The stakes are high when it comes to wealth and retirement. Unfortunately, salesmanship and conflicts of interest are rampant in the financial services industry. In most cases, the investment advice you receive will be a direct result of the type of financial professional you speak with (e.g., broker vs advisor vs insurance agent or a combination thereof). The purpose of this post is to help retirees and other investors see through the smoke and mirrors and make informed decisions in the context of generating income.
My goal here is to provide a high-level overview of the primary options available to generate income - not to go into the granular details. I believe the information below should be enough to help you narrow down your choices so you can start exploring and refining the most appropriate options.
Note: This post only discusses income, but it is also important to make sure your plan is tax-efficient and minimize the likelihood or impact of unexpected events that could jeopardize your financial security. One should conduct more comprehensive planning to address these issues.
Four Primary Strategies for Income
Below I identify what I believe are the four primary strategies for investors to use their savings to generate income. Each approach has pros and cons in terms of security, level of income, fees, liquidity, legacy goals (e.g., heirs or charities), etc. Each person naturally has unique perspectives, experiences, preferences, and priorities. So there is no one-size-fits-all answer. However, I suspect the attributes I highlight below can help you narrow down your choices.
Note: I left out the 'pillowcase' option whereby one could simply stash their cash in their pillow or bank account and take money out as they need. The math behind this situation is relatively simple (e.g., spending a $100,000 per year for 40 years requires $4 million). However, this approach is still subject to the risks related to inflation and longer than expected longevity (i.e., running out of money) - two specific concerns I address below.
Option #1: Living off dividends and interest
The first option is to buy a portfolio of stocks and bonds and then live off the income they provide - dividends and interest. The goal here is to live off the natural income streams these assets throw off without dipping into the principal. In addition to simplifying one's income strategy, this can also reduce one's dependency on market price performance.
Note: In my experience, most people are surprised with how steady dividend income can be. I suspect many assume dividends are volatile because market prices are. However, this is not necessarily the case as I discuss in my Destroying Steady Income article.
The obvious challenge here is having enough wealth to generate the income you need. Given the current low rates of interest and dividends (as of September 2016, dividend and bond yields are in the range of 2-3%), this requires savings on the order of 30-50x your annual spending budget. If your annual expenses are, say, $100,000, then you will need approximately $3-5 million to comfortably rely on dividends and interest without accessing the principal (absent other sources of income).
Of course, real estate and other income-generating investments can work too. Rental yields from real estate, for example, are typically higher (perhaps due to the lack of liquidity, potential headaches involved, or slower growth rates relative to stocks). Real estate transactions typically take weeks or months and involve significant transaction (e.g., closing) costs. Moreover, maintaining a property or dealing with tenants might be too much for many to handle. Notwithstanding these potential issues, it is possible to find real estate investments generating reliable yields of 4% or higher. Of course, real estate investments can be leveraged to boost the yields even higher (e.g., upper single digits). In this case, the quality of the cash flows generated by the properties is paramount. Whether you own the property yourself or through another party (e.g., manager or fund) with leverage, you do not want to miss an interest payment or your investment could evaporate.
The bottom line: Suffice to say, not many folks fall into the category of being able to live off their dividends and interest alone. However, you need not despair. Option #4 below (Structured Investment Income) provides a blueprint for how to structure a similar solution for income.
Option #2: Safe withdrawal rates (SWR)
Building a balanced portfolio (e.g., 60% stocks and 40% bonds) and chiseling off principal is probably the most popular approach to generating income for retirement. The idea is to estimate how much one can safely withdraw without jeopardizing financial security down the road - hence the safe withdrawal rate (SWR) label.
William Bengen, an MIT rocket scientist who went into financial planning, is credited with the seminal research on the topic of SWR income strategies. He ran historical simulations and illustrated the interplay between portfolio allocations, SWRs, and wealth depletion. He is also credited with coming up with the 4% rule. This rule of thumb suggests investors with balanced portfolios should be able to withdraw 4% of the original balance in the first year and then the same amount adjusted by inflation each year thereafter. In particular, his simulations indicated this strategy very rarely resulted in wealth depletion.
