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 (i.e., biased). The reason I am writing 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 is not to go into the granular details, but to provide a high level overview of the primary options available to generate income. In particular, I believe the information below should be enough to help narrow down one's choices and allow them to start exploring and refining the most appropriate options.
Note: This post only discusses income (as it is naturally an important focal point for many retirees and investors), but it is also important to minimize the likelihood or impact of unexpected events that could jeopardize your financial security. More comprehensive planning is required to address these issues, but this is not the topic of this post.
Four Primary Strategies for Income
Below I identify four primary ways investors can use their savings to generate income. Each one has pros and cons in terms of security, level of income, liquidity, legacy goals (e.g., heirs or charities), fees, etc. Given that each person has unique perspectives, experiences, preferences, and priorities, there is no one-size-fits-all answer.
Note: I have left out the 'pillowcase' option whereby one could simply stash their cash under their pillow or in a 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 also reduces 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 is having enough wealth to generate sufficient income in this way. Given the current (as of October 2017) low rates of interest and dividends, 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. This is based on stock (dividend) and bond yields in the range of 2-3%.
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 or potential headaches involved). 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. In many cases, real estate investments can be leveraged and this boosts 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), 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, do not despair. Option #4 below (Structured Investment Income) provides a blueprint for how to structure a similar solution for income.
Option #2: Annuities
No matter the quality of a stock or bond, there is always some risk to the income stream (and principal) since companies can run into financial trouble. 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 guaranteed payments minimal.
Without doubt, these guarantees are very desirable in the eyes of risk-averse investors looking to secure their financial well-being. They make for very compelling marketing pitches. However, it is important to weigh the benefits with the costs and other constraints such as lockups or surrender periods when considering annuities. The people selling annuities do not always focus on these items.
Another benefit annuity products can offer is tax-deferral. In particular, one may be able to 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.
The bottom line: Annuities are unique in being able to make guarantees related to income and longevity. However, they typically involve high fees. At the end of the day, you really have to work out the math and balance the risks to see how they compare to other income strategies.
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 of these products (but not all) charge outweigh the benefits they provide. These products involve much financial engineering, so the math is often difficult to untangle (but not impossible - just challenge me!). 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 cannot know the precise costs or profits embedded in these products, there is another way to estimate how much of your money goes toward the costs above (and thus how much 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 make its way to the market.
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. Accordingly, 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.
If you are interested in learning more about annuities, please read my article that includes more details.
Option #3: Safe withdrawal rates (SWR)
Building a balanced portfolio (e.g., 60% stocks and 40% bonds) and chipping off principal is probably the most popular approach to generating income. 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 dozens of historical simulations and illustrated the interplay between portfolio allocations, SWRs, and longevity. 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 critical issues with SWR strategies. The first issue is the 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.
The second issue I identify with SWR strategies relates to the fees. I see many instances where investors are paying investment advisors (say 1%) to execute these strategies. This effectively reduces the SWR by 25% (1% of the safe '4%' withdrawal going to the 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 intended allocations and sell enough principal to generate the 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.
Option #4: Structured Investment Income (SII)
The Structured Investment Income (SII) approach I describe below is a hybrid of the SWR and annuity strategies 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 Joe Retiree is 65 years old, has $2 million in savings, and expects to spend $100,000 a year in retirement. In other words, his current spending budget is 5% of his portfolio (but may increase with inflation). Unfortunately, 5% is higher than the 3% stock and bond yields and higher than the 4% 'rule of thumb' discussed above. In other words, he 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. At Joe's age, SPIAs payouts are around 7% per year. So if half of his portfolio ($1 million) is allocated to SPIAs paying 7% a year, then this will generate $70,000 of income per year. Then the other half will still be in stocks paying 3% or $30,000 per year in dividends (which should grow at a rate higher than inflation). Et voile! Joe now has a portfolio that generates sufficient income for his retirement needs ($100,000) and should grow through time to accommodate inflation.
With a portfolio like this, Joe does not need to worry as much about stock market volatility because he is only depending on the dividends; he is not accessing the principal (which is left to grow in the background). Moreover, there is little to no need to manage the portfolio. In other words, he does not necessarily need an advisor once this is set up. This can translate into significant savings in fees.
While the above example brushes some details under the rug (taxes, fees, inflation, etc.), the overall approach of marrying a SPIA payout to a stock portfolio and relying only on the natural income does not require any of the complex (expensive!) annuity products or statistical simulations. Most people can understand this basic structure in a matter of minutes when properly presented.
In additional to its simplicity, SII strategies produce a reliable source of income (dividends and guaranteed SPIA payments) with reduced dependency on market performance. It is also the cheapest strategy to execute since it eliminates many of the annual fees for management of the bond allocation within a variable annuity or SWR strategy.
On balance, I believe SII is a safer, simpler, and cheaper strategy that will maximize performance overall (whether that is in the form of higher income or residual wealth for legacy purposes). This may all sound like more marketing mumbo jumbo, however, there are two specific advantages the SII strategy has over the others we have discussed. The first is lower fees. Without doubt, lower fees means more money left working for the investor.
The second advantage stems from how SII isolates the principal erosion at the outset by confining it to the SPIA. In particular, the equity portfolios within SII strategies can be left to grow untouched. This is not the case with the other strategies. They are forced to rebalance and maintain their allocations (e.g., 60/40 ) in order to reduce volatility. They simply cannot afford to take the risk with higher volatility since it opens the door to wealth depletion and income impairment. Unfortunately, this required rebalancing limits overall portfolio performance by systematically constraining the higher growth asset (e.g., stocks).
The bottom line: SII offers investors a simple and efficient means to generate a robust and growing stream of income while maximizing the amount of legacy capital for heirs and charities. Its primary advantage is born out of optimizing risk. SII effectively transfers risk away from the income and concentrates it in the stock portfolio where it can be rewarded with higher expected returns.