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“But I’m looking to grow my money. Why would I want income investments in my account?”
This is a common question I get from Wela clients as we talk through the process of developing a retirement savings portfolio to meet their particular objectives. It’s a great question that makes sense. And here’s the answer.
When we think about saving for retirement, we often visual our efforts as growing something -- a “nest egg” that expands with every deposit we make in our retirement account.
But a well-crafted retirement strategy is actually more like a machine than an incubator. It has several moving parts that work together to leverage your contributions and move you towards your goal. The twin motors in that machine are growth and income investments, which work together, with each taking the lead at different times in the journey to and through retirement.
Growth stocks are shares in companies that currently prioritize expansion and increased market share. These businesses pour most of their profits back into operations, and thus don’t pay dividends. Netflix and Amazon are good examples. If/as a growth company expands, investors benefit from the steady, sometimes dramatic, rise in value of their shares. Growth stocks are what people talk about at the office coffee machine. “Yeah, I bought Acme Corp at $10 a share five years ago and just sold it for $71.”
Income stocks are boring by comparison. They tend to be established companies in mature industries – think Proctor & Gamble, Apple, Disney – that are unlikely to show dramatic growth in share price. Instead they just ton the revenue and pay their shareholders a regular dividend.
Bonds, which are essentially a loan to a business or government, are another source of income, as owners of the bond receive regular interest payments. Investors can also receive income from alternative investments, including real estate investment trusts, preferred stocks and shares in pipeline and energy storage companies. All of these assets are traded on open markets like stocks and bonds.
So, let’s assemble Wela’s version of the retirement investment machine. It consists of three buckets based on the above – stocks, bonds and alternative investments – designed to grow your money while providing diversity to protect you from market volatility.
Stocks – During most of your working career, your portfolio should contain mostly shares in growth companies. Ideally, these stocks will significantly appreciate in value over the years and decades, providing a nice profit when you liquidate them in retirement.
But you should also hold some income stocks to provide diversification and stability. The dividends these shares pay can be reinvested in your portfolio, turbo-charging your growth.
When you retire, we recommend shifting your focus to income stocks. You can continue to reinvest their dividend income, or use it to help fund your lifestyle. Income stocks also tend to be less volatile than growth shares and thus offer the stability you want in retirement.
Bonds – Contributions to this bucket are invested in a diversified range of bonds – Treasury municipal and corporate – that will provide a steady stream of interest income while protecting your principal.
Your portfolio should hold a greater percentage of bonds (as opposed to stocks), as you get closer to retirement. We recommend, “owning your age” in bonds. When you are in your 40’s, bonds should make up 40% of your portfolio. When you are 50, that percentage should be 50%.
Alternative investments – This smallest bucket of non-stock or bond assets provides more income and some insulation from the gyrations of the stock market.
So, why should you hold income investment when you’re seeking growth? Because income investments – stocks, bonds and alternative investments – can both enhance and protect that growth. The dividends, interest and other payments generated by income assets can be reinvested, even as those assets themselves insulate you from volatility by providing diversity and stability.
Your investment machine isn’t hitting on all cylinders unless you have income assets in the fuel mix.
Disclosure: The information is provided to you as a resource for educational purposes only. Nothing herein should be considered investment, legal, or tax advice. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results when considering any investment vehicle. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. It is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.
There are any number of core investment philosophies, each with it own merits and uses. How do you decide which strategy or philosophy works best for you?
At Wela, we believe both growth and income investing have important roles to play in a successful retirement portfolio. During the front part of your wealth-building years, we recommend a growth strategy in which you invest heavily in stocks that will gain in value over the years (and decades), allowing you to reap significant profits when you cash out.
But as you near retirement we believe in transitioning to an income-driven portfolio consisting largely of assets that generate a steady cash flow that can provide you with a “paycheck” in retirement. That income comes from stock dividends, bond interest and income from alternative investments, such as preferred stocks, real estate investment trusts (REITS) and royalties from energy trusts.
One thing I love about income investing is that a well-crafted income portfolio can meet your retirement spending needs for years while limiting the drain on your capital.
Working Years: To understand the benefit of income investing, it might help to think of your retirement portfolio as a house. During your working years, you build your portfolio brick-by-brick -- dollar-by-dollar, asset-by-asset. It begins as a starter home -- functional but not fancy. Over time, you add rooms and amenities; a second floor, basement media room and a deck. With luck, the house appreciates over the decades until it’s worth, say, a million dollars.
Retirement: Now it’s time to retire. How do you get your money out of the house? Well, if it’s a growth “house,” you sell it off piece-by-piece and use the proceeds to fund your retirement. When the last piece is sold, the money is gone.
But if it’s an income house, it generates “rent” in the form of that asset income from stocks, bonds and other investments. That income, previously reinvested while you were “building the house” can now be used to cover your expenses. You may well have to sell some parts of the house over the years, but at a slower rate than the owner of a growth “house.”
How much slower? Well, imagine you have a portfolio at retirement worth $500,000 that can generate $20,000 in annual income. Assuming you can live on that money (plus Social Security, pensions, et cetera) after 10 years you would have derived $200,000 from your portfolio but it would still be worth about $500,000, depending on how the market moves.
