Fisher Investments believes an important part of any well-crafted retirement plan is understanding your anticipated expenses in retirement and formulating a plan to cover them with both investment income (e.g., dividends and interest payments) and non-investment income (e.g., government benefits, pension salary or part-time wages).
A variety of investment income options exist. Each has its own pros and cons, along with implications to your overall retirement income strategy.
Differentiate Between Income and Cash Flow
To best plan for how to cover expenses in retirement, investors would be wise to understand the distinction between income and cash flow. Income is money received from your investments, while cash flow is money withdrawn from your investment accounts. Common income sources include dividends and bond interest payments—you would report them as such on your tax returns.
You can generate cash flow by selling a security. The difference between the selling price and your purchase price is considered a capital gain (or loss). When it comes to paying for retirement, Fisher Investments believes should really only be concerned about the total return of your portfolio and after-tax money received—not whether it comes from regular income or selectively selling securities.
Dividend Stocks
Many investors prioritize passive income as an important part of their retirement investment income strategy—often in the form of payments from dividend-producing stocks. Dividends are one way a company can distribute profits to its shareholders. While dividends from stocks or products like exchange-traded funds (ETFs) are an important component of an investor’s return, relying solely on dividend payments may not be the best way to work toward your long-term financial goals.
No Guarantees With Dividends
Some folks believe dividend-paying stocks are “safer,” but that is not always the case. Dividends are voluntary payments. That means a company can reduce or cut them at any point. Loading up on dividend-paying stocks may also mean over-concentrating your portfolio in the handful of sectors that tend to pay regular dividends.
A lack of diversification can leave you more vulnerable to stock market volatility, or lead you to miss potential gains. For example, Technology companies have been responsible for the bulk of the last decade’s market returns, but they tend to pay very little in dividends.
While there is nothing wrong with passive income or dividend stocks, overemphasizing these in your portfolio may not be the best way to cover your expenses in retirement
See Our Investment Guides
The world of investing can seem like a giant maze. Fisher Investments has developed several informational and educational guides tackling a variety of investing topics.
Bonds and Fixed Income Instruments
Fixed income instruments, like bonds, are securities issued by countries, municipalities or companies (corporate bonds) looking to borrow money. These issuers compensate their lenders (investors) by paying interest on the amount borrowed. Bondholders are entitled to these interest payments (called coupons) until the security reaches its maturity date. Upon maturity, the issuer also repays investors’ the original principal amount borrowed.
Fixed income can be an important tool for investors with expenses to cover and a desire to reduce short-term volatility. Bonds, bond mutual funds and bond ETFs are all simple ways to gain fixed income exposure. However, investing in fixed income securities comes with some unique risks:
- Default Risk – Losing some or all of your principal is a possibility should a bond issuer fail to make interest or principal payments.
- Interest Rate Risk – Rising interest rates can cause the value of your bonds to decrease. That means if you needed to sell your bond in a rising-rate environment, it could be below the price you paid for it.
- Reinvestment Risk – Falling rates could force you to reinvest in bonds that pay less than your original investment. This potentially reduces the income stream you were relying on.
While investing in fixed income can help mitigate some of the short-term volatility associated with stocks, long-term investors should consider these specific risks before deciding to invest in bonds for investment income.
Annuities
Annuities are often portrayed as simple investment products that produce regular income. In reality, they can be difficult-to-understand insurance vehicles that may not always provide the safety they promise.
In their simplest form, annuities are contracts between an insurer and an investor. Insurers entice volatility-fearing investors with phrases like “guaranteed withdrawals” or “minimum returns,” which make annuities seem less risky than other investment options. However, annuity contracts are complex and we have found that many purchasers do not understand what they are actually getting from these products.
Many annuities often have high costs and prohibitive lockup periods. Annuity investors can face a reduction in their purchasing power over time because annuity income typically isn’t generally adjusted for inflation. Annuities also have issuer risk, similar to bonds. The pitfalls of annuities can jeopardize your long-term financial goals, which can often make them a poor choice for investment income.
Real Estate Investment Trusts (REITs)
Real estate investment trusts are pass-through entities created to help investors gain access to real estate. REITs purchase everything from office buildings and apartments to medical facilities and hotels. REITs generate much of their revenue from rental and lease income and are essentially free from corporate tax if they distribute (i.e., pass through) at least 90% of their taxable income to shareholders annually.
Investing in REITs also has potential hurdles. REITs shift the tax burden to investors, who are taxed at ordinary income rates—typically higher than capital gains rates for stocks. REITs are also sensitive to interest rate changes. As rates increase, so does the cost of property ownership, which can hurt the value of REITs.
Other Sources of Investment Income
Not all sources of income in retirement come from traditional investments. Many people opt to generate investment income through owning an investment property or direct real estate investment.
Owning rental properties can offer a source of income, but owning and managing rental properties can also be time and labor intensive. Property ownership typically has associated expenses such as property taxes, maintenance outlays, and insurance costs. The initial purchase of physical property often requires a significant cash outlay or potentially taking on substantial debt. While physical property is a hard asset, it is not immune from market conditions.
Homegrown Dividends: A More Holistic Approach
Many people don’t fully appreciate the risks in chasing yield from more traditional investment income sources (dividend payments, “high-yield” dividends, annuities, etc.). Instead of solely relying on these types of investments for yield, you can create your own cash flow.
You can selectively sell stocks or other securities to generate cash flow and still maintain a well-diversified portfolio. We call this tactic “homegrown dividends” and we believe it a flexible, tax-efficient way to use your investments to cover expenses.
Selling stocks to generate cash can have tax benefits for investors. The long-term capital gains tax rates are often lower than the income rates that interest, REIT dividends, annuity income or rental income might incur. While stock dividends may be taxed either as ordinary income or as capital gains, depending on the circumstance, selling stocks can give you greater flexibility by balancing realized gains and losses while maintaining broad market exposure.
In a taxable account, you can pare back over-weighted positions or sell any stocks with accrued losses to offset capital gains. Fisher Investments believes using the homegrown dividend method is a flexible, potentially more tax-efficient approach that focuses on total return.
It can be risky to restrict your investment income options to only passive income sources like dividends, interest, annuities or real estate income. Instead, consider developing an investment strategy tailored to your personal situation and long-term financial goals. You may find options like homegrown dividends are available to you, which may often be better for your overall investment plan. Including assets that support your long-term investment goals, while also generating cash flow, can help you enjoy the retirement you have worked so hard to achieve.
Definitive Guide to Retirement Income
Do you know how much your retirement will cost? Do you know how to generate the retirement income you’ll need? This guide will help you find answers to these and other important questions.
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