Rethinking Income in Retirement

06/11/21 | Birchbrook Team | Birchpapers

As we approach retirement, we begin to think seriously about how we might replace our earned income. We add up expected income from sources like social security, pensions, part-time work, and, of course, our retirement portfolios. With luck, the sum is enough to provide a comfortable standard of living in retirement.

However, because interest rates are so low (and they will be for the foreseeable future), it is unlikely the portfolio portion of our retirement mix will generate sufficient income to meet our needs – that is, if we limit our definition of “income” to traditional sources, like interest and dividends. Bonds, for example, are paying very little in interest income compared to history. Today, a 10-year U.S. Treasury bond yields about 1.09% or just $109 for every $10,000 invested. To replace a modest $20,000 of annual gross income at this rate, a retiree would need over $1,800,000 invested in Treasury bonds!

Therefore, when thinking about how our portfolios might contribute to our income needs in retirement, we must expand our definition of income. Really, taxes aside, if the goal of one’s portfolio is to generate distributions that can be spent in retirement, then it doesn’t matter whether those distributions are funded by traditional income or by price appreciation. All of it replaces earned income for the purposes of budgeting. And, from a tax standpoint, the IRS considers all of it income in one form or another. IRA distributions are taxed as ordinary income regardless of what led to the IRA’s growth, and, in an after-tax brokerage account, capital gains are also considered income – even if long-term capital gains are taxed at a preferred rate.

With this in mind, the focus should be on a portfolio’s total return, particularly in this low interest rate environment. The formula to calculate total return is simple: Take the gain from any price increases in your stocks, bonds, and other investments, and add to it the interest and dividend income paid by those same investments. In short, total return is equal to the sum of gains plus income, and the two combine to replace earned income in retirement. Let’s look at an example:

Say you plan to retire this year, and you have a portfolio worth $500,000. Over the next five years, you expect your stocks to increase in price by 6% per year, and you expect your bonds to remain about flat. Additionally, you expect your stocks to pay 2% per year in dividends and your bonds to pay 3% in interest. This is like saying you expect a total return of 8% on your stocks (6% plus 2%) and 3% on your bonds (0% plus 3%).

If you need your portfolio to generate a minimum of $25,000 in annual distributions to fund your spending in retirement, then investing all of your $500,000 in bonds wouldn’t get the job done. With a total return of 3%, your portfolio would generate just $15,000 without invading principal.

However, a portfolio mix of 50% stocks and 50% bonds would meet your goals. In the first year of this five year hypothetical, the stock half of the portfolio would grow in price by $15,000 ($250,000 x 6%) and generate an additional $5,000 in dividends ($250,000 x 2%). The bond half of the portfolio wouldn’t increase in price, but it would generate $7,500 in interest ($250,000 x 3%). In total, you would have $15,000 in price appreciation plus $12,500 in income for a total return of $27,500 (5.5% stated as a percentage) – from which you could distribute the $25,000 needed to replace your earned income.

Stated another way, with a total return expectation of 5.5% on a portfolio of $500,000, sufficient dollars could be generated to replace $25,000 of income (and then some) that had previously been earned through working. This, despite the fact that the portfolio is only expected to generate “income” at a rate of 2.5% per year (50% x 2% dividend plus 50% x 3% interest).

This might seem like an exercise in semantics, but we wrote this blog post in response to a question we get with some regularity: “How can I earn enough income in retirement?” It is instructive to reframe the question. The focus shouldn’t simply be on how to increase income, as there are real constraints on a portfolio’s ability to generate income – especially in the current environment. Rather, the discussion should center on how one might generate a total return sufficient to replace earned income.

In prior decades, we had the luxury of interest rates that, on their own, could replace most, if not all, of an individual’s earned income. Such is not the case today, rendering income-only strategies less helpful, if not outdated. It is true that our above example implies the need for stock exposure, which implies the need to take more risk in one’s portfolio. This need for stocks cannot be entirely avoided at present, despite stocks sitting at all-time highs.

That said, this conundrum can be partially solved by again looking at things through a total return lens; it doesn’t much matter where the return comes from, so long as it comes, and so long as it comes with a level of risk appropriate for the portfolio. In practice, return need not come just from stocks or bonds. It can be generated from price appreciation on other asset classes, like currencies or real estate, and it can be generated through derivatives, such as options. Thus, the riddle of replacing earned income in retirement comes down to proper diversification, with a focus on generating total return, wherever and however. As such, much of our focus at present is looking at ways to generate total return at the portfolio level while keeping stock exposure in check, U.S. stock exposure in particular.

As a parting thought, we would caution against income-based strategies that appear too good to be true. In a low interest rate world, there is only so much income to be had. Of course, if ever you have questions about this or any other topic, please contact us. We’d be happy to speak with you.