By Jane Bryant Quinn
Jane Bryant Quinn
Director of Fiduciary Advice
It’s time (past time) to retire the concept of “income investing.” Forget you ever heard the words. Maybe the strategy worked in the 20th Century, back when dinosaurs roamed the earth. But not today. The 21st Century approach, used by all top advisers, is “total return.” That defines income broadly as interest, dividends, and capital gains. If you’re stuck on pure “income investing” to pay your retirement bills, you’re not going to get the most from the money you’ve saved. Let me explain.
Classic income investing orders you never to “dip into principal” (horrors!). Instead, you’re supposed to live off the interest and dividends that your principal earns. That’s possible – even with low interest rates — if your stash is high enough, your expenses low enough, and you have enough income from other sources. If not, it leads to warped decision making. To increase your traditional “income,” you start reaching for yield. That makes retirement investing riskier, not safer.
For example, you might fall in love with stocks that pay dividends. Sounds fine, but you won’t be diversified. You’ll be investing in just a few industry sectors, which is a risky bet. Back in 2007, banks were big dividend payers and you know what happened to them when the financial sector collapsed. Stock prices plunged and dividends were slashed (in some cases to zero). Dividend junkies invest too little in the universe of growth stocks that regularly drive the S&P index to new heights. You’re skipping small stocks, too. Your portfolio is likely to underperform.
In the search for yield, you might go for stocks I call “dividend traps.” The payout looks high, compared with the corporate average. But dividends are computed as a percentage of earnings, so they might look high because earnings have declined. The company could be in trouble. If so, it won’t be paying fat dividends for very long. You lose income in “trap” stocks and capital, too, because the market price goes down.
Fixed-income investors are vulnerable to risky, high-cost deals that promise checks in the mail. One example would be the non-traded real estate investment trust. You’re promised an income of, say, 7 percent a year. For this you pay 10 to 12 percent in commissions and start-up fees, maybe 2 percent annually for advice and management, and 2 or 3 percent more when the REIT’s investments are sold. Your investment is illiquid so you can’t readily get your money out. Your precious income might come from money that the REIT borrowed or even from your own capital, not just from rents. You’re unlikely to earn a decent long-term return.
To break loose from the “I need income” mindset, you need a better definition of what investment income is. Interest and dividends are important. But the capital gains that flow into your portfolio are income, too. Together, they represent your total return.
Say that you want a $50,000 income from your savings. Investing in quality bonds and spending only the interest, you’d need a portfolio of around $2 million. Investing in a mix of stocks and bonds, you might need only about $1 million, thanks to the capital gains that your stocks produce. If you do have $2 million and put it into stocks and bonds, you might be able to draw $100,000.
Your adviser, knowing your goals, will put together a mix of stock and bond mutual funds that are expected to yield the long-term, total return you need. Your $50,000 checks come out of the total pot – interest, dividends, and capital gains. Don’t worry about nibbling at your principal. Over the long-term, stock markets rise. The principal you spent will eventually be replaced. Getting this income stream right is what advisers are for.
If you don’t dip into capital from time to time you’ll live at a lower level than you can actually afford. Your heirs will cheer, because they’ll inherit so much more. But it’s your money. You earned and saved it. You deserve the highest standard of living that your money will buy.