The first rule of retirement income planning is: Never run out of money. The second rule is: Never forget the first. An observant reader will note that there is no conflict between the rules.

But, there is plenty of conflict between the need for safety and the need for growth to hedge inflation over the life of the retiree. Because inflation and interest rates so closely track each other, a zero-risk investment portfolio will steadily erode the value of the nest egg over the life of the portfolio, even with very modest withdrawals. We can all but guarantee that the zero risk portfolios will not meet any reasonable economic goals.

On the other hand, an equity-only portfolio has high expected returns, but comes with a volatility that risks self-liquidation if withdrawals are continued during down markets.

The appropriate strategy balances the two conflicting requirements.

We will design a portfolio that should balance the requirements of liberal income with sufficient liquidity to withstand down markets. We can start by dividing the portfolio into two parts with specific goals for each:

  • The widest possible diversification reduces the volatility of the equity portion to its lowest practical limit while providing the long-term growth necessary to hedge inflation, and meets the total return necessary to fund withdrawals.
  • The role of fixed income is to provide a store of value to fund distributions and to mitigate the total portfolio volatility. The fixed income portfolio is designed to be near money market volatility rather than attempt to stretch for yield by increasing duration and/or lowering credit quality. Income production is not a primary goal.

Total Return Investing

Both portions of the portfolio contribute to the goal of generating a liberal sustainable withdrawal over long periods of time. Notice that we are specifically not investing for income; rather we are investing for total return.

Your grandparents invested for income and crammed their portfolios full of dividend stocks, preferred shares, convertible bonds and more generic bonds. The mantra was to live off the income and never invade principal. They selected individual securities based on their big fat juicy yields. It sounds like a reasonable strategy, but all they got was a portfolio with lower returns and higher risk than necessary.

At the time, nobody knew better, so we can forgive them. They did the best they could under the prevailing knowledge. Besides, dividends and interest were much higher in your grandfather's time than they are today. So, while far from perfect, the strategy worked after a fashion.

Today, there is a far better way to think about investing. The entire thrust of modern financial theory is to change the focus from individual security selection to asset allocation and portfolio construction, and concentrate on total return rather than income. If the portfolio needs to make distributions for any reason, such as to support lifestyle during retirement, we can pick and choose between the asset classes to shave off shares as appropriate. (To learn more about the risk and reward correlation, read The Equity-Risk Premium: More Risk For Higher Returns.)

The Total Return Investment Approach

Total return investing abandons the artificial definitions of income and principal which led to numerous accounting and investment dilemmas. It produces portfolio solutions that are far more optimal than the old income-generation protocol. Distributions are funded opportunistically from any portion of the portfolio without regard to accounting income, dividends, or interest, gains or losses; we might characterize the distributions asĀ "synthetic dividends."

The total return investment approach is universally accepted by academic literature and institutional best practices. It's required by the Uniform Prudent Investment Act (UPIA), the Employee Retirement Income Security Act (ERISA), common law and regulations. The various laws and regulations have all changed over time to incorporate modern financial theory, including the idea that investing for income is the inappropriate investment policy.

Still, there are always those that don't get the word. Far too many individual investors, especially retirees or those that need regular distributions to support their lifestyle, are still mired in grandfather's investment policy. Given a choice between an investment with a 4% dividend and a 2% expected growth or an 8% expected return but no dividend, many would opt for the dividend investment, and they might argue against all the available evidence that their portfolio is "safer." It is demonstrably not so.

Unfortunately, in a low interest rate environment, the demand for income-producing products is high. Fund companies and managers are rushing to bring income solutions to market in an effort to maximize their own returns. Dividend strategies are the darlings of salesman, ever ready to "push them the way they are tilting." And, the press is full of articles on how to replace lost interest income in a zero-yield world. None of this serves investors well.

So, how might an investor generate a stream of withdrawals to support his lifestyle needs from a total return portfolio?

An Example

Start by selecting a sustainable withdrawal rate. Most observers believe that a rate of 4% is sustainable and allows a portfolio to grow over time.

Make a top level asset allocation of 40% to short term, high-quality bonds, and the balance to a diversified global equity portfolio of perhaps 10 to 12 asset classes.

Cash for distributions can be generated dynamically as the situation requires. In a down market, the 40% allocation to bonds could support distributions for 10 years before any volatile (equity) assets would need to be liquidated. In a good period when equity assets have appreciated, distributions can be made by shaving off shares, and then using any surplus to re-balance back to the 40%/60% bond/equity model.

Rebalancing within the equity classes will incrementally enhance performance over the long term by enforcing a discipline of selling high and buying low as performance between the various classes varies.

Some risk averse investors may choose not to rebalance between stocks and bonds during down equity markets if they prefer to keep their safe assets intact. While this protects future distributions in the event of a protracted down equity market, it comes at the price of opportunity costs. However, we recognize that sleeping well is a legitimate concern. Investors will have to determine their preferences for rebalancing between safe and risky assets as part of their investment policy.

The Bottom Line

A total return investment policy will achieve higher returns with lower risk than a less optimal dividend or income policy. This translates into higher distribution potential and increased terminal values while reducing the probability of the portfolio running out of funds. Investors have a lot to gain by embracing the total return investment policy.