Generating Retirement Income When Interest Rates Are Low and Fixed-Income Assets are Overpriced

Note:  This is a continuation on the series on retirement investing.  See the first post here.

Generating enough income to pay for expenses in retirement is a fairly simple thing (provided that account is large enough) when interest rates are reasonably high and bond and dividend paying stock prices are consequently low.  One can just select a set of dividend paying stocks such as utilities, buy a few bonds, and then collect the dividend and interest checks. If the income from these investments is large enough one will never needed to sell stocks to raise cash or touch most of the holdings at all.

When interest rates on quality corporate bonds are in the 8-10% range, and stocks paid 5-8% dividends, one can easily generate $50,000 per year on dividends and interest with a million dollar account.  Many people – foolishly, I believe – even invest their entire retirement savings in bank CDs when interest rates are high enough.  This may be “safe,” provided they didn’t live long enough for inflation to zap their savings, but they are not getting anything near the income they could have gotten without a lot more risk.  They are also steadily losing a couple of percentage points to inflation every year.  This is true if CD rates are at 0.25% or 25% because they will always pay less than the rate of inflation.  Really you’re paying the bank a little bit each year to hold onto your money for you!

Unfortunately there are times like the current period where  interest rates are too low to generate enough income to make this strategy work.  This is usually because the Federal reserve has lowered interest rates to near zero, as they currently did due to our real-estate bubble bursting, or as the Japanese did in the 1980′s when their real estate bubble burst. Unfortunately, we’re currently having about the same sort of luck the Japanese did, so interest rates may stay low a long time.

Having low rates means more than just needing to accept a low rate of interest.  When rates are lowered, the price of income producing assets go up as investors go from safe bank CDs into more risky assets like corporate bonds and dividend stocks in an attempt to get more income.  When rates eventually rise again, either because of an action by the Federal Reserve or because inflation starts to pick up, the price of these assets will fall.  Someone buying these assets at high prices will both not get the interest rates he should and be taking a risk of losing capital when prices reset to more normal levels.

When interest rates are low, one must be more creative to earn a return from a portfolio. One option is to hold equities instead and simply sell some of the equities each year to generate the needed income.  Over long periods of time equities will generally return between 8% and 15% per year, so one can comfortably sell between 3-4% of assets each year, withdraw the money from the portfolio, and still maintain the account balance while keeping inflation at bay.  A reasonable amount of cash investments should be held to reduce risk, say 5-10 years’ worth of expenses, so that one can suspend withdrawals during years like 2008 where the market declines considerably rather than needing to sell right after a major decline when stock prices are unreasonably low.

The sale of a fixed percentage of the portfolio each year is easy and straightforward, but is not necessarily ideal.  Remember that the market is like a river with deep portions, rapids, and eddies.  You know that you will eventually get downstream but the speed at which you do so will vary.  Sometimes you’ll even go back upstream a bit. Because you can’t see downstream – just where you are and upstream – you don’t know if you are   about to shoot down a rapid or spin back upstream in a whirl pool.  You do know, however, whether you just made a lot of progress or not, and you know that on average you’ll make about 8%.

A strategy that takes advantage of this knowledge, rather than blindly selling a fixed percentage of the portfolio each year, would be to time when you sell assets and raise cash based on conditions in the market.  When you’ve had a good year, you sell some assets.  On bad years, you hold pat and let your assets recover.  The cash position that you hold affords you the ability to delay sales on bad years since you can use some of the cash position to pay for expenses when the market does not perform well.

This strategy might work as follows:

a. Start out with a cash position of 7 year’s worth of expenses.

b. At the end of the year (note that most stock market gains will occur between October and January), if the portfolio gained more than 15%, sell enough assets to raise two years’ worth of cash.

c. If the portfolio gained more than 10%, sell enough to raise one year’s worth of expenses.

d. If the portfolio gained less than 10%, leave the portfolio untouched and spend the cash instead.

e. If the cash position ever drops below five years’ worth of expenses, sell enough assets to regain five years’ worth of cash.

f. If the cash position ever equals ten years’ worth of expenses, don’t sell no matter what the portfolio value did.

In this strategy, assuming that 4% of the portfolio was to be spent each year, on years when the portfolio gains at least 15%, you would sell 8% (two years’ worth of expenses).  On years when it gained 10-15%, you would sell 4%.  On other years you would leave the account alone.  This means you would be selling shares after rallies, when stock prices were high, and holding after modest gains or declines.

At times where there are a string of bad years, such that your cash drops below 5 years’ worth of cash – the minimum that is fairly safe – you would bite the bullet and sell some shares.  If there are a string of good years and you’ve gathered a large cash hoard, you would keep the extra money invested so that you don’t hold cash for a long time and lose money to inflation.

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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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