As yields continue to shrink, one source of spending money is hiding in plain sight.
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By Christine Benz | 12-19-13 | 06:00 AM | Email Article

You're retired, and you have two choices to generate the money you need for living expenses. The first entails taking more risk, and the second actually reduces risk in your portfolio.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

The right answer seems obvious: For the same return? Heck yeah I'll take some risk off the table. 

But taking on more risk, not less, is exactly what many income-focused retirees seem to be doing with their portfolios right now. Meanwhile, a safer way to harvest income from their portfolios is hiding in plain sight: lightening up on stocks through rebalancing and harvesting the proceeds for living expenses.

I've been writing about total-return strategies for retirement--and more specifically, the bucket approach to retirement portfolio planning--for several years now. I've interviewed the gurus on the subject, built model portfolios, and conducted back-tests. But the 2013 market environment, with its ultralow yields and rich stock returns, illustrates the virtues and mechanics of a total-return approach in living color.

You Paid What for That Bird in Your Hand?
There's a lot to like about income; on that we can all agree. Who doesn't like a bird in the hand? In the wake of multiple financial scandals and crises that have punctuated the past 15 years, it's not surprising that many investors are still in "show me the money" mode. Focusing on securities with the ability to pay income adds a valuable quality overlay to a portfolio, too, as income production can be an important show of an entity's financial wherewithal. From a practical standpoint, income can also provide a cushion on the downside when the market is falling, and extracting income from a portfolio during retirement is logistically simpler than managing a portfolio for total return and periodically selling off winners. And of course, income has historically been a huge component of the market's total return.

Yet some of investors' recent preferences make me concerned that they're gunning from income while neglecting total return--income plus capital appreciation or minus capital losses. Our asset-flows data show that investors have been shunning high-quality bonds, with their still-meager yields and their perceived vulnerability to rising rates. Meanwhile, yield-rich(er) bond categories have been feeling the love. The bank-loan group is by far Morningstar's top asset-gathering category so far in 2013, but yield-rich categories like high-yield bond, emerging-markets bond, and world bond have also been garnering new investor dollars during the past year. Dividend-rich equities and dividend-focused funds have been similarly popular. 

Meanwhile, yields on many historically income-rich sectors have dropped as demand drives up prices and prices move in an inverse direction relative to yield. For example, though the yield differential between high-yield bonds and Treasury bonds jumped up during the Fed's so-called taper tantrum this summer, it has been off to the races for high-yield bond prices since then, and yields have dropped back down. The dividend yield on the S&P 500 is similarly low relative to historic norms

All of this means that retirees are apt to find it difficult to wring a livable yield from a portfolio without taking risks, perhaps even sizable ones, if their income target is on the high side. A portfolio consisting of a dividend-focused stock fund (60% of assets), a high-quality bond fund (30% of assets), and a high-yield bond fund would yield just more than 3%, for example--maybe more, maybe less, depending on the quality of the portfolio holdings. To earn substantially more--say, the 4% rate that many retirees use as a benchmark for how much they can safely extract from their portfolios--an investor would need to hold bigger slugs of some combination of income-rich securities, such as high-yield and emerging-markets bonds, and income-producing equities, such as master limited partnerships. Yields, and in turn valuations, aren't what they once were in a lot of these asset classes, and many of them are also sensitive to rising interest rates and/or economic events. 

Total Return Mind-Set Buys Flexibility
Rather than stretch for yield at what might be an inopportune time to do so, a total-return approach allows retirees to be flexible about where they go for money for living expenses. 

Income producers may supply part of that money stream, to be sure, and in years when income is flowing freely, that payout may cover living expenses and then some. But at times when the yield gods are feeling stingy, as is the case right now, the retired total-return investor could harvest gains by selling securities--whatever has appreciated the most in the portfolio--via a rebalancing plan.

Right now, for example, that would mean selling stocks. Equity investors who have been reinvesting dividends have gained 25% or more so far this year; small- and mid-cap stocks have gained even more. In other years, rebalancing might mean lightening up on bonds or international stocks.

De-emphasizing income and instead focusing on the big picture of total return is apt to result in a better-balanced, better-diversified portfolio than one focused on income only. Most income-centric portfolios emphasize credit-sensitive bonds (especially these days) and stocks of companies in slower-growth industries.
The total-return portfolio, by contrast, includes growth and income-producing stocks and a diversified basket of bonds with varying characteristics. That intra-asset-class diversification provides even more rebalancing opportunities, which can help provide needed income and further take the edge off a portfolio's long-term volatility. In 2008, for example, a retired investor with a stake in a high-quality bond portfolio might have been able to pick off living expenses by selling some of those bonds, which soared during that year even as lower-quality corporates sustained big losses. This article provides a view of how a total-return portfolio might have been managed during retirement from 2000 through 2012.

Swimming against the tide is often a good idea in investing, and 2013 provides a clear case in point. Whereas other investors are latching on to securities with higher levels of income and buying stock funds, the savvy retiree should consider doing just the opposite.

See More Articles by Christine Benz

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