Financing Retirement: Turning Capital Into Income

by: David Van Knapp
This is the third article in a series on financing retirement as seen by someone who is retired (me). It’s a view from the front lines. It is pragmatic, not academic.
To recap my first two articles:
  • In “Financing Retirement: It’s All About Income,” I made the point that in retirement, you need to generate the income needed to cover your expenses. There are many ways to generate income—consulting, part-time work, Social Security, pensions—that may be overlooked in conventional retirement planning. Of course, income from your assets is an important ingredient in the recipe.
  • In “Financing Retirement: What’s Your Real Number?,” I criticized the “maximize capital” approach to retirement planning, noting that the “number” to focus on is not the sales-lot value of your nest egg, but rather its annual income-generating ability. The two are often assumed to be proportional, but they are not. I used myself as an example, noting that according to conventional calculators, I was years and more than $1,000,000 from being able to retire, whereas in fact I have been retired for almost 9 years and live comfortably.
In this article, I want to focus on that disconnect. I believe that it comes down to how capital in a nest egg becomes income in retirement. I will be careful here in my use of the word “assets.” It is tempting to use “assets” and “capital” interchangeably. But to do so is misleading, because it assumes that the only value of an asset lies in its price if sold, and thus that the only measure of its value is its price. That notion is incorrect.
In conventional retirement planning, there are three critical steps:
  • Maximize your capital before you retire.
  • Make your capital a lot safer as you approach retirement.
  • In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.
The problem I have with that thinking is this: It ignores the fact that some assets generate income themselves. They do not have to be sold to produce income. A few examples of such assets are:
  • Pensions
  • Social Security
  • Annuities
  • Bonds
  • Dividend stocks
That is why it is important to distinguish assets from capital. The first two items above are not capital at all, but they generate income. They are truly assets: They are rights that you have acquired to receive income. If you have a pension, you earned it over time from your employer. You earned your right to Social Security payments in the same way, by working and contributing (along with your employer) to the system.

The last three items, on the other hand, are investments purchased with capital. Once purchased, they confer an important right: The right to receive an income stream.
  • Annuities allow you to purchase that right from an insurance company for a price and fees that depend on your age, gender, the payout plan you choose, etc. You never get your capital back, you trade it for the right to receive income for the rest of your life. (There is a useful annuity calculator at Immediate Assuming that the insurance company remains solvent, your right to the income is totally safe, except from inflation. The price you paid is totally gone.
  • Bonds are also purchased with capital. Let’s assume that you invest only in “investment grade” bonds and hold them for income. The income they generate is as safe as with annuities. Instead of being for life, your right has a term limit stated on the bond, which is a contract of debt (you loaned your money to the bond issuer). Being fixed, the income stream is not safe from inflation. The capital you purchased the bonds with is safe in the sense that you will get it back at the end of the bond’s term, but its value will also have been eroded by inflation. So with investment-grade bonds, the income is safe, except from inflation. The principal is also safe, except from inflation.
  • Stocks are also purchased with capital. Conventional wisdom is that they are far less safe than bonds, because their prices are volatile. Retirees who invested throughout their lifetimes mainly in stocks to maximize capital, and who then unfortunately suffer a significant loss in the value of their portfolio just before they reduced their stock exposure—because of, say, a bear market—are screwed. The income available from selling a percentage of their assets each year falls proportionately with their stock portfolio’s total price. Even after the stock exposure reduction, that percentage of your nest egg still in stocks is subject to the usual risks of the market.
But what if the stocks were well-selected—“investment grade”—dividend-growth stocks? Does the same misfortune happen? No.
  • Dividend stocks generate income. Their value does not lie in their ability to be periodically sold off. Their true value lies in their ability to generate income on their own. In that respect, they are like bonds.
  • But unlike bonds, dividend growth stocks are not fixed-income investments. Their yield on cost—which is comparable to the yield on bonds—goes up each time that they raise their dividend payout. They are rising-income investments. In fact, the income from investment-grade dividend growth stocks generally keeps up with or surpasses inflation.
  • Unlike bonds, there is no term. Ideally, dividend-growth stocks can be held “forever.” You do not have to worry about the impact of inflation on your principal. An investment-grade dividend-growth stock whose price goes down does not ordinarily reduce its dividend nor even stop increasing it. Scores of stocks have been raising their dividends for 25 to 50 years or more. They have done this since the Eisenhower administration, through every kind of economic condition—wars, recessions, inflation, stagflation. See the Dividend Champions document here that lists them. While their prices have gone all over the place, their dividends have gone in only one direction: Up.
  • Finally, unlike bonds, over long periods of time, investment-grade dividend-growth stocks are likely to increase in principal value too. Every study that I have seen shows that dividend-growth stocks have the best total returns of all categories of stock.
Conventional wisdom is that a retiree’s stock-to-bond ratio should go way down as one approaches retirement age. The reason, of course, is that bonds are considered to be much safer than stocks. But are they? How do you weigh the safety of bonds’ principal and interest payments—both fixed and subject to the ravages of inflation—against dividend-growth stocks’ ability to raise their rate of return and potentially increase their principal value too? We are conditioned to think, when talking about safety, only of the principal (or capital) side of the equation. Subliminally, we fall into the “capital is everything” mind-set very easily.
But let’s raise that up to a conscious level and actually think about it. If you believe, as I do, that “it’s all about income” in retirement, then the safety we should be focused on is the safety of the income stream, including its safety from inflation.
Looking at dividend-growth stocks in this way is a paradigm shift. We are brought up and taught as investors to maximize that nest egg. But in retirement, it’s all about income. In a well-chosen ‘investment grade” dividend stock portfolio, very few stocks will fail to consistently increase their dividends each year. So the income stream goes up, in most years easily surpassing inflation. Even in bad dividend years for stocks generally (like 2009, when the total dividends paid out by the S&P 500 declined by billions), a portfolio of stocks chosen specifically for their dividend-raising prowess will throw off more dividends. I maintain a demonstration portfolio about this (see it at my Web site, Sensible, and in 2009, I received 19% more dividend dollars than in 2008.
Am I suggesting that conventional approaches to asset allocation in retirement—heavy on bonds, light on stocks—might be improved upon if the stocks in question are investment-grade dividend-growth stocks? Yes. And I am also suggesting that the income available for retirement from a portfolio that includes a heavy dose of excellent dividend stocks may exceed the income created by slicing off and selling a portion each year of a maximum-capital portfolio—even if the max-cap portfolio is significantly larger in size.
That may be why the retirement calculators tell me that I can’t retire until I accumulate $1,000,000 more—they don’t know about my dividend stocks. They didn’t ask.

In the real world, most retirees gather their income from a variety of sources. While the goal for dividend investors may be to live off of the dividends without selling off any of the base, the dividend stream may not be large enough. So some of the base—but far less than the “4% + inflation” standard—may be sold off to close gaps. There is an excellent recent article by Morningstar author Christine Benz that addresses how real retirees achieve the right balance: “Income or Total Return? Retired Investors Weigh In.” I highly recommend it.

Disclosure: No positions mentioned.