Why Not Target a 4% Income Rate For Retirees’ Portfolios?
Ten years ago, we wrote a very similar article but it was during a time when interest rates were much lower. We felt it was appropriate to revisit this topic given interest rates are higher but expected by some to move lower. In fact, the federal reserve recently lowered the fed funds rate to 4.0%- 4.25% range with future decreases possible. Given this backdrop, we hear quite a few people wonder why we don’t shift our portfolio strategy and “lock in” these higher rates. The line of thought usually goes:
“If you can structure my portfolio to generate income of 4%, then I am confident my portfolio will cover all of my expenses in retirement.”
On the surface this seems like a straight-forward request that can easily be achieved. However, there are many underlying issues that make targeting a specific income return (from a combination of bond interest and stock dividends) a risky proposition. In fact, pursuing this sort of investment strategy can create a false sense of security and actually backfire – hurting an investor’s probability that their portfolio will last throughout retirement.
So what are the pitfalls of targeting a specific income level to satisfy retirement spending needs?
Issues from a Fixed Income (Bonds) perspective:
Currently, it is possible to achieve a 4% yield on higher quality bonds. For a point of reference, the 10-year treasury is currently yielding approximately 4%. However, the following issues must also be considered:
Emergency/Large Expenses
Let’s assume your portfolio is yielding the 4% you desire. However, a large, one-time expense occurs. This could be anything from an emergency health event, a new roof needed on a house, or even a wedding for a child. Therefore, you must sell some of your bonds to fund this expense. In doing so, you have reduced your invested capital and therefore your income stream. Your remaining assets may still be yielding 4%, but you have less assets at work, thus reducing your income.
Inflations Impact
As we know, inflation is not inherently a bad thing. In fact, the fed targets a 2% yearly inflation target. So, during even “normal” times, we can expect prices to rise. If we factor in inflation shocks like we recently had a couple years ago, purchasing power can be further eroded. If your portfolio is yielding a consistent 4% and generating a constant income stream that meets your expenses today, odds are this income stream will not be enough to meet your needs 1, 5, 10, or 20 years from now as your purchasing power is reduced year after year.
Let’s assume inflation is above target and averages 3.5% every year. In year 10 of retirement, your portfolio will need to generate about 5.7% income yield (on the same asset base) in order to maintain a similar lifestyle. Unfortunately, you locked in at 4%.
Bonds can default.
Although fairly uncommon for high quality bonds, it can happen. If it is necessary to increase exposure to lower rated bonds to meet your income requirement, your portfolio’s risk profile has changed.
Issues from an Equity (Stock) Perspective:
The returns earned by investing in stocks are comprised of two components 1) dividends and 2) stock price appreciation (or depreciation). Historically, dividends have been a significant contributor to stock gains. However, we need to keep in mind the following:
Currently, a diversified stock portfolio is not yielding anywhere near 4%. As a point of reference, diversified stock indexes currently have dividend yields below 1.25%.
There are stocks currently yielding above 4%, however:
This is a limited list, typically concentrated in a few industries/sectors. This can often result in a portfolio that is not diversified.
There is no guarantee your dividend payments will keep up with inflation. If the dividend rate stays constant and the stock is flat, your income will stay flat and purchasing power will be reduced.
Yields can be misleading regarding a company’s health. Consider a stock with a 4% yield. This seems good on the surface but what if the yield was recently only 2% and the jump is because of a drop in stock price?
Dividends are not guaranteed and can be reduced or even eliminated. Companies typically do not like reducing or eliminating dividends but, if necessary, this can happen.
Don’t Forget About Taxes
When it comes to investing, taxes are an important consideration that impact total return. From a tax standpoint, a bond yielding 4% in a personal/taxable account is taxed at your income tax rates. Therefore, if you are in the 24% bracket, your actual yield is closer to 3% and that does not even factor in any state taxes. If 4% was the goal, you already missed. If you attempt to compensate for this, now you must take on more risk for higher yield, subjecting your portfolio to a higher potential for losses and thus not reaching your goals.
If you are considering municipal bonds as a possible tax workaround, remember, they offer lower yields for an equivalent level of risk to account for the tax benefit. Therefore, this might not be an approach that works either. Minimizing the tax impact of any investment strategy requires an understanding of the tax attributes of both the investments utilized and the accounts in which those investments are held.
We Prefer a Total Return Approach
On the surface, creating a portfolio that “produces a 4% yield” seems simple. There are “investment products” continuously being made that claim they achieve this. However, in reality, these products always come with their own shortcomings and should be viewed very skeptically.
At Beacon Financial Strategies, we agree that investments that generate income should be a valuable component of most retiree’s portfolios. However, we also believe that maintaining a diversified investment approach will enhance returns and reduce risk for most long term investors. This really proves beneficial during the distribution phase of your life as it provides for income, growth, potential tax efficiency, and flexibility as life changes. If you have any questions regarding your portfolio or a potential investment opportunity, please reach out and we can assist.