In my role as a financial advisor, I often encounter the idea that a secure retirement means living off of the income generated from your portfolio. A quick google search confirms that this ideology is still very much espoused as a sensible approach to retirement funding in order to never need to worry about running out of money.
A strong desire to leave their nest egg untouched is one reason retirees spend significantly less than they can actually afford to spend during their retirement years, a challenge I wrote about here. A recent Blackrock whitepaper confirms this, finding that retirees prefer to manage expenses rather than spend down their portfolio. While I appreciate the simplicity of this dictum, it isn’t the best approach to funding your retirement.
You’re Going to Need a Bigger Portfolio
There are several challenges with this approach to retirement funding. The primary being that, if you are intent on living off only the portfolio income, you’re likely going to need a bigger portfolio.
For illustrative purposes, a 65-year-old with a $1 million portfolio in retirement accounts, earning 6% annual returns could reasonably afford to withdraw around $47,000 per year, increasing each year by inflation, assuming a 30-year retirement. This would leave a buffer of around $300,000 at age 95, and a strong likelihood of success throughout most possible market outcomes (80% Monte Carlo success rate, for those who want specifics).
If that same retiree didn’t want to touch the principal, ensuring that they would still have $1 million at age 95, the amount that they could reasonably withdraw each year drops to $40,000. That’s a decrease of nearly $600 per month, or the price of a nice vacation each year.
Income Plus Growth Equals Return
I often see confusion around differentiating the concepts of living off the income of a portfolio versus not touching a portfolio’s principal. People tend to use these phrases interchangeably. However, living off of the income generated by a portfolio is different than not touching a portfolio’s principal.
This is because the return of a portfolio is generated by two elements – income plus price appreciation (e.g. you bought a stock for $50 a share and now it’s worth $100 a share). Income generated in the form of dividends or interest is only one part of the investment return.
Using only the income generated would inevitably leave some of the investment return, the price appreciation, in the portfolio. Those who use only the income generated by their portfolio would have an even larger portfolio at the end of retirement than when they started!
Forsaking All Else in the Name of Generating Income Can Lead to Lower Overall Returns
Because investors often confuse the income generated by a portfolio for its overall growth, many investors look to maximize income-generating investments. Although this may feel intuitive, it’s important to remember that the primary aim of investing is to maximize overall returns while managing personal risk. Focusing exclusively on income-generating assets could potentially reduce overall returns if price appreciation is not also considered.
The past two decades have given us a good example to work with. Someone looking to invest only in income‑generating assets might invest their stock allocation solely in what are called “value” companies (think JP Morgan, FedEx, or GM). Value companies tend to have consistent cash flows with which to pay dividends to their investors, and tend to be less exciting than their sexier “growth” company counterparts (think Amazon, Tesla, or Meta). While growth companies can pay dividends, too, they’re known for piling more of their profit back into the company with the objective of maximizing stock appreciation, rather than paying out that profit to investors in the form of dividends.
Growth and value companies tend to trade off outperforming each other, and both have a place in a diversified portfolio. However, for the past 20 years, growth stocks have outperformed value stocks, returning a 10% annualized total return compared to the 8% annualized total return of value stocks. Investors only interested in maximizing income may have sacrificed overall portfolio return in the name of generating said income.
Investors Have Little Control Over Income
Another challenge with the concept of living off the income is that income generated, like portfolio returns, can be highly variable from year to year. In the 10 years leading up to 2022, the yield on a 10‑Year Treasury fell as low as 0.62%. Interest rates fluctuate based on the Fed Funds rate and economic conditions that investors have no control over.
Dividends paid to stock investors are also highly variable and up to the discretion of company management. The classic example being GE stock dividends, which peaked at $2.48 per share in 2009, and now pay only $0.08 per share, a 97% decrease. I don’t know any investors who could simply absorb that large a drop in income into their budget.
Income Can be Expensive
If the portfolio in question is a non-retirement account, taxation should also be a consideration. Focusing solely on generating income can lead to paying more in taxes, further eroding your portfolio’s overall return. Interest income is taxable at ordinary tax rates, as are non-qualified dividends, whereas realized gains from selling a stock or bond that has appreciated in value are taxed at much lower capital gains tax rates.
You can purchase municipal bonds and stocks that pay more in qualified dividends to shield this income from taxes, but you will give up some yield and overall return for the privilege.
Stick to the Basics
The notion of relying solely on portfolio income in retirement can present challenges. Neglecting growth in favor of income may require a larger portfolio and perhaps delayed retirement, and concentrating solely on income-generating assets can result in missed opportunities.
The predictability of income can vary significantly, subject to economic conditions and corporate decisions, and income-focused strategies may have negative tax implications, further reducing overall returns.
A better approach is to focus on the fundamentals and prioritize maximizing overall returns while managing risk. Maintaining a balanced approach, diversifying investments, and being open to using some principal can help ensure a comfortable retirement without unnecessary financial constraints. After all, your retirement savings are meant to be enjoyed.