In my view, there are two issues with SWR strategies. The first issue is market dependence. No matter how many simulations or statistical analyses you run, markets may not behave the way they have in the past or how your simulations assume they will. I find this notion to be discomforting since past performance is not necessarily indicative of future performance.
The second issue I identify with SWR strategies relates to the fees. I see many instances where investors are paying investment advisors to execute these strategies. For example, consider a 1% advisor fee and a withdrawal rate around the 4% rule of thumb. You would effectively be sharing a quarter of your retirement with your advisor. Truth be told, SWR strategies are fairly straightforward to execute once they have been set up. All one has to do is periodically rebalance the portfolio to match the specified allocations and generate the desired income. Indeed, there are now many robo-advisors who do this for low or no cost. This is not to say advisors cannot add value in other ways. For example, I believe it is important to tactically alter the allocations to reflect different market conditions. Value-adding strategies like this can earn an advisor's fee many time over. However, this is not the norm for most advisors who employ a reactive rebalancing process based on what markets have already done.
Option #3: Annuities
The above SWR approach clearly involves a significant degree of market risk. Moreover, standard investments are not structured to fit your lifespan. One way to address these risks is to purchase products which guarantee income as long as you live. These products are called annuities and are only sold by insurance companies (who deal in longevity risk).
Note: Insurance companies can run into trouble too as many did during the financial crisis. However, they are highly regulated and many of their products are backed by state guarantees. In my view, this makes the risk of defaulting on their guaranteed payments minimal.
Another benefit annuity products can offer is tax-deferral. In particular, investments can grow and one can make changes to the underlying portfolios without triggering capital gains. In general, tax-deferral can provide immense benefits. However, the net earnings are ultimately taxed as income tax (which is generally much higher than capital gains rates) when they are eventually withdrawn. This is a significant issue in taxable accounts.
Without doubt, income that is guaranteed to last throughout one's lifetime and tax-deferral are very desirable in the eyes of risk-averse investors looking to secure their financial well-being. So insurance agents are able to make very compelling marketing pitches. However, it is important to weigh the benefits with the associated costs and constraints. Some annuities (e.g., variable annuities) have fees as high as 4% or more per year and may involve lockups or surrender periods whereby one cannot sell their annuity for several years without paying significant penalties. Suffice to say, people selling annuities do not always focus on these items.
The bottom line: Annuities are unique in being able to make guarantees related to income and longevity. However, annuity salespeople often like to sell the higher fee products because they get bigger commissions. At the end of the day, you have to work out the math and balance the risks to see how they compare to other income strategies. For example, fixed annuities strip out many of the bells and whistles to isolate the core benefits of lifelong income and tax-deferral. As a result, these products typically have much lower costs than their variable annuity cousins.
I have had extensive experience analyzing annuities on both the consumer side working with individual investors and (earlier in my career) on behalf of insurance companies looking to hedge their annuity businesses. In my experience, the fees most (but not all) of these products charge outweigh the benefits they provide. These products involve much financial engineering, so the math is often difficult to untangle. However, the basic logic is straightforward.
An insurance company is an intermediary between you and the market. They provide a service (aggregating and hedging risk) which costs them money and then they tack on their profits on top of those costs. They must also educate and incentivize (via commissions) armies of salespeople to sell their products - a costly endeavor to be sure. At the end of the day, all of these costs add up and ultimately come out the pockets of people who purchase these products.
While we do not know the precise costs or profits embedded in many of these products, there is another way to estimate how much of your money goes toward the costs above (and thus how much of your investment is left to work for you). You can simply add up the annual fees over the expected lifetime of the product. For example, if the annual fees are 2.75% and you plan to hold the product for at least 10 years, then you will lose approximately 27.5% (10 x 2.75%) of your original investment to these fees. Just 72.5 cents of each dollar will will be working for you.
