Figure 1 Source
On Seeking Alpha there are plenty of articles on how to manage a portfolio if one is an investor with a full-time job in the accumulation phase. And there also are plenty of articles that look at portfolio management from the perspective of an investor who's retired and living off their portfolios (at least in part, they may have other sources of income). We don’t see many articles covering the topic of transitioning from accumulation phase to retirement.
One of the very first things to do when retirement is being considered as something that has a concrete date is to put together a budget. Sure, many investors already will have a budget (of some level of formality), and that's a very good place to start. In retirement a budget is very important. For one thing, when one is working, spending too much of one’s paycheck in any one month will rarely have an impact on the amount of that paycheck going forward. If you take too much cash out of your portfolio however, the same cannot be said.
In putting together a budget for one’s retirement years, one also must consider what will change upon retirement. One of the biggest cost items to change will be healthcare expenses. Questions needing answer to figure out this budget item include what government healthcare or health insurance programs will one be eligible for (like Medicare if one is 65 or older).
- Does your current employer provide any healthcare benefits to its retirees?
- Can you continue with your current health insurance and will there be any changes in its costs?
Depending on the answers to these questions and the costs involved this might even require some adjustment to your retirement date.
Not going to work every day also will change what you spend money on. For instance, many places have a dress code and business attire can be more expensive than casual clothes. You may have picked up a spiced latte every day at the coffee shop across from your work. Or your employer might have provided free or reduced price coffee. You likely won’t be putting as much mileage on your car, reducing both maintenance and fuel costs.
Another big thing that will change is that while you were working at least eight hours a day and 40 hours a week you were taking care of tasks that others demanded of you. Now that time is your own. Folks who fill that time with activities and tasks they find rewarding or enjoyable tend to live longer (and often healthier) lives.
So at least start the process of figuring out what you want to do with that time. And remember, you aren’t stuck with any choices, that’s the beauty of this time, it’s yours do with as you want. But be sure to understand what the expenses involved will be and add them to the budget.
What other decisions do you need to make?
Now that you have a potential budget put together, you can begin making the decisions about how much income you will need and how it will be generated. The first time though this is likely to be an iterative process (by which we mean you will go through the process several times using the numbers from later stages to adjust things in earlier stages on a later run through). And yes, you did read that word first correctly too. This will need to be repeated each year or whenever anything significant changes.
So the first step in looking at sources of income in retirement is to look at any defined benefit programs your employer (and even past employers) offer to their employees. Sadly, for many, especially those in the U.S., this will be a quick process as their employer doesn’t offer such a program or they don’t qualify for it. If you are one of those lucky enough to have such a benefit, there are lots of possible options, potentially including:
- Inflation protection
- Spousal benefits
- Death benefits
- Lump sum payouts
Next up is government retirement programs. In the U.S. this is Social Security, and most countries have some sort of retirement program. Your age when you retire will impact the level of benefits you can claim. For Social Security you can opt to retire early (for reduced benefits) at age 62, retire at your normal retirement age (this used to be 65 but each year moves up 1 month until it hits 67 in a few years), or delay your retirement past your normal retirement age until age 70 (for a benefit that increases 8% each full year one delays collecting it).
Next are a mixed bag of various programs typically offered by insurance companies. Annuities are one such as are some varieties of life insurance. If you have such a benefit don’t forget to include it on the income side.
Now it’s time to look at what you need to do to your investment portfolio
At this point, we are ready to see how much income a retiree would need to generate from their investment portfolio. Here we will get into more details and work on a specific example.
Let’s create a hypothetical prospective retiree, we will call him John. After working through his budget and his other sources of information, John has determined that his portfolio will need to generate $38,000 a year. Below is John’s hypothetical portfolio (based on an actual real portfolio).
John’s portfolio is currently configured more to grow future income than to produce current income, so some changes will be needed. Currently the portfolio has a yield of 5.27%. Between his budget and other sources of income John needs the portfolio to generate $38,000 a year. That level of income will require the portfolio to have an average yield of around 6.9%, or an extra $9,000 in cash above the current income of roughly $29,000. John currently holds his portfolio in an IRA and so he doesn’t have to consider any tax issues when changing his holdings.
To do that, the first step will be to sell positions that have a low yield (or at least well below the current average) and if possible ones with a large unrealized gain.
Figure 2 Author's calculations and closing prices on 11/13
The table above shows what was sold from John’s portfolio to produce the cash needed to buy more income. The dividend numbers are based on the shares sold and the last declared dividend. The proceeds column is an approximation based on a 4% discount of the closing price of the stocks on Nov. 13 rounded down to the whole dollar amount. These sales reduce the number of positions in John’s portfolio from 42 to 32. Notice that the yield for the positions sold Apple (AAPL) was sold because its yield is so low. While it’s a great dividend growth play, at the current time it just costs too much to get those dividends. So while it fit John’s goals earlier, now that he needs more income it is just too expensive.
Cisco (CSCO) also was sold because of low yield and thus too expensive when more income is needed. Also the 30% or so unrealized gain on the position allows us to use that gain to purchase more dividends. CSCO is typical of the types of positions that should now be sold to gain more income since it has below average yield and substantial unrealized gains to be harvested.
Digital Realty (DLR) as a REIT once had fairly high yield. Now it has risen so much in price that its yield is below average. Given the very large unrealized gains, 100%-plus, selling this will produce a lot of cash to buy more dividends.
General Mills (GIS) is one of two holdings in the packaged foods portion of the consumer products segment. That whole group has below average yields and slow growth as well. It makes sense to drop at least one of them and we judge GIS to have the less promising future. Kimberly-Clark (KMB) always can be sold later if more dividends are needed.