In order to derive the benefits of both growth and income investing, we recommend the “bucket” approach to creating an effective retirement investment portfolio. As the name suggests, your investments will fall into one of three categories or “buckets.”
Bonds – Contributions to this bucket are invested in a diversified range of bonds – Treasury municipal and corporate – that will provide a steady stream of interest income while protecting your principal. To maximize your return over time you will need to diversify these holdings.
Your portfolio should hold a greater percentage of bonds (as opposed to stocks), as you get closer to retirement. We recommend “owning your age” in bonds. When you are in your 30’s, bonds should make up 30% of your portfolio. When you are 50, that percentage should be 50%.
Stocks – This is where growth comes into play. During your working career this bucket will contain mostly shares in companies that have large growth rates, but don’t pay much of a dividend. Think Netflix or Amazon. Ideally, these stocks will significantly appreciate in value over the years. When you retire, you will shift your holdings into income stocks – shares that show some growth but pay a nice dividend. Apple and Disney are good examples. There are several excellent growth ETFs that allow you to tap into the appreciation of a whole basket of companies.
Alternative Income – This smallest bucket holds income-generating assets that are neither stocks nor bonds. This includes real estate investment trusts, preferred stocks and shares in pipeline and energy storage companies. All of these assets are traded on open markets like stocks and bonds.
While income investing isn’t the only way to saving for the future, in our experience it’s a way to have your “house” provide safety and warmth during your retirement years.
Interested in learning more about investing? Read how an average family retired with 1 million dollars in savings. Download our free eBook on investing here
Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.
How do we determine the number that is needed for you to retire? You see these ING commercials with the numbers above people’s heads and assume that you need this ridiculously high “number” to retire.
But how do they come up with these numbers? Are you supposed to replace 70% or 80% of your current income?
Many retirement tools utilize different methodologies to determine the exact number you need in retirement, but the one thing they all have in common is that they assume you will utilize principal in retirement. These tools also assume they know when you will die or that you know when you will die. It seems crazy, doesn’t it!?
Another way to calculate your retirement “number” is to utilize some of the basic principles of income investing. The idea behind income investing is that you utilize your investment nest egg to generate a specific cash flow without touching the principle.
You can calculate your retirement number utilizing an income investing method which calls for needing to know what streams of income you will have in at retirement (if known) and what you will need for expenses. To start, use your current expenses. This way you can start setting realistic goals of what you will need in retirement and what you need to save to get there.
Let’s use a simple example, say you need $4,000 per month for expenses and you will have $1,000 per month in pension or rental income coming in during retirement. Then you will need to build up your retirement nest egg to a point where you are able to generate $3,000 per month. If we are able to build a portfolio that can generate 4.5% in dividends and interest per year, then your retirement goal would be to have a nest egg of $800,000 by the time you retire.
Now the question gets to how does someone build a portfolio that generates income. It starts with knowing the toolbox we have to choose from for an income-oriented portfolio.
First, you have dividend stocks. As companies mature and find fewer opportunities to reinvest in their own companies, they start to pay monies out to investors. What this means is that instead of using the cash companies generate to reinvest into the next big innovation, they pay you and me as investors. An example we could use is being a family. As we earn money we decide to invest that into our future (retirement) or into our kids future (college savings). If we find that all of these are filled up enough, then we may start looking into giving more money to philanthropic initiatives. By giving money to things outside our own family growth, we could look at it as being like a dividend and our family being at a more mature state.
There are also bond investments which are debt obligations. These companies, governments or municipalities borrow money and are forced to pay back the debt at a particular interest rate. They pay this interest rate to you and me. When we own a bond it is like being on the other side of our mortgage payment. Instead of having to pay the bank on our mortgage, we are, basically, the bank when we hold bonds; these institutions pay us.
Other income investments are preferred stock, REITs, and MLPs.
- Preferred stock is a blend of both a bond and a stock. They tend to pay a higher income stream than most stocks (which makes them similar to bonds), but they have some opportunity for price appreciation (which makes them similar to stocks). These investments tend to be a little less liquid (not as easy to buy or sell) than stocks. But you are able to access these within ETFs, which make them a little easier to buy.
- REITs stand Real Estate Investment Trusts. Simply put these are investments into different types of real estate (commercial, healthcare, apartments, etc.) where you are able to get income from the lease payments and also have some exposure to the upside of real estate values.
- MLPs stand for Master Limited Partnerships. These are investments in the pipelines that transfer natural gas and oil across the country. They tend to provide slightly higher than normal dividend yields because they are multi-year contracts which companies enter into. The MLPs pay out the income they generate to shareholders like you and me. Again, these can be less liquid investments, but investors have the ability to invest in ETF-like investments that hold multiple MLPs.
The goal with income investing is to get an asset allocation that is built utilizing all these different types of income investments.
It is great to build a portfolio that can pay you income, but it isn’t the end-all be-all for investors. There are many other ways to utilize your retirement savings, but income investing is an option that we’ve seen work for many retirees.
So, focus on growing your asset base over the years and constantly monitor what your “need” will be for living expenses in retirement. Have that be the “number” you are striving for, rather than just picking a large number out of thin air.
