LUTZ BUSINESS INSIGHTS
the pitfalls of income investing
josh jenkins, cfa, senior portfolio manager & head of research
As people advance toward retirement, their investment objectives inevitably shift. During their working years, the goal is to build wealth. By forgoing some consumption today, investors accumulate future spending power in the form of a portfolio of assets. When the time comes to leave the workforce, those assets must step in and replace earned income.
There are a variety of approaches a retiree can use to turn their portfolios into spending power. We will discuss a couple of common methods here. Before we get to that, it may first be helpful to understand how portfolio returns are generated:
Appreciation + Income = Total Return
In the equation above, appreciation refers to changes in the asset’s price, while income generally consists of dividends and interest. ‘Total return’ is simply the combination of the two.
The Income Approach
A common strategy to fund retirement spending focuses specifically on the income component of return. With this approach, the retiree lives off the dividends and interest generated by the investments. This is a very attractive proposition for many investors, particularly those with an aversion to dipping into principal. While this seems like a great idea in theory, in practice, it doesn’t work well for a variety of reasons.
To start, the idea that dividends allow you to bypass a reduction in principal is not true. A dividend does not represent value created out of thin air. Before being distributed to investors, it was cash on the balance sheet and comprised some part of the company’s value. When a firm decides to pay a dividend, its value is reduced by that amount. However, the direct impact on the stock is difficult to observe, given the myriad of other factors that cause day-to-day fluctuations in price. Dividends are not a free lunch. Whether it is the company distributing capital to shareholders or investors selling shares in their portfolio, there is a reduction in principal.
Another weakness of the income approach relates to the current market environment. Let’s assume that a typical retiree spends about 4% of their portfolio’s value per year. Thirty years ago, stocks and bonds could have easily handled that need, but that has since changed. As the chart below illustrates, a decline in yields (particularly for bonds) means a traditional portfolio would not be able to satisfy that spending rate.
Source: Morningstar Direct. Data from December 1987 through June 2020. Popular Vanguard funds (VFINX for the S&P 500 Index and VBMFX for the Total Bond Market) were used instead of the actual indices due to data availability.
If the income from a traditional portfolio is no longer sufficient, how do retirees make up the difference? One option would be to take more risk in the bond allocation. This can be accomplished by buying either longer-term or lower-quality bonds. Each option has material drawbacks.
Bond prices have an inverse relationship with interest rates (when rates rise, bond prices decline), and that relationship grows stronger as the time to maturity stretches longer. With yields near historic lows, relatively small increases could cause the value of longer-term bonds to decline by more than the interest payments they receive. On the other hand, lower-quality bonds carry an increased risk of default, which can cause them to behave more like stocks than high-quality bonds. When the market becomes volatile, low-quality bonds can experience dramatic equity-like price declines.
Increasing the risk of the bond allocation could potentially help reach a specific income target, but in doing so, the principal value of the portfolio is put at risk. As famed investor Howard Marks once observed, “If riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.”
Another option for increasing portfolio income is to focus the equity allocation on areas that produce high dividends. Again, doing this has some profound drawbacks. For starters, the really high dividend companies are generally concentrated in a few sectors (including energy, utilities, and REITs) and represent a small subset of the overall market. To really emphasize them, an investor must embrace a more concentrated portfolio. Additionally, stocks that share a similar feature, such as a high dividend yield, may also share a sensitivity to certain macro risk factors. An example here would be rising interest rates. The end result is a less diversified portfolio, which is thus taking on more risk than necessary.
Taxes represent another important consideration, as income strategies are generally less tax-efficient than alternatives. While 100% of a dividend is taxed, only the portion representing a gain is taxed when selling stock. The rate the dividend is taxed at could also be less favorable. While most traditional stocks pay qualified dividends, which are taxed at the long-term gains rate, others get classified as ordinary dividends and are subject to the higher ordinary income rate. Finally, an investor has no control over the timing of when a dividend is received but does have the flexibility to manage stock sales around actual spending needs. At the end of the day, the spending power of a taxable account will depend on the after-tax return, which is typically lower on high-income strategies.
A Better Solution
An alternative to the income strategy for funding retirement spending is the ‘total return’ approach. This method embraces both components of return rather than focusing on just the income piece. In practical terms, this involves holding a diversified portfolio of traditional stocks and bonds. The income generated is tapped to pay expenses, and the difference is covered by selling shares. By focusing sales in the portfolio areas that have recently done the best, the benefit of rebalancing is captured. During periods of strong market returns, some gains are taken off the table in the stock allocation. When the market is under pressure, bonds are sold to allow the stocks time to recover. This leads to a consistent practice of “selling high.”
The income-based approach is very common, in part because of how intuitive it is. In theory, the idea of protecting your portfolio by never dipping into the principal is very enticing. While doing this efficiently was an option a few decades ago, declining yields mean it’s no longer possible without adding avoidable risks. At Lutz Financial, we instead advocate the total return approach. This hybrid method can take advantage of both components of return while avoiding the pitfalls of yield chasing.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.
ABOUT THE AUTHOR
JOSH JENKINS, CFA® + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH
Josh Jenkins is the Senior Portfolio Manager and Head of Research at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.
AREAS OF FOCUS
- Asset Allocation
- Portfolio Management
- Research & Data Analytics
- Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
- Chartered Financial Analyst (CFA)
- Chartered Financial Analyst Institute, Member
- Chartered Financial Analyst Society of Nebraska, Member
- BSBA, University of Nebraska, Lincoln, NE
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