Don't Let Income Obsession Cheat You

March 19, 2006

Retirees, you're not too old for stocks.

There's a natural instinct among retirees to build an investment portfolio that generates a reliable stream of income -- just like the paychecks they used to get while working.

This often means loading up on bonds that throw off interest and on dividend-paying stocks. Increasingly mutual-fund firms and insurance companies are creating complicated new products to satisfy that demand for steady income, which is expected to surge as the Baby Boomers enter retirement.

But some financial advisers warn that too much of a focus on income can be harmful. The main problem, they say, is that a portfolio overly concentrated on generating income can fall short when it comes to growing money at a sufficient rate to outpace inflation.

Instead, they say, investors should concentrate on structuring a portfolio that meets their long-term needs by keeping up with the cost of living. That can mean holding a greater percentage of their portfolio in stocks than some retirees had contemplated.

These advisers also say it doesn't matter if the money pulled out to cover living expenses comes from price appreciation or income.

Understand Your Needs

"People confuse the need for cash flow with [a need for] dividends and income," says Harold Evensky, a financial planner in Coral Gables, Fla.

The process of designing a retirement portfolio should begin with a retiree calculating the budget needed to cover everything from groceries to health care.

But the advisers say it's a mistake for investors to look at their portfolio and try to produce that money in interest -- for example, trying to take a $500,000 portfolio and design it solely to kick off 7% interest because a retiree needs $35,000 a year to live.

Part of the issue, planners say, is that dividend yields and interest rates are at relatively low levels compared to inflation. That makes it difficult to build a portfolio that produces sufficient income to live on unless large amounts of money are involved. For example, an investor trying to create a portfolio of U.S. government bonds that would pay $45,000 a year would need $1 million.

Reaching for higher yields could result in owning bonds that are riskier than investors realize.

Equally important, what retirees often don't understand is the importance of having their portfolios continue to grow and not just generate a set amount of income, says Scott Dauenhauer, a financial planner in Laguna Hills, Calif. "Even though your income looks may be losing purchasing power" to inflation, he says.

To make the point with clients, Mr. Dauenhauer boils it down to a simple example: postage stamps. A retiree in 1975 whose "needs" were to buy two postage stamps required a "portfolio" that produced income of 20 cents. Six years later that same amount of income would only buy one stamp. Today that income buys half a stamp.

For that portfolio to keep up with the "cost of living" it would have needed to grow about 4.5% a year. "Inflation happens and it matters," Mr. Dauenhauer says.

Plan for Inflation


The inescapable press of inflation means retirees should expect the dollar amount needed today to cover costs will rise over time. But by building a portfolio designed to generate a specific amount of cash flow from interest, an arbitrary limit is set on the allocation to stocks. That in turn can hamper the portfolio's ability to grow with the cost of living over time, says Mr. Evensky.

Despite the notion that retirees should have a "safe" portfolio of bonds, many advisers say it's the stock portion of the portfolio that can ultimately make the difference in making sure they have the money they need down the road. The value of a bond at maturity is fixed and so is the periodic interest payment. In contrast, stock prices and dividends rise over time when companies do well.

Michael Sadoff, a Milwaukee investment adviser, says that while stock prices and returns are more vulnerable than bonds to sharp swings in the short term -- such as over the course of a year -- over longer time periods such as a decade, stocks usually shine. Citing historical averages, he says that a portfolio with 80% stocks and 20% bonds has provided twice the average returns over a 10-year period as a portfolio consisting entirely of bonds, with only a slight increase in volatility.

And contrary to what many investors think, it's possible to add stocks to an all-bond portfolio and lessen the volatility. A portfolio split evenly between bonds and stocks has, over the average rolling 10-year period since 1926, had smaller ups and downs than an all-bond portfolio, Mr. Sadoff says.

To see the value of stocks in a retirement portfolio, consider a hypothetical investor who retired in 1971 with a $100,000 nest egg and began taking out annual income of 4%, or $4,000, adjusted each year for inflation. An analysis by Vanguard Group, using actual stock and bond returns over the years, shows a portfolio invested only in bonds would have been exhausted in 1997.

A portfolio split between bonds and stocks would have fared far better, even though its value would have been nicked early on in the brutal bear market of 1973 to 1974.

Tax considerations also come into play in portfolio design. Interest income -- such as from bonds -- is taxed at regular income tax rates which go as high as 35%. Long-term capital gains, meanwhile, are taxed at a maximum of 15%, as are many stock dividends. If the money is held in a retirement account, taxes aren't an issue.

Mastering the Mix

There's no one-size-fits-all answer on how a portfolio should be divided between stocks and bonds. Portfolio size, other sources of income and real-estate holdings can all make a big difference. Family health history or a wish to pass money on to heirs are also important considerations. There are also varying approaches to setting aside a portion of an investment portfolio to be used as spending money in the near future.

Mr. Sadoff budgets for a year and a half of spending money. To replenish a spending account, he'll harvest cash from the investment portfolio during periodic rebalancing of the client's holdings.

Mr. Evensky says he prefers to segregate two years of spending money, trying to avoid situations in which clients have to sell holdings during a steep market downturn. That way, he says, even in the worst of times, "you know where your grocery money is coming from."

Write to Tom Lauricella at