The fee example I used above is admittedly on the higher end of the spectrum (but not the highest I have seen!). There are many different types of annuities with varying costs. In general, the fancier products have higher costs and the simpler products have lower costs.
Now that I have made my views clear about annuity fees (beaten the horse to death?), I will now highlight two different annuity products that guarantee lifelong streams of income. The first is a variable annuity with a guaranteed lifetime withdrawal benefit (GLWB). A variable annuity is effectively a retirement vehicle which invests your money in various funds and allows the earnings to grow tax-deferred (though the returns are taxed as income when they come out).
When one also purchases the GLWB for the annuity, they are guaranteed a minimum level of annual withdrawals (e.g., 5% of the original investment) as long as they are alive. While the minimum level of withdrawal is guaranteed from day one, this minimum level can also increase (but not decrease) through time if the performance of the portfolio reaches certain hurdle rates. In other words, this product can both guarantee a minimum level of income but also allow for some upside if the underlying portfolio performs well.
In addition to the GLWB, there are many other options (called riders) investors can add to their annuity contracts (for additional fees) - enough to make most heads spin. On balance, the wide array of features, riders, payouts, and embedded costs make variable annuities fairly complex. So I am never surprised when I meet people with variable annuity contracts they do not understand.
Now I will discuss an annuity product which is on the opposite side of the complexity spectrum: the single premium immediate annuity (SPIA). This product simply converts a lump sum of cash investment into a guaranteed lifelong stream of income (e.g., 7% of the original investment). When discussing these products, many folks are quick to ask "What if I get hit by a bus the day after I sign the contract?". Luckily, there are fairly inexpensive options that can add guarantees relating to the minimum number of years of payments or total amount of payout that is guaranteed.
There are some important distinctions between the two products I have discussed. For example, variable annuities are more complex (hence the multiple paragraphs to describe them versus just one for the SPIA). In terms of income, the guaranteed payouts of the variable annuities with GLWB rider are typically lower than for SPIAs. However, variable products provide potential upside to the guaranteed payments and may also have some money left over for at the end (i.e., for beneficiaries).
On balance, annuities can offer some attractive features such as guaranteed income and tax-deferral. However, investors must weigh these and other benefits against their costs when figuring out which of these products (if any) are suitable for their financial plan.
Option #4: Structured Investment Income (SII)
The Structured Investment Income (SII) approach I describe below is a hybrid of the SWR strategy and annuity products I discussed above. I try to extract the primary advantages of both strategies (reliable income, liquidity, and capital growth) while addressing two of their major drawbacks (costs and market dependency). On balance, I believe SII is a much simpler strategy and allows investors to enjoy more peace of mind via an increased understanding of their financial plans.
As I highlighted above, very few people have enough money to live off interest and dividends. In other words, they will have to dig into principal. This is precisely what happens with annuities and SWR strategies - even if it is not evident. The constant gravity of fees may be subtle and market volatility may obscure the trend, but principal erosion is a certainty for those who cannot live off the natural income generated by their portfolio (i.e., dividends and interest).
So what is my SII approach? The easiest way to understand SII is to consider a hypothetical example. Let us say Jane Retiree is 65 years old, has $2 million in savings, and expects to spend $100,000 a year in retirement. So her current spending budget is 5% of her portfolio (=$100k/$2m), but will likely increase with inflation. Unfortunately, 5% is higher than the 2-3% yields on stocks and bonds. Moreover, it is higher than the 4% 'rule of thumb' discussed above. In other words, she cannot live off the dividends and interest and traditional SWR strategies would run a higher risk of capital depletion.
So let us consider changing the SWR approach by replacing the bond allocation with a SPIA (single premium immediate annuity - see the 'Annuities' section above for more information). In practice, we generally do not purchase a SPIA. We often purchase a series of CDs and bonds first. This creates a stream of fixed cash flows going out, say, 10-15 years. Then we would purchased a deferred income annuity (DIA) that would start paying when these CDs and bonds left off. Together, the CDs, bonds, and deferred income annuity would create a level stream of payments that would continue for as long as she lives - effectively piecing together the same income stream as a SPIA while maintaining more liquidity with the CDs and bonds.
