MMM Newsletter and Website Header 10.2.15

By Rob Williams, Charles Schwab & Company 


Key points


  • Market volatility and low interest rates make it challenging to develop retirement income strategies.


  • We recommend using three primary building blocks of retirement income after Social Security: cash and short-term reserves, interest, and dividends, and capital gains.


  • Consider tapping interest, dividends and predictable income first if that’s your preferred approach, then drawing from the cash or capital gains portion of your portfolio.

If you are approaching retirement, you may be wondering how to generate retirement income. It’s a ubiquitous, and critical, question in investment planning. Low-interest rates and market volatility don’t make it any easier to put together retirement income strategies.

There isn’t a single source of income that you should use to fund your retirement spending. Instead, consider building blocks of returns from different parts of your portfolio.

Three building blocks of portfolio income

There are three primary building blocks, after Social Security:

  • Block #1: Cash and short-term  reserves


  • Block #2: Interest and dividends


  • Block #3: Capital gains on assets invested

Each “block” comes from a diversified portfolio, structured to deliver return as well as distributions — meaning cash flow — from multiple sources.

Your foundation of guaranteed income starts with Social Security

Before discussing portfolio income, don’t underestimate the power of non-portfolio sources, in particular Social Security. It’s guaranteed, you can’t outlive it and it grows with inflation. Your spouse receives benefits too.

This type of income is valuable. For example, $20,000 in annual Social Security payments, started at age 65 for life, growing at the rate of inflation as measured by the CPI (consumer price index) each year, is worth about $500,000 if you had the money to invest. This is an approximation, but it gives you a sense of the value. Use it wisely.

Also consider whether it makes sense to add additional guaranteed income sources, such as income from annuities, to strengthen the foundation and ensure a larger “block” of retirement cash flow.

Now let’s look at the portfolio building blocks.

Building Block #1: Cash balances and short-term investments

We suggest you set up and maintain an emergency fund while saving. This is a low-risk, highly liquid source of money to backfill spending if other income sources fail. Do the same in a retirement portfolio such as an IRA. Having cash balances and other short-term investments allows you take on higher risk investments that have the potential to generate capital gains, which make up your third building block.

One way to generate this cash flow is to use a CD or bond ladder, or a combination of cash investments and a short-term bond fund. The role of these investments is to manage risk and line up spending you’ll need soon to allow you to take the right amount of risk elsewhere. We recommend that your goal be to add liquidity and stability for two to four years.

Building Block #2: Interest and dividends

Interest and dividends from stocks and bonds are a natural source of portfolio income. These flows are always positive, are the first logical source of portfolio income, and many retirees generally have a preference for them. A problem, of course, is the low-interest rate environment — and the fact that if you focus on income to the exclusion of other things, like investments that have more growth potential, you won’t have a balanced portfolio.

Many investors think interest and dividends make up the first source of income, but also the only source. That’s great if you have a large portfolio relative to your needs, and interest and dividends are enough to support your lifestyle. But it’s not necessary to limit yourself to this building block. Investors who think of interest and dividends as the main source of retirement income may spend less than they really need to, or take more risk in their portfolios to generate more interest or higher dividends. An alternative is to use interest and dividends simply as the first source of income — after Social Security, of course.

Don’t let the Federal Reserve or interest rates drive your retirement spending.

Building Block #3: Capital gains on assets invested

Too much cash and short-term investments such as CDs with short maturities and low-interest rates can be a drag on your portfolio. You want to have enough in these investments to support near-term spending, but not too much. Invest the rest to deliver income and growth potential.

Capital gains are the underappreciated income engine of diversified portfolios. They generally produce greater cash flow than interest and dividends over time, tend to outpace inflation, and are taxed preferably (in taxable accounts) if you tap gains on investments held for more than one year.

The flip-side, of course, is that stocks and investments for growth are often riskier over the short term, plus they often carry transaction costs. We define risk here as prices moving up or down, often in sharp unanticipated moves that can derail poorly-designed portfolios.

A well-designed portfolio uses the other blocks to allow you to take more risk to help support higher spending than you could achieve with blocks one and two alone. It should also allow you to both manage inflation and manage risk in the short-term.

Over time, you can likely rebalance your portfolio and harvest gains from stocks, possibly to fund spending or to replenish your cash balances and short-term investments (such as the bond ladder or short-term bond portfolio) shown above.

In summary

As you approach retirement, consider thinking of your retirement income sources as building blocks as you develop your drawdown plan. This is a diversified, flexible, and stable approach to combating low-interest rates and funding retirement.

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About LRPC’s Monday Morning Minute

Lawton Retirement Plan Consultants, LLC (LRPC’s) Monday Morning Minute is crafted to provide decision-maker’s with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to retirement plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or bob@lawtonrpc.com or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.

Additional Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.  All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve. Dividends are not guaranteed and stocks may reduce or stop paying dividends, affecting the portfolio’s ability to generate income. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.