By Tim Courtney, Chief Investment Officer
From the Great Financial Crisis until 2023, finding yield and income from investments was exceptionally challenging. Cash money markets and bank deposits rarely paid more than 1%. Bond yields also dropped during this time frame, with the 10-year Treasury yield averaging only about 2%. Dividend yields on the S&P 500, which started at over 3% in 2009, are now less than half that at 1.4% today.1 This happened as the Federal Reserve (Fed) lowered key interest rates and typically kept them below the rate of inflation.2
Thankfully for bond investors, who need reasonable interest rates to compensate for accepting default and inflation risk among others, interest rates have moved higher. Even so, many investors look for still higher yields. Should our primary goal be to maximize income?
Many investors are wired to look for yield and income. This is not surprising since most of us spend our working years looking for ways to generate income and cover our expenses. It seems natural that as we approach retirement, we look for investments that can generate investment income to replace working income. However, when this idea leads us to place income generation above all other considerations, it can cause us to make poor decisions.
Let’s consider an example. An individual with one million dollars may need $4,000 per month (about $50,000 per year) for living expenses, so is looking to generate 5% from investments. The investor actually needs more than this to account for inflation, so they really need investments to generate at least 7%.3 However, broad markets don’t offer yields near 7%.
Investors sometimes try to solve this problem by focusing their portfolio investments in high-yield assets, complex annuities, structured notes, or smaller, more niche areas of the market that offer 7% income. The result is often a riskier portfolio that lacks diversification and can be oddly structured. While these investments can certainly be a part of a well-diversified portfolio, investors are taking on more risk than they know when they become the focus of a portfolio.
We may need to reconsider how we think about income. First, we should understand that the concept and classification of investment income often has more relevance for how it is treated legally and taxed than for planning purposes. Certain investment structures and accounts can retain income while other types must pay out income, and different types of income may be taxed under differing rules. While investment income can play a role in household cash flow planning, total return — of which income is a part — is usually more important in meeting goals.
Second, income generated within a portfolio doesn’t have to be withdrawn and spent. For a retired investor that is withdrawing monthly from their portfolio, there will be many times in which it makes more sense to reinvest income, say from a bond, to buy more bonds and sell shares of a high valuation, appreciated stock and withdraw those proceeds instead. In other words, investors who have a well-diversified portfolio have the flexibility to create their own “income” as circumstances warrant.
For many investors, “income” and “withdrawals” are nearly synonymous: I need to take this much in withdrawals, therefore I need to generate this much in investment income. This thinking has led many to make big investment mistakes. It highlights the need for investors to have a well-defined withdrawal plan that outlines which dollars will be withdrawn, under what circumstances, and when. If you have any questions about your withdrawal strategy, please contact your Exencial advisor.
Sources
- ShillerData.com (04/30/24) – S&P Dividend and Price from US Stock Market Data
- Bloomberg (3/4/24) — Cash Returns Rival Bonds Now and Over Decade on Rate-Cut Delays
- NerdWallet (5/15/24) — The Current Inflation Rate is 3.4%. Here’s Why It Matters.
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10 Yr U.S. Treasury is a debt obligation issued by the U.S. government with a maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate every six months and pays the face value to the holder at maturity. This index is not available for direct investment; however 10 Yr U.S. Treasuries can be purchased individually.
S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