At Jane's age, a SPIA might payout around 7% per year. So if half of her $2 million portfolio is allocated to SPIAs paying 7% a year, then this will generate $70,000 of income per year. Then the other half will be in stocks paying a current dividend yield of, say, 3%. This provides another $30,000 per year in dividends (which should grow at a rate higher than inflation). Et voile! Jane now has a portfolio that generates sufficient income for her retirement needs ($100,000) and should grow through time to help address inflation.
Rather than chiseling away from her portfolio and being at the mercy of the market, Jane's income is now naturally generated via fixed income and dividends. It is important to understand that dividends are far volatile than market prices and there are many companies who have paid and increased dividends for many years - even through the last two recessions and market collapses.
With a strategy like this, Jane does not need to worry as much about stock market volatility. Moreover, there is little to no need to manage the portfolio. So she likely not need an advisor to manage her portfolio once this is set up and this can translate into significant savings. For example, an ongoing advisor fee of 1% per year would consume approximately 20% of her retirement income (1% x $2m = $20,000 out of her $100,000 of income).
As the above example illustrates, the SII approach is remarkably simple and can produce a reliable source of income (dividends and guaranteed SPIA payments) with reduced dependency on market performance. It can also eliminate many of the annual fees and taxes associated with the bond allocation - as would be the case within a variable annuity or SWR strategy. However, SII has other benefits we have not yet discussed. SII can help minimize tax friction and maximize performance - which might translate into more income or residual wealth for legacy purposes (e.g., heirs or charities).
There are three ways SII can help minimize taxes. The first way is that it involves significantly less, if any, portfolio rebalancing. Thus, it should trigger fewer capitals gains. Second, the fixed income side of the portfolio is effectively consumed throughout retirement (but is guaranteed not to run out!). So much of the income is actually principal and thus not taxable. Moreover, this also means that the fixed income allocation decreases through time. This is good because fixed income is generally less tax-inefficient given that interest is taxed as income. The third tax benefit of SII stems from the use of the fixed annuity. These products defer all of the taxes until income is actually paid out.
Our calculations indicate these tax benefits can save many retirees the better part of 1% per year. To put this into context, consider tax savings of 0.50% per year versus a 5% withdrawal rate. This amounts to a 10% boost to retirement income via tax savings alone (10% = 0.50% / 5%).
SII also offers potential performance advantages. These stem from how the portfolio is managed (or not managed). Most other strategies rebalance and maintain fixed asset allocations (e.g., 60%/40%). They generally have to do this because their income stream is dependent on market performance and they must keep a lid on overall volatility. Otherwise, they would risk opening the door to wealth depletion and income impairment.
Unfortunately, this rebalancing process can limit overall portfolio performance as it systematically constrains the higher growth asset (e.g., stocks). Each time stocks outpace the other investments, their allocation is trimmed with the proceeds being redistributed to other parts of the portfolio (presumably triggering taxes as well). In the words of famed investor Peter Lynch, this process is akin to "trimming your flowers and watering your weeds."
By using the fixed income side of the portfolio to secure enough income via the SPIA, SII leaves the equity side of the portfolio alone to grow without constraint. In terms of risk management, this transfers risk away from the retiree's income stream and to the retiree's beneficiaries. This is a much better alignment as equity risk is better placed with their presumably longer time horizons. Of course, a retiree may wish to take advantage of the equity growth within their lifetime and sell some of the equity allocation. However, this would not done in such a way to systematically constrain growth and trigger taxes.
The bottom line: The above description and example brush some details under the rug (e.g., inflation). However, the overall approach of marrying an income annuity to the dividends of a high-quality stock portfolio offers investors a simple and efficient means to generate a robust and growing stream of income. On balance, we find SII offers the best balance of income, risk, cost, tax, and performance. Combined with its simplicity, we believe this building blocks approach to income produces can provide you with the most peace of mind in retirement.