With the decline in the stock market, there's lots of talk these days about how to create retirement income. While there are a number of different strategies, I prefer to use a simple method of creating cash flow to fund distributions. It doesn't require you to time the stock or bond markets, and gives you staying power through difficult economic cycles.
Cash Flow. Cash flow is the amount of money that is produced each year from your bond interest and stock dividends. And surprisingly, it's quite stable and predictable. If you just distribute your cash flow during lousy markets, you won't be forced to liquidate holdings and can preserve your capital for the eventual rebound.
Bond Interest. If you own a diversified portfolio of high quality corporate and government bonds, you can basically predict the amount of income you'll get from your bonds every year. The payments are guaranteed, and unless the issuer defaults, you'll get your interest payments.
A good proxy for the bond market is the Barclays U.S. Aggregate Bond Index. It's a mix of U.S. Treasury, agency and high quality corporate bonds. Today, the yield is about 4.5%. So it's fair to assume that if you had $100,000 invested in a portfolio designed to track that index, you could anticipate $4,500 of interest payments for the next 12 months.
Stock Dividends. You might be surprised to learn that stock dividends tend to be relatively stable even through bad economic cycles. While we have had a number of high profile dividend cuts, the dividends paid on the S&P 500 over the last 12 months are only down about 12% from the peak of the market about two years ago. Compare that to the price of the index, which is down close to 40%.
If you study prior recessions, you'd find a similar pattern of steep stock price declines, but modest declines in dividend payments. While there are no guarantees, the cash flow from a diversified pool of stocks is reasonably predictable. And when the economy recovers, the dividend payments tend to grow to provide an income stream that helps offset inflation.
By the way, since January 2000, the price of the S&P 500 index is down about 33%, yet the dividends paid (cash flow) has grown by over 60%. That's why I like to focus on cash flow.
The dividend yield for the S&P 500 this year has fluctuated between 2.5% and 3%, depending on the price of the index. But let's assume it's about 2.75%. That means if you have $100,000 in a portfolio designed to track the S&P 500, you could anticipate about $2,750 of dividends over the next year.
Combine The Two. As an example, if you have 60% of your money in bonds with a yield of 4.5% and 40% in stocks with a dividend of 2.75%, you have total cash flow of 3.8%. This 3.8% cash flow is pretty close to the base 4% withdrawal rate most advisers consider prudent for retirement income.
And if you're more selective about the types of bonds and stocks you own, you can move your cash flow above 4% in today's market.
For example, the dividend yield on the Dow Jones Industrial Average is about 3.3%. It's not a recommendation. It's just meant to illustrate that a different collection of companies can change your dividend profile.
Staying Power. The key to this strategy is that you aren't selling assets to create the distributions in bad markets. Now you have the confidence to ride through some pretty tough cycles. And when the stock market recovers, you can take distributions from the capital gains, in addition to the annual cash flow.
Bucket Strategies. I prefer the cash flow method over strategies used by other advisers who advocate a bucket approach to creating distributions. This approach requires you to liquidate a bucket of "safe" capital during down markets. But if the stock market decline lasts 10 or more years, as this one has, you might find you've liquidate more than you anticipated. And then you might discover you're left with a risky bucket of stocks that may be worth less than they were 10 years ago.
Now, you can't get everything you need to know about retirement income from a couple of blog posts. The point is to help you see that there are multiple ways to create income, and you're going to need to spend some time educating yourself about the options.
Bottom line. Retirement income investing is complicated. Take your time, get educated on the strategies and select an approach that makes you comfortable.
As with all financial matters, consult your individual advisor prior to making any financial decisions.
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