The first rule of retirement income planning is: Never run out of money. The second rule is: Never forget the first.

It sounds pretty straightforward. Where it gets complicated is negotiating between two equally valid but conflicting concerns: the need for safety and capital preservation, and the need for growth to hedge inflation over the life of the retiree. Few people want to take high-flying risks with their retirement funds, but a zero-risk investment portfolio—one invested solely in safe income vehicles, like Treasury bonds—will steadily erode the value of the nest egg, even with very modest withdrawals. Counterintuitive as it sounds, it is all but guaranteed 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 volatility that risks decimation if withdrawals continue during down markets.

The appropriate strategy balances these two conflicting requirements.

Key Takeaways

  • Retirement-fund portfolios need to balance between two conflicting needs: preservation of capital for safety, and growth of capital to protect against inflation.
  • Modern financial theory advocates a focus on total return rather than income for retirement-oriented portfolios.
  • The total return investment approach relies on well-diversified equity assets for growth and fixed-income vehicles as a store of value.
  • If and when the portfolio needs to make distributions, investors can pick and choose between the asset classes to shave off shares as appropriate.
  • A total return investment strategy will achieve higher yields with lower risk than a dividend- or income-oriented investment strategy.

A Balanced Portfolio

The goal will be to design a portfolio that balances 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:

  1. 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.
  2. 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 the duration and/or lowering credit quality. Income production is not a primary goal.

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.

Total Return vs. Income

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 touch the 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 wisdom. Besides, dividends and interest were much higher in your grandparents' time than they are today—and life expectancies after retirement were shorter. 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 securities selection to asset allocation and portfolio construction, and to concentrate on total return rather than income. If the portfolio needs to make distributions for any reason, such as to support your lifestyle during retirement, it is possible to pick and choose among the asset classes to shave off shares as appropriate.

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 as 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 an inappropriate investment strategy.

Still, there are always those who don't get the word. Far too many individual investors, especially retirees or those who need regular distributions to support their lifestyle, are still stuck in grandfather's investment strategy. 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.

Total Return Investing in Action

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

  • Start by selecting a sustainable withdrawal rate. Most observers believe that an annual 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 60% (the balance) to a diversified global equity portfolio of perhaps 10 to 12 asset classes.
  • Generate cash for distributions 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 the Portfolio

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 among the classes varies.

Rebalancing involves looking at the value of assets in your portfolio—stocks, bonds, etc.—and selling those that have exceeded the percentage allocated to them when you first structured your portfolio.

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 a rebalancing between safe and risky assets as part of their investment strategy.

The Bottom Line

In a low-interest-rate world, it's easy for investors to become obsessed with yield. However, even for retirement-oriented portfolios, a total return investment strategy will achieve higher returns with lower risk than an invest-for-income approach. This translates into higher distribution potential and increased terminal values while reducing the probability of the portfolio running out of funds.