For prospective retirees who don’t simply want to annuitize most or all of their wealth, determining how best to invest a retirement portfolio to generate income is a substantial challenge. Not only because of the need to invest for enough growth to sustain inflation-adjusting retirement distributions over time, and managing portfolio volatility to avoid triggering an adverse sequence of returns in the first place… but also because, as retirement investing has evolved beyond simple strategies like “buy the bonds and spend the coupons” and into more total return strategies, it’s surprisingly difficult to come up with a system to actually generate the distributions themselves.
After all, most prospective retirees who are looking at making the transition away from work have spent the better part of 40 years paying their ongoing bills from a steady series of monthly or perhaps bi-weekly paychecks. Which means the most straightforward way to facilitate retirement is simply to re-create those ongoing retirement paychecks. Except as noted, modern retirement portfolios – especially those that include both income and growth (i.e., capital gains) components – aren’t necessarily conducive to generating consistent retirement paychecks. At least not without creating a system behind the scenes to ensure the cash will be there as needed.
Over the years, advisors have created a number of different systematic approaches to address the retirement paychecks challenge. For some, it’s about investing into a “traditional” income-generating portfolio of bonds and dividend-paying stocks (perhaps supplemented today by income-generating alternatives like REITs and MLPs), and simply passing through the income as received. For others, it may start with accumulating interest and dividends, but then “topping up” the portfolio’s cash with periodic liquidations of capital gains. For still others, with the ongoing decline of transaction costs, the approach has shifted to simply keeping all cash fully invested, and making liquidations as needed in real-time to generate retirement distributions without any cash drag at all!
Whatever the particular methodology, though, any advisor needs to be able to answer a number of important questions about their mechanical process of generating retirement paychecks, including how they will handle dividends and interest, whether there will be a cash position (or not), how capital gains liquidations will be handled (in various up- and down-market scenarios), the frequency of distributions (monthly, quarterly, or annual?), the sources of distributions from various account types, and how those distributions will be coordinated with the rest of the client’s retirement income picture (from Social Security to pensions and annuities to reverse mortgages).
The bottom line, though, is simply to recognize that the mechanical challenge of how to actually generate those retirement “paychecks” that transitioning retirees are accustomed to, is an entirely separate matter from just investing the retirement portfolio itself, and entails a number of distinct policy-based decisions about how to standardize a process for a wide range of retirees. In turn, advisors might even consider creating Withdrawal Policy Statements to then codify the processes they will use to generate retirement income withdrawals, just as an Investment Policy Statement is used to codify the processes used to invest the retirement portfolio itself!
Early in my career, I had a meeting with a prospective retiree that I will never forget.
Sitting second chair to a senior advisor and mentor, we were meeting with a relatively affluent prospect who had accumulated a significant retirement portfolio, and who wanted to learn more about our services to decide if he was going to work with us.
After the exchange of just a few pleasantries, the rather matter-of-fact gentleman asked us point blank the question that was weighing on his mind: “How will you generate income for me from my retirement portfolio?”
It was a perfect set-up for us to talk about our investment management process, the way that we didn’t just focus on dividends and interest to generate income, but took a more total return approach, which in turn dovetailed into our overall investment philosophy of how we managed portfolios for long-term return to keep up with inflation.
After about 20 minutes of proudly walking through our investment process for retirees, the prospective client simply looked at us somewhat exasperated, and asked again “But how will you get the income from my retirement portfolio into my checking account so I can pay my bills!?”
To which we answered “For all of our clients, we set up a monthly ACH transfer directly from your brokerage account to your checking account so you can pay your bills every month. And our process ensures that there’s always cash available to transfer.”
“Great, that’s what I needed to know! Not all that other investment stuff. If I wanted to deal with that, I’d be doing it myself,” the prospect replied. “Now, how do we get started?”
The Need For Ongoing “Paychecks” In Retirement
For most of our working lives, paychecks are deposited on regular basis into our checking accounts – most commonly (according to the Bureau of Labor Statistics) on a bi-weekly basis – around which we build our financial lives of paying our periodic (mostly weekly and monthly) expenses. Such that by the time we reach the age of retirement, we have a nearly 40-year history of handling household expenses by receiving bi-weekly or monthly paychecks.
And then suddenly, when retirement begins, the paychecks stop. Leading to one of the most pressing yet natural questions for retirees: how will I replace the ongoing paychecks that have been deposited into my checking account for the past 40 years, so I can fund my expenses for the next 30-40 years?
In the early days of the modern retirement planning (the post-World-War-II era), the solution to this situation was rather straightforward: retirees bought bonds and clipped the coupons to generate the additional cash needed to fund retirement expenses. As back in the 1950s and 1960s, bonds were still issued in physical certificate form, and bond interest was paid in the form of physical bond interest “coupons” attached to the bond, which could be clipped and taken to the bank and cashed just like a paycheck. Retirees merely needed to buy enough bonds to have enough interest-payment coupons to regularly cash as their retirement paychecks to pay their retirement bills.
