). 

I Will Just Live Off Interest And Not Touch Principal

This is an all-time classic. The sentiment makes perfect sense. Be conservative and preserve wealth. Unfortunately, this strategy has never really worked, at least over any substantial period of time.

Sure, interest rates of the late 70s and early 80s were high but often forgotten is the economic environment at the time. CD and Treasury buyers got a nice nominal rate, but net of the higher taxes and inflation of the day, conservative investors were running to stand still.

Having seen rates rise for years, it was a bit scary to buy long-term debt for fear of significant price declines should rates rise so few received the higher interest payments for long.

We don’t need a high tax, high inflation environment for “just living off interest” to not work very well either. In early 2000 one could get 6 percent from a money market fund. By 2003, .6 percent was common. A 90 percent decline in spendable cash is not what one would expect from a “conservative” strategy.

Anyone trying this over the last couple of decades has not fared well or, has been flirting with disaster chasing yields. Which brings me to…

High Yield Is Better Than Low Yield

Well duh. How can 5 percent interest not be better than 1 percent? Simple. 5 percent is riskier than 1 percent, even if you cannot see why it is riskier.

One of the worst years for long-term treasuries that I’ve seen in my career was 1994. The pristine credit quality of the U.S. Government didn’t keep long-bond prices from sinking over 20 percent. So much for preserving principal through conservative investments.

2008 highlighted the importance of credit quality. Treasuries held their value and made a little money during that crisis while lesser credits got hammered. For instance, JNK, a popular ETF tracking high-yield bonds, started 2008 at $46.75. By November 1^st, it was trading at $28.39 according to Yahoo! Finance. The fund sits at just under $36 today and has yet to crack $42 let alone get back to that 2008 starting price. Instead of bonds providing stability when stability was needed the most, high-yield bonds dropped over 39 percent.  

Yes, it has made higher interest payments but retirees attracted to JNK for higher interest payments have had poor price stability. That does not jibe with what clients are looking for when they want to just live off interest. Whether we are talking about term risk or credit quality, a high yield should be viewed as a threat to principal rather than an opportunity for most clients.

Dividends Are Income

Dividends feel like income. You get a check or interest payment like a CD or a bond after all. But “like” isn’t the same as “same.”

When one buys a bond or a CD, they are buying an agreement that obligates the issuer to pay x percent of a specific amount on certain dates and pay a specific amount upon a specified maturity date. In most cases, people conceptualize interest as an amount paid in addition to principal. 

By contrast, neither the amount of a dividend nor a principal value is guaranteed. In fact, the act of paying a dividend, in effect, reduces the principal amount. Many clients do not know what trading ex-dividend means or why it happens. A fairly effective way of explaining how dividends payments get to them is through a simple illustration.

Ask the client to imagine handing a $5 bill to the next person that comes down the sidewalk. Now ask, did your net worth increase, decrease or stay the same. The answer, of course, is their net worth declined by $5.

The same thing happens to a corporation when it pays a cash dividend. It takes money out of its account and hands it to shareholders. The stock trades lower by the amount of the dividend to reflect the decrease in the company’s net worth.

As a receiver of the payment the shareholder’s net worth is unchanged. It has just changed form a little. Instead of just owning the stock, the shareholder has $5 cash and stock worth $5 less. If owned in a taxable account, the shareholder now gets to pay taxes on the dividend.

Most clients don’t realize that the cash to pay the dividend came from coffers filled after corporate taxes were paid and the distribution is not deductible to the corporation. Most also don’t understand that cash paid for dividends aren’t available to be reinvested in staff, facilities, research, development, marketing or any other activity management may want to undertake to improve the health of the business.

Once clients understand these things, they can see why dividend payers are a minority in the market. Many think dividends are a sign of corporate strength and in many cases, they are, but what is viewed as a strength can become a weakness. Just ask GE. Some companies hurt themselves by continuing to pay dividends because they fear a negative reaction from the market or make themselves less competitive.

Dividend-Paying Stocks Are A Good Substitute For Bonds

Yield-obsessed clients can bite on this one a lot. The dynamics I described above can help people get over this one because they see many of the elements of uncertainty involved. Unfortunately, there is a lot of press out there suggesting dividend-paying stocks are great sources of income and dramatically safer than non-dividend-paying stocks.

In addition to the discussion about what happens when a dividend is paid, I’ve also found a simple chart showing the behavior of dividend-focused funds during the financial crisis helps keep client enthusiasm in check. The purported relative safety in some dividend payers pales in comparison to the safety inherent in good-quality bonds and CDs. Look at just about any dividend-paying fund or ETF and its clear, the dividends were of little help if any during the crisis while good-quality bonds were a true safe haven.

The point isn’t that dividend paying stocks are inherently bad. All of my clients own broadly diversified portfolios with many dividend payers in their allocations to equities. The point is dividend stocks are just that—stocks. They are not structured like bonds and should not be presented to clients as an apples-to-apples substitute for bonds or as a small step up on the risk scale.

Next month, I’ll run through a few common misconceptions outside the investment arena. I’m sure readers encounter a few misconceptions that seem to recur frequently. I’d love to hear about them.

Dan Moisand, CFP, will be speaking at Financial Advisor's Inside Retirement conference in Las Vegas on September 26-27. He has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla.  You can reach him at www.moisandfitzgerald.com.