Realty Income (O) with its monthly dividend is great to have when you are working on growing future income and reinvesting dividends. But when an investor needs current income its yield is a bit low, right around portfolio average. The large, around 30%, unrealized gain also makes it a target for sale.
Next Era Energy (NEE) is a great dividend growth company, but its yield is low. PPL Corporation (PPL) has some issues that while one was still focused on future income were OK, now present too much risk. Given the lower yields on these and the lower yields on utilities in general, it makes sense to cut out these two to get more cash.
Unlike the other positions, where the whole position was sold, Main Street Capital (MAIN) and Johnson & Johnson (JNJ) were only trimmed. Both of these companies are very good even if the yield isn’t as high as one might like. So the compromise was to reduce the portfolio’s dependence on them and deploy the extra cash into higher yielding securities.
The picks in the table above are all from the HDO Portfolio Sheet spreadsheet. The two ETNs are 2x leveraged funds, UBS ETRACS 2X Leveraged Long Wells Fargo Business Development Company ETN (BDCL) and Credit Suisse X-Links Monthly Pay 2xLeveraged Mortgage REIT ETN (REML), which are rated with a high risk, but all the other picks are rated as average or lower risk. The allocations to the ETNs are each just over 2% of portfolio value (to help control risk) while the others are around 3%. The costs for each position are based on a share price that's 3% above the share price listed in the HDO Portfolio sheet at 10 a.m. on Tuesday Nov. 14 ,rounded up to the next dollar amount. At the time of this writing, all picks were trading below the buy below price. The dividend column contains the dividend per share amount (or a low ball estimate in the case of shares that pay a variable distribution amount). The income column is just the dividend multiplied by the number of shares purchased. Purchasing these picks increased the portfolio from 32 to 40. Overall between the sales and the purchases, John’s portfolio went from 42 positions to 40.
Note that the yield on the new positions averages 11.33% which is a big increase from the 4.12% yield on the positions sold, resulting in an increase in income of $9,170 per year. This shows yet another way that the swapping of low yield stocks for those with higher yield helped increase the dividend income John’s portfolio produced. The new dividend payout even beat the goal which was to generate an extra $9,000 per year. And this was done by swapping only 9 positions out of the 42 that were available in John's portfolio.
REML is an ETN based on the FTSE NAREIT All Mortgage Capped Index with 2X leverage that pays monthly and is reset monthly. It currently has a rate of 21.53% based on a reference price of $24.811. This is calculated by taking the last three distribution payments and multiplying them by four to get an annualized amount, although since the payments are variable there's no guarantee that future distributions will match this rate. That annualized amount is $5.534, which to be conservative we will round down. While this is listed as a high-risk investment, that's mitigated by the payment being generated from multiple sources, so if one mREIT cuts its dividend it will have only a small impact. Also since the fund (and all of the HDO recommended funds are done this way) it's rebalanced monthly rather than daily, nearly all of the issues with price decay that's associated with "daily reset leveraged ETFs" are eliminated.
BDCL is another 2x leveraged ETN from UBS ETRACS. BDCL, as one might guess from the name, is based on an index of business development corporations. John buys this ETN for the income boost, but keeps the position small to manage risk and because a number of the other picks are BDCs. These 630 shares add almost $1400 of dividends for less than $10,000 in cash.
We are having John buy ClearBridge Energy MLP Opportunity Fund (EMO) instead of ClearBridge American Energy MLP Fund (CBA) as EMO is the surviving fund. This purchase will make EMO just about 3% of the portfolio and produce almost $2,000 in dividends a year.
Triple Point Venture Growth (TPVG) is a top buy and this purchase produces almost $2,000 in dividend income a year. This purchase produces a nice boost to the income John’s portfolio will throw off in the future.
Macquarie Infrastructure Corporation (MIC) adds $1,800 in dividend income. Monroe Capital (MRCC) is a good buy despite (or even because) of its recent drop in share price adding $2,170 more dividend income. Pattern Energy Group(PEGI) is from the High Dividend Opportunities "Core Portfolio" and its approximately 8.8% yield and lower risk rating adds nearly $1,500 of dividend income.
Newtek Business Services (NEWT) is the final new purchase and it brings the total dividend income from these picks to $14,428 of dividend income for the year. NEWT is second of two picks with an HDO risk rating of low. That exceeds the target John had of $14,258 by $169. And it leaves $170 of the cash produced by selling.
John’s adjusted portfolio now produces just over $38,000 which meets his goals. Having 40 positions he still retains lower yielding stocks with growth potential. The overall portfolio yield went from 5.27% to 6.93%. This should provide income growth to offset inflation and if needed can be sold to generate cash to increase income.
How much time before you retire should you start the transition process?
The more time one has to plan the better. Many investors like to have cash reserves in their accounts to cover unexpected expenses or give time to recover from dividend cuts. Typically, somewhere between six months to two years of expenses might be kept in cash ready to cover the unexpected. The need for enough cash to cover most eventualities must be weighed against the ravages inflation will inflict on cash held for long periods of time.
Another thing for John to consider is that the new portfolio configuration just covers his needs. So if he has some time before he needs to use the dividends to pay expenses, he can continue to reinvest all the dividends and grow the income more. Also for consideration is that not all low-yield securities have been sold, so more can be sold and used to buy higher yield securities in order to increase the cushion.
This is a good start to moving from a portfolio that's designed to grow its income over time and one that is designed to produce enough current income to cover expenses. Going forward the new configuration isn’t fixed in stone, but it's now well positioned to produce current income but still grow to help cover inflation.
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Disclosure: I am/we are long TPVG, MIC, REML, BDCL, PEGI, EMO, MRCC, NEWT. 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.