Retiring clients often tell me, “I only want to take the income from my portfolio. I don’t want to spend the principal.” What they really mean is they want to be able to see the interest and dividends earned by the investments to feel OK about spending it. Unfortunately, this ignores the fact that most earnings will come from capital appreciation and it ties our hands when it comes to tax efficiency.
You can’t retire today on a portfolio that is over-weighted with fixed income. This strategy causes portfolios to shrink because today’s low interest and dividend yields can’t keep pace with inflation. According to BankRate.com on May 1, 2011, the highest yielding 5-year CD rate is 2.65%. The average dividend yield of all the DOW Jones Industrial stocks is 2.74% according to indexarb.com. None of this is good news for the fixed income investor when food prices are up 5% and energy is up 11% this year alone.
You need to look at the total return potential of your portfolio and target a rate of spending that would allow the portfolio to still grow after inflation. At Rodgers & Associates, we target a withdrawal rate of no more than half of what the portfolio is expected to earn from all income sources. All income sources include interest and dividends along with capital appreciation. We then build a portfolio of fixed income and stock funds that are well diversified to achieve the total return goal.
A total return approach also provides opportunities to create tax efficiencies so that all of your income is either not taxed (return of principal) or at least taxed at lower rates. This happens when you take some capital appreciation from your portfolio (like when stock prices are high) because long-term capital gains are taxed at lower rates than ordinary income.
A successful retirement requires growing your principal to keep pace with inflation after you withdraw the income you need to maintain your lifestyle. The best way to grow principal is to be willing to spend some in the form of capital gains. Think total return so your income can grow along with your principal.