How To Turn Retirement Assets Into Income

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Is a portfolio worth $500,000 a lot of money for retirement? How about $1 million? What if you’ve saved $5 million? I get asked this a lot, and I find it helps to reframe the question: Is $2,000 a month a lot of money? What about $5,000 a month? Or $10,000?

When you look at it this way, you probably already know your answer. That’s because we generally conceive of wealth in terms of current income and not assets. Think about it: We pay income taxes and see our tax withholding on every pay stub, and we routinely deal with monthly bills and expenses that must be paid with current income.

Clearly, the answer to the question above about whether $500,000, $1 million, or $5 million is “a lot” of money for retirement depends on how much income you need the portfolio to generate. By “income” I mean how much cash does the portfolio need to provide you on a monthly basis in order for you to pay your bills. Interestingly, people who retire on a pension and social security don’t have to worry about their portfolio generating income. It just comes every month, like clockwork. Folks who retire on a pension don’t worry about the size of the pension fund of the company they retired from. They just deposit the check and continue to worry about other, more important matters. (Note: This doesn’t mean they shouldn’t worry about their company pension plan…. Unfortunately most people are simply unaware.)

I recommend to clients that they think of their retirement income as a pension payment that is funded by their personal account. With the help of their advisor, they will determine the proper amount of monthly cash they need to live on. I usually suggest they have the monthly withdrawal direct deposited into their checking account so they don’t have to bother with it. If you want a quick rule of thumb, figure you can take about 4% to 5% of your portfolio as income each year. So a $500,000 portfolio will afford you an annual payout of $20,000 to $25,000 per year, or $1,666 to $2,083 per month. (Please check with your financial advisor about sustainable withdrawal rates to get the withdrawal rate that works in your individual situation.) Generally speaking, your job is to not spend more than your monthly portfolio payment plus whatever other sources of income you might have. Enjoy yourself. Spend your time thinking of creative ways to entertain the grandkids.

However, our job is a lot more complicated. We have to figure out exactly how to find the 4% to 5% of your portfolio value we will pay out to you during the year. The first thing you should note is that Pinnacle invests your money to earn the highest total return possible for the amount of risk you are willing to take. We don’t invest your money to generate current income. The income from the securities in your portfolio is counted as part of the portfolio’s total return. So if the income from your portfolio is 2% of the portfolio value, and the securities in your portfolio appreciate in value by 4%, then the total return of your portfolio is 6% (2% income plus 4% appreciation.) Pinnacle will use the income generated by the portfolio and/or sell the appreciated or depreciated securities in your portfolio, in order to pay you your monthly retirement distribution (or as I prefer to call it, your personal pension payment). This is an especially good thing, because in a world with very depressed interest rates, it’s almost impossible to invest in securities that drive enough income for you to live on your portfolio alone. And ‘reaching for yield’ by buying higher risk securities is often a major cause of catastrophic investment mistakes.

Once we determine how much monthly (or bi-monthly, or quarterly) income you need, your wealth manager works with you to decide which individual account(s) will be the source of your monthly income payments. In making this decision, your advisor will be considering a number of issues relevant to your income bracket. Clients are often surprised when their advisor recommends taking distributions from both taxable and tax-deferred accounts, because it is actually in your best interest to generate more rather than less taxable income to maximize your tax situation.

After we decide on the correct portfolio(s) to fund your withdrawal, we rely on software tools to make some sophisticated decisions in terms of selling securities. That’s correct: Turning assets into income typically involves selling securities, and the trick is to sell the right ones. We subscribe to a sophisticated computer program that is based on the general rule that it’s best to buy assets at low prices and sell them at high prices, and then make appropriate sell decisions to generate your most efficient retirement income. Here are four decision rules that are built into the program:

1. The yield, or current income, from the securities in your portfolio is not reinvested, but is ‘swept’ directly to the cash account in your portfolio. The software will recognize this additional cash as being available to fund your monthly retirement payment.

2. Securities to fund monthly payouts are sold based on how far they are from the target percentage in your portfolio model. So if you own a security that is 0.9% over its target weight, it will be sold before a different security that is only 0.3% over its target weight.

3. We can program specific rules for taxes into your individual retirement plan. For example, we can specify a limit to the amount of taxes we generate from selling transactions. Or we can create rules for limiting realized short-term capital gains. Clients have to balance the benefit of any custom rules they create against the possible cost of running their portfolio differently than Pinnacle’s model portfolio strategy. Our financial advisors are there to help advise on these tricky tax questions.