However, the inflation of the 1970s ravaged the purchasing power of bonds by 57% in the span of a decade alone, driving a shift in the 1980s to dividend-paying stocks as an alternative retirement income vehicle that could better keep up with inflation. The essence of the retirement paycheck strategy was substantively the same, though; simply buy enough dividend-paying stocks (as opposed to interest-paying bonds) to have a regular series of retirement paycheck inflows to be able to cover the retirement expense outflows. And fortunately, a well-diversified portfolio of dividend-paying stocks also typically ended out being a well-diversified series of dividend distribution dates – perhaps not quite distributing retirement paychecks as consistently and evenly as bond coupons were. But more than even enough to be manageable.
The added complication of introducing dividend-paying stocks to the retirement portfolio, though, was that stocks can also produce potentially-quite-substantial capital gains as well. In fact, through the decade of the 1980s (when retirement investors shifted from interest-paying bonds to dividend-paying stocks to keep up with inflation), not only did dividend payouts more-than-keep-pace with inflation (rising 80% through the decade, while inflation was only up a cumulative 57%), but the raw price level of the S&P 500 also appreciated by 150%! Which meant retirees suddenly had another very substantial source to generate retirement paychecks!
Except capital gains are not nearly as stable and consistent as dividends or interest, producing outsized potential “distributions” in some years, but little or none (or even outright losses that force principal liquidations) in other years. As a result, while capital gains are capable of generating substantial amounts of additional retirement income, they are far less conducive to a steady approach of generating retirement “paychecks” for regular deposit into a retiree’s checking account.
The significance of this evolution in the sources of retirement income from interest to dividends to including capital gains as well – and the potential need to rely on principal in years when capital gains don’t occur – is that when the sources of retirement income are so unstable, it effectively begins to dissociate the generation of “income” from simply creating retirement “cash flows” instead (that may or may not be “income” in a traditional sense). And the situation is only further complicated by the fact that tapping principal itself may or may not be taxable income, depending on whether it’s from an IRA or not, which just further dissociates income (for tax purposes) from retirement cash flows to cover retirement spending needs.
The good news is that there’s actually more retirement income and wealth potential to be created by navigating the investment intersections of interest, dividends, capital gains, and principal, and the tax dynamics of ordinary income, qualified dividends and long-term capital gains, principal liquidations, pre-tax retirement account distributions, and the use of Roth-style tax-free distributions (or IRA conversions to them in the first place). The bad news, however, is that it becomes remarkably difficult to simply figure out where the actual cash will come from to generate those retirement paychecks in the first place!
Translating Retirement Portfolio Strategies Into Retirement Paychecks
Of course, the simplest and most straightforward solution to generating steady retirement paychecks is simply to eschew portfolio-based investing altogether and simply purchase a traditional single premium immediate annuity (SPIA). Though, for retirees who want to maintain greater liquidity and/or have a desire to leave behind to their children or other heirs whatever they don’t use, or simply want the potential for some future upside (even if it entails the risk of future downside), it becomes necessary to use – and figure out how to use – a more diversified retirement portfolio. Which brings back the question: how should retirees (and their advisors) generate retirement paychecks from a (diversified, total return) retirement portfolio in the first place?
The first option is the more traditional “income-based” approach; to simply invest into vehicles that can produce a steady stream of cash flows in retirement, and then pay out those income distributions as they are received. This might be buying into a mixture of bonds that pay interest and stocks that pay dividends, along with more recent additions to the income-portfolio mix like real estate (e.g., via REITs) and Master Limited Partnerships (MLPs) as well. With this approach, capital gains are largely ignored, and/or are not even actively invested towards in the first place. Instead, the portfolio is simply invested into “income-producing” assets, whose ongoing income payments will be transferred to (or directly paid into) the retiree’s retirement account.
The risk of the income-based approach is that investment markets don’t always pay the level of “income” that one desires, as has been the case in the low-yield environment of the past decade in particular. Which in turn can drive some investors to stretch for yield by taking on additional investment risk, and increasing the possibility that the income itself may stop (or at least be cut) in difficult times (e.g., a recession that causes high-risk bonds to default).
By adding in the capital gains component of retirement portfolio investments, the retiree literally becomes less reliant on “just” traditional income alone, but as noted earlier, relying on not-always-present capital gains requires developing a system to handle generating consistent retirement paychecks from inconsistent capital gains.
One approach is to use capital gains to supplement or “top up” income to generate retirement distributions. For instance, interest and dividends might still be accumulated first (and held in cash until paid out), but on a quarterly or annual basis the available cash position may be supplemented by rebalancing the portfolio – effectively liquidating whatever investment was recently up the most – to generate additional cash for the coming 3 (or 12) months on top of whatever the interest and dividends were ultimately providing. In the event that markets were down (and there was nothing “up” to rebalance), the next quarterly or annual distribution supplement might be designated to come from cash instead (i.e., from “principal,” to avoid liquidating equities while they’re down).
