Avoid Trojan Horses In Planning For Retirement

January 02, 2009

As retirement approaches, tweaking your focus from growth to income is a key. Here are some suggestions on how to strike a proper balance.

 

If you're one of the millions of baby boomers soon to exit the full-time workforce, a stark reality of investing on a fixed income is about to take center stage. 

It's likely you still haven't accumulated a large enough retirement nest egg to be absolutely certain of not running out of money during a hopefully long and fruitful retirement.

But take heart. It's a sobering truth facing almost all of us at some point—whether we're approaching retirement or already at that point in our investing lives. 

You've probably heard the warnings before. And they keep coming. Labor exports are now estimating that 25% of all retiring Americans will be dependent on working part-time jobs after they begin to draw Social Security benefits. Another stark reality facing retirees in coming years is that with increasing medical breakthroughs in cancer and heart disease research, many retirees may live years beyond their current life expectancy.

The traditional solutions to solving retirement shortfalls are not reassuring. The usual mantra on retirement Web sites is to save more, cut expenses, delay retirement or continue working part time. 

A much easier retirement strategy is to reduce your growth investing and invest primarily in investments that always pay monthly or quarterly distributions. You can accomplish this quite simply by diversifying most of your retirement dollars into high-income-paying stock, bond and "alternative investment" exchange-traded funds.

The Trojan Horse Of Retirement

Traditional retirement planning often advocates investing in growth stocks or mutual funds and systematically withdrawing monthly checks of 6-7% per year. A more conservative financial planner might suggest withdrawing less. But what's the risk in withdrawing only 6-7% when the market historically grows 9-10% annually? Aren't you spending less than you're earning?"

Wrong! No you are not. And that's the great Trojan Horse of retirement investing. What you expect is not what you get. Inside that wonderful old-world strategy in which growth stocks historically have been dependable generators of 10% annual earnings is a startling surprise. While you may be withdrawing just 6-7%, your principal is being mercilessly invaded every time the market dips.

How so? If your fund doesn't pay distributions, you must sell principal shares to meet your monthly income requirements. In a bear market, this steady sale of shares greatly accelerates—the greater the market decline, the more shares you need to liquidate. Admittedly, the lower your withdrawal rate, the longer your principal will last. But sooner or later the result will be the same—your principal will be gone.   

Consider a study by Ibbotson researchers in 2005 looking at withdrawal rates from a 50/50 balanced portfolio of stocks and bonds from 1972-1995. It's sobering. Even modest withdrawal rates eventually exhaust your principal. Here's a look: 

 

Withdrawal Rate

How Long Until Principal Exhausted

5%

22 Years

6%

15 Years

7%

12 Years

8%

10 Years

9%

9 Years

 

With today's dividends and interest rates yielding 5-10% and even higher, most retired investors should never need to withdraw principal to live on. It is crucial, in fact, that you only withdraw the income you earn on your principal—the dividends and interest.

True income investors should never need to make withdrawals from their principal. Never.

 

Income Investing Works Better In Retirement

So, why does income investing work better for retirees than traditional growth investing? It's simple. If you never sell any shares of your stocks or mutual funds, then you will never have fewer shares than you started with. Your share prices may decline, of course, as they always do in a down market, but to an income investor, it doesn't really matter because your income checks won't drop if you don't sell any shares. 

Say for example, you buy 1,000 shares at $10.00 each. You receive 50 cents in dividends, or $500 yearly. Now suppose your investment drops 20% in a market downturn to $8,000 total. In spite of your 20% "paper loss," you still have your $500 spendable income every year. 

Simply stated, if you do not have to sell any of your 1,000 shares, you keep receiving your original $500 per year because each share still pays 50 cents annually regardless of your principal value.

Our example assumes, of course, that the issuer of your shares always keeps its dividend payment constant. Since dividend distribution payments aren't guaranteed (unlike interest payments on bonds and certificates of deposits), a careful analysis of the sustainability of dividends or interest payments is critical to your success as an income investor.

Based on historical patterns, the following list of dividend-paying asset classes are a good starting point for retired investors wishing to construct a well-diversified, retirement portfolio for income. (Included are some possible ETFs to tap into these categories): 

Asset

Symbol

Distribution Rate

Municipal Bonds

PZA

5.1%

Treasury Inflation Protected Bonds

TIP

9.5

Mortgage Backed Securities

MBB

4.5

Government/Corporate Mix

AGG

4.6

Corporates - Investment Grade

LQD

5.5

Corporates - High Yield

JNK

15.3

Global TIPS

WIP

5.7

Emerging Market Bonds                 

PCY, DEM

7.9, 6.1

US Equities

SDY, PEY

6.1, 8.1

Preferred Equities

PFF, PGF

10.9, 14.7

International Equities

IDV

9.3

Emerging Market Equities

VWO

5.1

Commodities - Gold Mining

GDX

9.2

Commodities - Energy

ENY, IPW

11.2, 4.4

Commodities - Real Estate

IYR, ICF

10.1, 9.6

 

By building your retirement nest egg into a dividend-paying, high-income powerhouse of carefully selected income ETFs, you just might find riding out this bear market a little easier. 

And remember: Don't buy into the Trojan Horse growth-fund trap. When you're retired or trying to live on a fixed income, it's not about the growth in your portfolio. Success is all about generating more income.


Chance Carson is president of Alpine Strategies in Colorado Springs, Colo. He also serves as editor of AboutETFs.com, an educational Web site for retired investors. He welcomes comments and suggestions for future columns at [email protected].

 

 

 

 

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