Should Retirees Invest for Yield or Total Return?

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Chart of PenniesI recently gave my mid-year “Pulse of the Market” presentation where I provide my insights on what has been happening in the financial markets. The people in the audience were primarily retirees. I started by pointing out that stocks, as measured by the S&P 500 index were up nearly 20% over the past 12 months. During the same time, interest rates, as measured by the 10-year US Treasury Note, had nearly doubled. I expressed that it just doesn’t get any better for retirees. Imagine my surprise when only a week after my presentation I saw Brett Arends’ article in the Wall Street Journal, “High Stock Prices + Rising Bond Yields = Bad for Retirees”. It appeared Mr. Arends had come to the opposite conclusion.

The article reasons that stocks are riskier at higher prices and the dividend yield isn’t as attractive. Interest rates have risen but yields are still below historic averages. The article recommends staying in cash because “the situation is likely to improve”. Unfortunately, chances are that inflation is not going to sit on the sidelines while you do and cash equivalents are still yielding less than 1%.

One of the biggest mistakes people make when investing for their retirement is focusing on yield. I believe the premise of this article falls into the same trap. You should invest for total return and take distributions of the amount you want to spend. It shouldn’t matter if the distribution comes from growth or income. In fact, it is better from a tax perspective if the distribution comes from growth.

For example, a retiree invests $100,000 in a bond with a 10% yield. The $10,000 of interest is fully taxable at ordinary income tax rates which can be as high as 39.6%. Another retiree invests $100,000 in a growth investment that appreciates to $110,000. This retiree sells $10,000 of the investment to create his income. Only $900 of the $10,000 sale is subject to tax because the rest of the gain is deferred until the entire position is sold. The $900 is taxed at a maximum of 15% capital gain rate if the position has been held at least 12 months. In this case, growth is significantly better than yield from a tax perspective.

Many retiree’s problem with total return investing comes from planning to spend earnings that may not be there if the stock market declines. They believe the dividends and interest are OK to spend because they have been earned. Appreciation may or may not be there but they still need to buy groceries. This thinking ignores the fact that income investments can also decline in value. Barclays U.S. Aggregate Bond Index yields about 2% but had a total return of -1.8% for the 12 months ending July 31, 2013. The retiree spending the yield off the investment has seen their principal decline by 3.8%. This cannot be ignored because inflation would have eroded another 2% of their principal during this period.

A solid investment strategy should be based on total return to assure principal is growing over time to fight inflation. Total return investing also eliminates the risk of relying on interest rates to produce spendable income. The increased yield on the 10-year treasury over the last 12 months has only recently started to exceed inflation. Those retirees who have been spending interest off their investments have been falling behind inflation. This pattern can devastate a retiree over a life expectancy of 25 years or more in retirement.

The key to success with a total return strategy is not overspending principal in down markets. This is where the 4% rule can help. A retiree begins distributions from their portfolio at no more than 4% of their principal. They can continue this distribution in down years providing the rate of distribution does not exceed 6% of their principal. Increases can be resumed once their principal recovers. The 6% red flag would permit a portfolio to drop by nearly a third before an adjustment has to be made to the withdrawal. While the stock market has fallen by a third at times it is unlikely a balanced portfolio of stocks and bonds would decline this much.

We should rejoice that stock prices are up and yields are increasing. I couldn’t imagine changing the headline to “low stock prices + falling yields = good for retirees”!

Rick’s Tips:

  • One of the biggest investment mistakes retirees make is investing for yield.
  • Growth oriented investments have a significant tax advantage over fixed income investments.
  • The 4% rule says a portfolio invested for total return can prudently distribute 4% of the principal each yield for spending.

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