Using a Total-Return Approach to Retirement Income

The basic retirement portfolio consists of three main asset classes: Stocks, bonds, and cash investments. (Of course, there are many other kinds of assets and sub-categories within each asset class, but we'll focus on these three for now.) Each asset class has a unique role. 

• Stocks can deliver price growth over the longer term and pay dividends.
• Bonds can generate income through fixed coupon payments, help stabilize a portfolio during a stock market downturn, and repay a promised principal amount at pre-determined future maturity date.
• Cash and other short-term investments, such as bank deposits and short-term bonds or CDs, offer a high level of stability, as well as liquidity and flexibility to fund reinvestment or spending when needed.

How you allocate across these classes will depend on your plans and should be structured to provide income when you need it, as well as growth for the long term. We suggest retirees keep a year's worth of expenses in cash—after accounting for Social Security and other income sources outside their portfolio. Then, within their investment portfolio, they should consider allocating two-to-four years' worth of expenses to cash and short-term bonds or bond funds. Finally, the remainder should be invested for growth potential and income (in line with their risk tolerance and time horizon). 

The goal is to have a portfolio that can deliver investment income, but also potential growth to keep pace with inflation and fund future spending.

Now for an example.

Here's how to turn a total return strategy into cash flow:

First, interest and dividend payments can accumulate in your cash allocation throughout the year. Take your targeted annual withdrawal from there. If you have enough, great! You've met your income needs for the year through dividends and interest alone. 

Then, if you still need more, consider using some of the proceeds when you rebalance your portfolio as part of your regular portfolio maintenance. 

So, let's say you're retired at 75, with a $1 million portfolio holding a 60% allocation to stocks or stock funds and a 40% allocation to bonds, bond funds, or cash. The latter portion includes $50,000 in cash and other short-term investments. 

You hope to spend $100,000 each year of your retirement. We'll assume your Social Security payments and an annuity will generate $50,000 every year. That means you'll need to withdraw another $50,000, before taxes, from your portfolio.

The table below shows how this hypothetical portfolio might evolve over the course of a year. The Income Return column records how much investment income, or yield, each part of hypothetical portfolio might generate. That sum is collected as cash. 

In this scenario, you can see how the yield from your holdings of cash and short-term investments would have boosted your cash balance from $50,000 at the start of the year to $76,375 at the end. 

That means you'll enter the next year with $50,000 in cash that can be withdrawn to cover your annual spending target—combined with the $50,000 from Social Security and an annuity—plus an additional $26,375. 

Now it's time to rebalance the portfolio back to your target allocation of roughly 60% in stocks and 40% in bonds and cash investments (including next year's withdrawals in cash). As you can see at the bottom of the Ending amount ($) column, investment income and capital gains have boosted your $1 million portfolio to $1,054,150—and pushed your allocations away from their target weights. 

So, the next step is to buy investments that are below target—for example, in addition to replenishing your cash allocation, you would also buy bonds to bring your fixed income allocation from its 33.2% weight back up to your 35% target—and sell investments that are above target—for example, you would sell large-cap equities to bring that 35.1% weight back down to 35%.

As the next table shows, with this approach, you not only preserve your target allocations, but also go into the next year with a bigger portfolio. 

Of course, your portfolio won't always grow. When the market is up, you may have more. When it's down, you may have less. Over time, the goal is to maintain a portfolio that holds cash investments to support withdrawals; generates investment income to help replenish those withdrawals; and offers growth potential to fund future spending and other goals.

It's worthwhile to contrast this approach with one where you rely entirely on dividend and interest income in the hope that you'll never have to sell assets for cash. Believe it or not, that kind of rigidity can be risky. Why? 

• You may stretch for yield. An inflexible focus on generating as much yield income as possible could tempt you to focus too much on historically higher-yielding—but riskier—investments, such as high-yield bonds, master limited partnerships (MLPs), and real estate investment trusts (REITs). Though these can be appropriate in the right circumstances, our research shows that certain higher-yielding investments can expose you to equity-like risk and leave you with a more volatile portfolio. Investing too much in such volatile assets could mean that in a down year, you'd end up having to tap the principal you were trying so hard to preserve.
• You may fail to diversify. Most portfolios should have a mix of growth and income investments. The growth piece offers the potential for the principal to appreciate faster than inflation. The income piece, of course, provides money to live on. Trying to eke out a reasonable living from dividends and bond income may necessitate dedicating a disproportionate share of your portfolio to fixed income, making the overall mix less diversified and paradoxically—since bonds are often viewed as safe, conservative investments—riskier because it may not keep pace with inflation.
• You may not generate enough to support your lifestyle. Our hypothetical $1 million portfolio was able to generate a $50,000 retirement "paycheck" through a combination of dividends, interest, and asset sales. Removing asset sales from that calculation would leave you well short of your funding goal—which could translate to a very different retirement lifestyle.

Again, the goal of a total-return approach is to use your whole portfolio to support your current and future spending in retirement. That assumes you're starting out with an appropriate mix of investments to provide properly diversified sources of return. 

To make sure you're starting from a good place, consider sitting down with a professional to determine how much income your portfolio is likely to produce each year through interest and dividend payments. Compare that to your yearly income needs. The difference between those two amounts is what you'll cover through the sale of assets and rebalancing.