According to a recent study, a middle class couple aged 65 has a 43% chance that one of them will live to age 95. The challenge for this couple is to continue to enjoy their lifestyle and have enough money to live worry-free. Once you stop working you are dependent on income sources like pensions, annuities, social security payments and withdrawals from the savings you have accumulated over the years.
Most of these retirement income sources are fixed once we retire and are out of our control. It’s the retirement savings component that has people concerned. Most retirees don’t want to run out of money before they run out of time. For many they, themselves, are the income source that makes the difference between just getting by and enjoying life. Many retirees focus on the dividends and interest that their portfolios create. That may not be the best answer. Let’s examine the problems associated with this approach.
For the last five years the interest rate on high quality bonds (and CDs) has been close to zero. People who have chosen the “safety” of U.S. Treasury bonds or CDs have actually lost purchasing power after you take inflation and taxes into consideration. The same holds true for owners of tax-free municipal bonds. Those who bought bonds 10, 15, even 20 year ago when interest rates were higher have realized that bonds eventually come due. And when bonds mature, new bonds pay whatever the current interest rate is. That has meant a huge drop in income for many people who depend largely on interest payments.
Dividend payments are also subject to disruption. The financial crisis of 2008 was devastating for many investors. Those who owned bank stocks were particularly impacted. Bank stocks were a favorite for many income investors at that time because they produced lots of dividend income. Most banks slashed or eliminated their dividends, and some went out of business completely. Even companies that were not considered banks, like General Electric, were forced to cut their dividends. Dividends are nice income sources, especially in a low interest rate environment, but they are not guaranteed and you have to be careful about having too much of your portfolio concentrated in any one stock or industry.
The preferred method of planning for withdrawals from retirement savings is to take a “total return” approach. Total return refers to the growth in value of a portfolio from all sources, not just dividends and interest but also capital appreciation. In many cases, capital appreciation provides more return than either dividends or interest.
So how does one go about taking an income from a total return portfolio? Many advisors use 4% as a good starting point for withdrawals. That means for every $100,000 in your portfolio you withdraw $4,000 (4%) per year to live on while investing the rest. The goal is to invest the portfolio is such a way that over the long term, the growth offsets the withdrawals you are taking. It’s like a farmer harvesting a crop, leaving enough so that your portfolio has the chance to actually grow a little over time.
Of course, as we age other factors enter into our lives and the retirement equation, often headlined by medical problems related to aging. We will deal with these issues in another essay.