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. This is the case 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.
This makes sense, since 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. That 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.
Overall, though, the mechanical problem of how to actually generate those retirement “paychecks” is an entirely separate matter from just investing the retirement portfolio itself. In turn, advisors might even consider creating Withdrawal Policy Statements to 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!
The Need For Ongoing “Paychecks” In Retirement
For most of our working lives, paychecks are deposited on a 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. 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 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. 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 to fund a paycheck account to cover the retirement expenses.
The added complication of introducing dividend-paying stocks to the retirement portfolio was that stocks can also produce potentially-quite-substantial capital gains as well. Through the decade of the 1980s, not only did dividend payouts more-than-keep-pace with inflation, but the raw price level of the S&P 500 also appreciated by 150%! That meant retirees suddenly had another very substantial source to generate retirement paychecks… except for the fact that capital gains are not nearly as stable and consistent as dividends or interest, producing outsized potential “distributions” in some years, but little or none in other years. As a result, while capital gains are capable of generating additional retirement income, they are far less conducive to generating retirement “paychecks” for regular deposit.
The significance of this evolution in retirement income from interest to dividends to capital gains—and the potential need to rely on principal in years where 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. This is further complicated by the fact that tapping principal may or may not be taxable income, 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 potential in navigating the investment intersections of interest, dividends, capital gains, and principal. The bad news 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 solution to generating steady retirement paychecks is to eschew investing altogether and simply purchase a traditional annuity (SPIA). However, for retirees who want to maintain greater liquidity and/or have a desire to leave a legacy from the unused balance, it becomes necessary to use a more diversified retirement portfolio. How then should retirees (and their advisors) generate retirement paychecks from a (diversified, total return) retirement portfolio?
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. The portfolio is simply invested into “income-producing” assets, whose ongoing income payments will be transferred to 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. This 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 regress in difficult times.
By adding in the capital gains component of retirement portfolio investments, the retiree literally becomes less reliant on “just” traditional income alone. Of course, relying on not-always-present capital gains requires the development of a system to generate consistent retirement paychecks from inconsistent capital gains.
One approach is to use capital gains to supplement or “top up” retirement distributions. For instance, interest and dividends might still be accumulated first, but on a quarterly or annual basis the available cash position may be supplemented by rebalancing the portfolio to generate additional cash for the coming 3 (or 12) months. 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 “principal.”
More recently, some advisors have opted for a “Pure Total Return” approach that invests in a more growth-oriented portfolio, and any interest and dividends are fully and immediately reinvested. In turn, when the retiree needs distributions, it’s time to simply sell the desired investments if/when/as needed to generate that cash to fund a retirement paycheck. For tax-sensitive clients, lot-level accounting ensures that the shares sold will be the ones just purchased and will have little short-term capital gains exposure.
Codifying The Nuts And Bolts Of Generating Retirement Paychecks In A Withdrawal Policy Statement
The challenge remains that even from something as “simple” as a total return portfolio, there is a significant amount of work left to turn all the various moving parts into a steady series of retirement paychecks. Additionally, while a retirement portfolio may have multiple sources of return, most retirees simply want to pay their bills the way they always have: with cash that simply shows up in their bank account. Once you retire, that must be accomplished from the available retirement portfolio and other assets.
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. In fact, the whole point of a Withdrawal Policy Statement is to recognize that generating retirement distributions is not just a function of how the portfolio will be invested, but includes a range of other issues, from how interest and dividends will be handled, whether/how capital gains will be generated, the proactive use of cash (or not), the frequency of distributions, and how the strategies will be coordinated with other assets and income sources.
The bottom line is simply to recognize that for many retirees, generating “income” in retirement isn’t an investment problem, it’s a mechanical problem. How will the cash be generated to show up in the bank account regularly, as it has for the past several decades? In practice, generating those retirement paychecks from a diversified portfolio is not as simple as it may seem. It gets easier once decisions are made about the specific retirement income process and policies that the advisor intends to use.