Israeli troops are in Gaza, ISIL is storming through the Middle East, oil prices are volatile, you should have to take out a life insurance policy to fly Malaysian Airlines, and stocks are at all time highs. All told, it’s a scary time to be an investor. As an investment advisor, I’m constantly answering the question, “How do I cut through the clutter of bad investment strategies?” Everyone wants a strategy that makes them feel confident about investing in the future, especially at times like this when everyone seems to be holding their breath.
My answer to this is a strategy that I preach to pretty much anyone who will listen, income investing. I even dedicated a whole chapter to it in my book, You Can Retire Sooner Than You Think.
What is income investing?
Income investing is a way to generate consistent cash flow from your liquid investments.
What this really means is that you are collecting the cash flow from dividends from stocks, interest from various types of bonds and distributions that come from a variety of investments (investments that pay distributions but don’t fit neatly in the stock or bond category). Adding the three of these together gives you a personal portfolio yield.
Income investing focuses on the production of a steady cash flow from the yield of your stocks, bonds and other investments, which can be reinvested in your portfolio or used to fund your spending needs if you need the cash flow.
This is different from pure growth investing in that pure growth investing relies on a rising stock market to build value. Income investing allows you to diversify your investments, collect a steady stream of income along the way, and (most likely) see a steady increase in the value over time. If this still seems confusing, let me explain this approach using my bucket system. (They’re buckets because you put your liquid net worth into them. Get it!?)
Bucket 1 – Bonds - Income – Contributions to this bucket are invested in various types of bonds -- Treasury, corporate, municipal, high yield, TIPS, international, and floating rate. They will provide you with a steady interest income. A well-diversified bond portfolio should protect your principal, as well. To maximize your return over time you have to diversify within this bucket.
Bucket 2 – Stocks – Growth – This bucket will hold different stocks for people in different stages in life. If you’re under 60 and still working, you should consider owning growth stocks. These are shares in companies that have large growth rates, but usually they don’t pay much of a dividend. Their focus is on capital appreciation through growth in their revenue and earnings. On the flip side, if you are a retiree, you should probably focus more on dividend-paying stocks. These are companies that aim to give you some capital appreciation and pay you a nice dividend along the way. Dividends accounted for 44 percent of the total return of the S&P 500 over the last 80 years. This is one reason I’m such a believer in income investing.
Bucket 3 - Variety of Investments – Alternative Income – This is the smallest bucket of the three. It holds investments that don’t fit neatly into either of the above buckets. For example, this bucket holds investments in energy royalty trusts (publicly traded oil and gas trusts), real estate investment trusts, preferred stocks, and MLP stocks (pipeline and energy storage companies). These are traded like normal stocks on the open exchanges, but they don’t pay traditional dividends or interest…they pay distributions.
The idea of using the bucket approach to income investing is that you can diversify your liquid savings and use them to either supplement your income in retirement, or reinvest the portfolio’s income to accumulate more wealth over time.
All that being said, this is obviously not the only functional investment method in the world. However, I’ve found it to be a tried-and-true method for those who are looking for a low cost, transparent, and consistent investment strategy built for the long-run. You can learn more about this method by reading my Wall Street Journal article on it here, or by picking up a copy of my book, You Can Retire Sooner Than You Think.
Wes Moss, the Chief Investment Strategist for Wela, writes a weekly blog for AJC.com. You can find his original article here.
John Grisham writes some great books. They are engaging, quick to read and they tend to keep you on your toes for the entire book. As I read through Grisham books, I tend to find myself believing the story is about to go one direction before shifting completely in an opposite direction. Just as I begin to get comfortable with the new direction, there is another shift in the story, and as I near the end, I begin to believe the ending will be one way, but, yet again, I am left surprised with how the story concludes.
There are many different examples that we could use to allow people to relate to this idea of pivoting/shifting plots. We see it in movies and TV shows all the time as we believe one person or group to be the villain before being surprised that we were completely wrong.
Within the markets, there is a constant presence of believing investments will act one way, but they end up performing another. This surprise factor is constantly evident and that is what makes investing so difficult.
After just two months this year, we have seen this element of surprise creep back up. Heading into the year, it could have been deemed a foregone conclusion, by market participants and media outlets that rates were going up. Although the year still has plenty of trading days left in it, rates have gone against expectations and have declined over the first two months.
To start the year, rates on the 10-year were at 3.03% and through February the yield on the 10-year has fallen to 2.65%, a fall of nearly 40 basis points.
The conclusion that rates will rise over the longer term seems to be a fair conclusion, depending on how long one views the “longer term.” But the fact of the matter is that the equity volatility we have seen so far this year does not bode well for those in the yield spiking camp. And economic growth in the U.S. probably does not support yields much higher than 3.50% on the 10-year.
Given that we saw the huge rate spike in the summer of last year, we are probably in a more realistic range for yields (around 3%). But just as we don’t tend to sit back on those Grisham novels, we probably should not do that with yields. We saw a slight shift in the bond plot through the first two months and we know we can expect something else to come up before year end. We just have to stay tuned.