4. You can specify ‘back-up cash’ if you want to have an emergency fund of cash to fund monthly payouts. It isn’t recommended because it will ultimately reduce your portfolio total return, but those who feel better knowing that cash is available at all times to fund their monthly payment can do so.

Turning assets into income is an important part of any financial plan, and Pinnacle advisors can help you to turn this ‘straw into gold.’ After all, you get a portfolio statement every month from your custodian telling you how much you owe in assets. But the money that shows up in your checking account each month is what you get to spend and enjoy!

Moving to a Negative Interest Rate

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With the Federal Reserve recently raising interest rates for the first time in many years, the U.S. economy may be at the beginning of a transition away from the ultra-accommodative monetary policy environment that has existed since the global financial crisis. However, central banks in other major developed economies are not following suit—in fact, they are still trying to counteract the current low growth, low inflation economic environment.

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How the New Financial Law Affects Pinnacle Clients

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As the laws governing how financial professionals guide client retirement assets are set to change, financial advisors are being required to place the interests of their clients first. With this change, all advisors must not only recommend investments that are suitable for their clients, but more importantly, they must act as a fiduciary and place their clients’ interests ahead of their own.

So how will this affect the investments of Pinnacle clients? It won’t.

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Bearish Tendencies and Silver Linings

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2015 had many twists and turns, but from a financial market perspective, it was effectively a road to nowhere when looking across a variety of asset classes. In U.S. equity markets, large company stocks (large cap) barely moved as just a few sectors and stocks were big winners. In the broad market, many stocks performed far worse than the large cap averages and gave investors the false impression that the market was generally flat. On the contrary, a broader measure of the market which consists of 1700 equally weighted stocks was down roughly 7% on the year, and helps to highlight how skewed the major indices were, due to just a few large companies that had good years.

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A Message to Clients from the Chairman of the Investment Committee

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The S&P 500 Index is down over 12% from its high last May, which qualifies as a market correction but not a bear market. In fact, it’s been quite a while since we experienced our last bear, although it may not feel that way. From April to October of 2011, the stock market declined by 19.39% on a closing basis. While experts can debate whether this meets the definition of a bear market (which are typically defined as 20% declines), those who remember it will recall how scary it was. By the time the market bottomed in October, many were recalling the 2007–2009 bear market, which was gut wrenching for everyone. During that excruciating market decline, the S&P 500 Index fell by 55% and the economy tumbled into a deep recession. It is only in hindsight that we can see that both the market bottom in 2009 and the October low in 2011 marked important market bottoms. Since October of 2011, the S&P 500 Index rallied 94% to its eventual high set in May of last year.

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A Time for Caution

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The third quarter came in like a lamb and went out like a lion, as the return of volatility hit risk assets hard across the globe. As in previous quarters, emerging market stocks and commodities suffered double digit declines as markets continue to deal with the end of the commodity super-cycle and the mix of structural and cyclical problems reverberating throughout the emerging market complex.  But the big news of the quarter was a catch up in developed markets that had previously appeared impervious to the problems that were festering in the developing world.

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Not All Bear Markets Are Created Equal

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We’ve recently changed our cyclical view, as we don’t think the recent downdraft we’ve been experiencing is over yet. In fact, while many believe we’re experiencing a ‘garden variety pullback’ that provides us with a buying opportunity, we believe there’s a growing probability that the long running cyclical bull market may be transitioning into a cyclical bear market. We could be wrong—and hope that we are. But hope is not a strategy and we need to align with the evidence that calls for playing defense and protecting against a possible change in the market cycle.

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What’s Going on with the Market?

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It is hard to believe that in three trading days, the market has penned its first 10% correction in over 900 trading days. This decline may be an unfortunate reminder of the last bear market, and if you are feeling anxious about your portfolio, don’t worry—you have lots of company. In fact, the market has set a new record for the speed and breadth of market volatility.

Not only has the market dropped, but we have also witnessed several areas of the evidence we follow move into bearish territory. Given this recent downgrade, we now believe the probabilities are high that we are transitioning from a bull market to a bear market cycle.

In the remainder of this post, I’ll summarize our response to the recent market events in each of our three Pinnacle strategies.

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