The Top-Up approach was appealing in the past in part because it helped to minimize transaction costs and trading activity by first accumulating any/all available interest or dividends, and then liquidating “just” enough to top up the required distributions on an ongoing basis. Advisors (or retirees) particularly sensitive to trading costs might generate cash from capital gains on an annual basis, while those with more modest transaction costs might do so quarterly instead (to keep more of the portfolio fully invested in the first place).
However, as transaction costs have continued to decline further, some advisors now opt for a “Pure Total Return” approach that invests in a more growth-oriented portfolio, and to the extent there are any interest and dividends, they are fully and immediately reinvested (to avoid any ongoing cash drag in the portfolio). In turn, when the retiree needs distributions, it’s time to simply sell the desired investments if/when/as needed to generate that cash… at the exact moment it is needed to fund a retirement paycheck. After all, in a near-$0 transaction cost environment (e.g., because unlimited trading is permitted via a single wrap fee, and bid/ask spreads are $0.01), arguably there’s no reason to ever hold any cash at all, or even “income-producing” investments that generate cash. Even if a recently-received interest or dividend check will be needed in just a few weeks, it could still be invested in the meantime and liquidated later. For tax-sensitive clients, lot-level accounting ensures that the shares sold will be the ones just purchased that will still be mostly basis and have little short-term capital gains exposure.
Codifying The Nuts And Bolts Of Generating Retirement Paychecks In A Withdrawal Policy Statement
Ultimately, the reality is that even from something as “simple” as a total return portfolio that combines together interest, dividends, and capital gains, there is a non-trivial amount of complexity in turning all the various moving parts into a steady series of ongoing retirement paychecks for retirees… recognizing that while a retirement portfolio may have multiple sources of return, most retirees simply want to pay their bills the way they’ve already been paying their bills for decades: with cash that simply shows up in their bank account on a regular periodic basis. Which after retirement – and actual employee paychecks are gone – must be accomplished from the available retirement portfolio and other assets.
Accordingly, some of the key practical components that must be considered for any portfolio-based retirement income process include:
- Dividends and Interest. Will they be swept to cash, distributed immediately, or reinvested (for future liquidation)?
- Cash. Will it be allowed to accumulate? What will be done to increase/supplement it over time? Is there a better place for it to sit that generates a more favorable yield?
- Liquidations. What will be liquidated if additional cash flows are needed, either on an ongoing basis or for one-time large expenditures? Will a rules-based system or other policy be established to determine formulaically what to liquidate as needed (e.g., from stocks if the market is up but from cash if the market is down, or rebalanced from whatever investment is most overweighted, or rebalanced from whatever investment has had the biggest recent run-up)?
- Cash Reserve. Beyond having the cash to distribute to the retiree, will an additional cash “bucket” or “cash reserve” be held to smooth out distributions from potentially-volatile sources?
- Distributions. Advisors historically have rebalanced on an annual or perhaps quarterly basis, but most retirees are accustomed to monthly (or even bi-weekly) paychecks. How often will distributions be made?
- Accounts. From which accounts will distributions occur, given that many retirees have a mixture of up to 3 different primary account types (taxable accounts, tax-deferred retirement accounts, and tax-free Roth-style accounts)? How will distributions for paycheck purposes be coordinated with ongoing tax planning for the retiree (e.g., tax-efficient drawdowns or systematic partial Roth conversions)?
- Coordination. How will retirement distributions be coordinated with the other available sources to generate retirement cash flows, from Social Security benefits (which may or may not be delayed) to potential uses of annuities, and even reverse mortgages to supplement retirement cash flows? Will retirement withdrawals have to be adjusted dynamically to handle these other cash flow sources?
In the end, the point is not necessarily to pick any particular methodology for generating retirement withdrawals, but simply to recognize that some clear and consistent policy is needed… ideally, one that can be applied consistently to a wide range of clients and situations. Which, in turn, can then be codified into a “Withdrawal Policy Statement” that, similar to an Investment Policy Statement, articulates the key policies that will be implemented to consistently generate retirement distributions for clients.
In fact, the whole point of a Withdrawal Policy Statement, as distinct and separate from an Investment Policy Statement, is to recognize that generating retirement distributions – i.e., re-creating “paychecks in retirement” – is not just a function of how the portfolio will be invested alone, but encapsulates a whole separate (albeit related) set of policy issues, from how interest and dividends will be handled, whether/how capital gains will be generated and used, the proactive use of cash (or not), the frequency of distributions, and how the strategies will be coordinated with both the impact of taxation and the availability of other assets and income sources.
The bottom line, though, is simply to recognize that for many retirees, generating “income” in retirement isn’t merely (or even primarily) an investment problem. In some cases, it’s a far more straightforward mechanical problem – how, literally, will the cash be generated to show up in the bank account every other week or at the end of every month, as the retiree has been accustomed for the past several decades. Except, in practice, generating those retirement paychecks from a diversified portfolio is not necessarily as simple as it may seem. At least, not until decisions are made about the specific retirement income process and policies that the advisor intends to use!
So what do you think? How do you mechanically generate retirement distributions from a portfolio to create retirement paychecks? How does your liquidation methodology impact the rest of your investment and tax-planning approach in retirement? Please share your thoughts in the comments below!