Retirees Don't Need Income, They Need Spending Money

by: Paul Price

Our ZIRP (Zero Interest Rate Policy) world has turned retired people and pension fund managers into half-crazed income scavengers. Otherwise risk-averse investors that would have been holding insured CDs, treasury bonds and investment-grade corporate debt are now loaded up with risky mREITS, junk bonds and alternative investments they often don't fully understand.

Why did otherwise sane people become so financially reckless? There's no chance now to earn reasonable risk-free interest income. At today's 5-year T-bond rate of 0.59% a $1,000,000 portfolio would bring in a paltry $5,900, pre-tax.

(click images to enlarge)

In normal times, not too many years ago, a prudent individual who had saved $1,000,000 during his working lifetime could confidently spread out his money in a laddered portfolio of insured bonds and CDs, locking in about $60,000 a year in interest income.

Adding that to about $30,000 in annual social security payments provided the ability to live comfortably, if not extravagantly, on $90,000 a year, even if you had no pension coming to you. This asset mix avoided stock market risk while also eliminating credit risk. Barring U.S. government default, inflation was the only bogeyman lurking in your future.

More sophisticated pension fund managers took similar approaches while adding equities, real estate and alternative investments to their mixes in an attempt to conquer the rising COLA (Cost of Living Adjustment) problem.

Our theoretical retiree needs that $60,000 annual spending supplement to live reasonably. How, then, can I say he doesn't need income?

He has liquid assets of $1,000,000. He's capable of simply putting aside a couple of years' worth of spending needs ($120,000) while investing the rest in whatever way will bring the best total return. That key concept leaves him with a world of choices instead of just prototypical "income" vehicles.

All that is necessary for this to function well is the ability to generate at least $120,000 in new cash during the first two years of this new program. This would go toward replenishing the rolling cash reserve.

The $120,000 could come from any combination of dividends, covered call writing, stock sales and/or interest on uninvested cash. With only a $5,900 annual risk-free hurdle (at the five-year average maturity rate) to beat, it shouldn't be hard to put together a portfolio that could easily add alpha.

A real no-brainer, relatively low-risk portfolio could be constructed by simply owning all the components of the DJIA that have current yields higher than the 10-year Treasury bond. Sixteen of the 30 Dow Industrials were out-yielding even the 10-year T-bond coupon at the end of August. That list included some names you'd rarely think of as "income" stocks:

After setting aside the $120,000 for 2 years' living supplemental living expenses, (the remaining) $880,000 invested in these fine companies would generate $30,536 in annual income. That's versus the $5,900 a laddered portfolio of fixed income with an average coupon rate equal to the 5-year T-bond rate of 0.59% would bring in. This ignores the approximately $84 a year you might eke out at 0.07% at the bank on the $120,000 held out for the first two years' living expenses.

Dividends on the $880,000 portfolio would also be far in excess of what the full $1,000,000 would bring in at the 2.67% 10-year T-bond rate. That would equal only $26,700, while exposing you to serious inflation risk.

Most of the 16 names in the DJIA portfolio have a history of steady dividend increases. You can expect the second year's dividend stream to generate more than today's indicated rate.

Nobody can guarantee that the value of this portfolio will increase in price over the next two years, or even the next full decade. I can show you the results from the same exercise for the period July 16, 2010 through July 31, 2012.

At the start of that period, 10-Year T-bonds were paying almost 3%. What was the total return from the 14-company equal dollar weighted DJIA portfolio that was out-yielding 10-year fixed income back then? The portfolio brought in a gratifying 51.56% gain for the 24.5 months (not including any of the actual dividend increases).

You can see details from the original articles by using these links:

Published July 17, 2010

Published July 31, 2012

Replacing the requirement to get strictly defined "traditional income" allowed our retiree to attain far superior total returns. It also provided a degree of protection against the ravages of inflation through the possibility for dividend increases as well as share price appreciation.

Fixed-income, by definition, can provide no increase in annual payouts. The initial rate will hold steady, regardless of any increases in your personal cost of living.

I'm sticking with my concept from the first two articles -- income investors should be buying equities. I own a nice diversified portfolio of good quality stocks. I hold no bonds.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.