How can I create cash flow in retirement? Do I need bonds and dividend paying stock?
Cash flow management is one of the most important things we do for our clients. Decades ago the common wisdom was to live off the interest and dividends a portfolio pays while not touching the principal. This old-fashioned way of thinking reminds me of the Monopoly card that reads, “Bank pays you dividend of $50” and the idea of “clipping coupons” from bearer bonds before investments were stored electronically.
But those days are gone. Currently, we have the advantage of research and multiple investment vehicles to make cash flow management less rigid and far more responsive. The challenge is knowing how to generate cash to produce monthly income without pulling money from the wrong investment at the wrong time. That approach can have lasting effects on the sustainability of a portfolio during retirement.
Sequence of returns risk is the possibility that when you need the money for income the market is in a downward trend and you may have to start selling assets at a loss putting the future value of your retirement savings in jeopardy.
That’s what happened in 2008 when the market crashed, and you heard stories about retirees losing half of their retirement savings. But that didn’t have to occur! Had someone been guiding those folks during that crisis, to take from investments that were less risky, and to manage their cash flow, they would have been back to even in their portfolios by 2011.
A well-planned cash flow strategy takes into consideration:
- Other sources of income such as a pension, part-time work and social security.
- The proper mix of stocks, bonds and cash based on your risk profile. Like Goldilocks, the portfolio needs to be just right for you.
- The tax ramifications of taking money out of different investments and types of accounts like IRAs or annuities. Taxes generated by selling highly appreciated securities in a taxable account also need to be evaluated.
- The correct selection of assets to sell to generate the cash needed for income.
If you are nearing retirement, make sure to have cash and short-term bonds to weather any market down turn. With assets that can be liquidated with little risk of loss a portfolio can survive any downturn. A two-year plan for immediate cash flow needs may not always be enough, but it will help to mitigate the damage to your portfolio in the long run.
Beyond the 2-year period, plan for withdrawals that manage taxes and reduce losses by carefully balancing withdrawals from all assets and account types. Don’t be afraid to take distributions from tax free accounts prior to required minimum distributions, especially if those accounts hold the bulk of your investment assets.
We recently had a client, we’ll call him William, who come to us for help in generating income starting at age 66. He thought he would spend down his cash and then start taking Social Security. Since we recommended delaying Social Security until age 70, the task was to figure out the best way to replace the funds he would have received from Social Security for that 4 year period and beyond.
We all know that Required Minimum Distributions (RMD) must be taken out of retirement accounts at 70 ½ but, as in William’s case, it works better to delay Social Security and draw down the retirement account to supplement income needs. Using his substantial retirement account, taking distributions starting at age 66 accomplished a few goals: the income was sufficient to meet his needs, the taxes were spread out over a longer period of time and the retirement account value declined reducing the RMDs he would need to take at age 70 ½ at the same time Social Security kicked in.
What remained was to determine which assets to liquidate in order to raise the cash needed for the distribution. That decision needs to be made closer to the sell date as it is determined by a multitude of factors such as market conditions, interest rates, and capital appreciation, to name a few.
Deciding which assets to liquidate also depends on maintaining the correct level of risk in a portfolio. It may mean taking some losses in order to keep the appropriate ratio of stocks to bonds. If stocks are declining at the time cash needs to be raised but selling only bonds will cause the portfolio to be out of balance; then it is prudent to sell a portion of stocks. Maintaining a consistent equity to fixed income ratio is crucial for the long-term health of an investment strategy.
Having a well-diversified mix of investments will also make managing cash flow easier particularly when non-correlating assets are included. Using index ETFs and low cost mutual funds is the easiest way to make sure you are diversified. All asset classes need to be included: US, Emerging and Developed markets on both the equity and bond side should be in the mix. Also the range of bond duration and of stock company size needs to be taken into consideration.
Adding what I like to call income boosters is another way to get a little more yield in a portfolio. Master Limited Partnerships, Real Estate Investment Trusts, “Junk” Bonds, and Options Strategies can all produce higher yields and may be useful in declining markets to increase cash flow. Just like eating only dessert; however, having too much of a good thing can cause long term harm as many of these investments carry additional risk and a steady diet of high yield investments can prove unhealthy in the long run. Don’t be a yield hog!
Annuities are another way to guarantee cash flow in any portfolio. Other than CDs, annuities are the only way to guarantee a specific level of income. Index annuities provide a floor to prevent losses in a declining market but also have upside potential in a raising market making annuities a viable option for those concerned about maintaining a specific standard of living throughout retirement.
But annuities also have drawbacks: (nothing is perfect!)
- They are expensive with high internal fees
- Most pay the advisor an upfront commission
- The liquidity is restricted as cashing out an annuity during the first 5-12 years, depending on the contract, comes with a hefty surrender charge.
- There are tax implications that may not be right in your circumstance.
Cash flow management is complicated but just as important as choosing the right investments in retirement. It requires thoughtful planning for the immediate and distant future and must be maintained from year to year.