Seeking Alpha

Just Retired? 3 Strategies To Earn High Income With Less Risk

|
Includes: ABBV, ADM, AGG, ARCC, BBN, D, DMO, DNP, DWX, ENB, EOI, EOS, ERH, ETV, FFC, FLC, GBAB, HPI, IEF, IRM, JCE, JLS, JMT, JNJ, JPC, JRI, JRS, KO, LMT, LYB, MAIN, MMM, NBB, NLY, O, OHI, PCI, PCM, PDT, PFD, PFO, PG, PGZ, PRU, QQQX, RFI, RNP, ROC, RQI, STK, STOR, T, TXN, UL, UTF, UTG, VLO, VTR, VZ, WBA, WFC, XOM
by: Financially Free Investor
Financially Free Investor
Long-term horizon, dividend growth investing, portfolio strategy
Summary

If you have just retired or about to retire and wondered how you could earn adecent income while preserving your capital? Please read on.

The era of 5%-6% income from bank CDs is long gone and is not coming back. They barely meet the rate of inflation.

After 10 years of the bull market, while markets are near their all-time high, they are showing signs of old age and exhaustion.

We discuss three income strategies. Especially when combined, they exhibit the "sleep well at night" (SWAN) characteristics that can preserve and grow capital while providing very decent income, all at the same time.

One of the biggest worries for retirees or anyone who's going to retire soon is how and where to look for sustainable income. Sure, there are a lot of investment avenues where you can get very high yields, sometimes even more than 10%, but most folks know that high yield comes at high risk. While income is important, it would serve no purpose if you were to incur large losses. So, the sustainable income is one that generates high enough income stream while it preserves the capital.

The safest investment in terms of preserving capital would probably be bank CDs (fixed deposits). However, even though the yields on bank CDs have improved somewhat in the last two years, they are still far too low to provide a good stream of income. Worse still, the yields are likely to fall once again as the Fed is now cutting interest rates. That's one reason that so many investors have piled into the risk assets in the last decade in search of income. In fact, at current interest rates, bank deposits barely protect you from inflation. So, after taking inflation into account, there's really no income left to spend, and if you were living off of those savings, you are depleting the savings every year. To be sure, the low-interest rates are good for borrowers and businesses but not so much for retirees and savers. There are many other securities or funds out there that promise high yields, but many of those are simply minefields and fall short on the safety of capital.

So, what about the broad indexes like the S&P 500, after all, the Oracle of Omaha Warren Buffett advises that most folks would be better off investing in the S&P 500. Should retirees simply invest in the stock market using broad indexes? Well, broad indexes may be just fine if you were investing for the long term (maybe 20 years or more) and were in the accumulation phase when putting additional money every paycheck would give you the benefit of dollar-cost averaging. But unfortunately, most retirees are not in that situation -they need the income now. Second, we are late in the cycle, and there are plenty of warning signs on the horizon. The stock market has been in a bull market for more than 10 years, but since early 2018 volatility has returned, causing a lot of stress to investors. Even though the market is once again at near an all-time high, the market direction remains far from clear.

Recent retirees or near retirees are most vulnerable to the market's big drops and corrections. It can especially be devastating to those who are in a withdrawal phase and not in a position to add new money. On the other hand, if you let fear overtake you and continue to remain in cash while the bull market continues for another two years, not only you could lose a big chunk of gains, but you will also be deprived of income. That’s why we need a well thought out, multi-pronged strategy to deal with any market, be it a bull market, a bear market, or a sideways market. At the same time, our strategy should be able to generate good enough income stream. Do such strategies exist? In our opinion, the short answer is “yes,” though nothing is perfect.

Three Keys to Success in Retirement

Let's say you are 62 years old and just retired with $1 million in total savings, a vast majority of which is in mutual funds inside your 401k account. Where do you go from here?

More than likely, you are not sitting on 100% cash. Maybe until now, you were just invested in funds that were available within the 401k. In another scenario, you may have been invested in a bunch of ETFs and some individual stocks, but with no clear strategy for income or downside protection. More than likely, your investments do not generate enough income, and you do not know what to sell and when to sell. Either way, you need a clear strategy with definite goals, income needs, and most important downside protection based on your risk tolerance.

There are three key goals that we can clearly define for retirees or conservative investors:

1. Avoid Big Drawdowns: We want to avoid any serious bear markets and the huge drawdowns that come with it, at all costs. In a worst-case scenario like that seen in 2008-2009, when the S&P 500 nosedived 57% from top to bottom, we want to see a maximum drawdown of 15%-20%. Essentially, we want downside protection. For recent retirees, there's nothing more harmful than a 50% drawdown, and we must protect against it.

2. Generate A Good-Enough Income Stream: Retirees need income. But income should not mean the return of your own capital. The traditional ways to generate a decent income from CDs or bank deposits are long gone. Another method that has been pushed by many financial advisors, of withdrawing 4% from your stock portfolio by selling shares every year, is too unreliable and is full of risks and pitfalls.

So, how much is “good enough” income? This is a subjective question, and the answer may vary from person to person. But if we wanted to generalize, we advocate a method that generates at least 5% income, so that there's no need to sell shares every year and at times just at the very bottom of the market. Not only is such a system superior for the long term, but it also will help sleep well at night.

3. Ensure Long-Term Decent Returns: Even retirees need a decent long-term return on their investment capital. Why? Because retirements can be 20-40 years long, and unless you have a huge portfolio, you need decent long-term returns to beat inflation and ensure that you don’t outlive your money. This is the reason we want to take part in a bull-market scenario to be able to get reasonable growth for the long-term health of our portfolio and investments.

Portfolio Structure

If you are familiar with our work, you know we are a big fan of the multi-pronged or multi-basket approach, each basket with a unique strategy and goals. In this article, we will discuss three different strategies with unique goals, distinct risk levels, and income targets. However, when combined, they can provide 5%-6% income with market-beating long-term returns, while providing safety and preservation of capital to a large extent.

We admit that the kind of strategies we are going to discuss here require some work, especially in the initial stage. It also will require ongoing low-level management. So, in a sense, it's not suitable for highly passive investors. However, in our opinion, the benefits of a multi-pronged and diversified bucket system outweigh the time and effort required. The table below shows how we will structure an overall portfolio of $1 million divided into three sub-portfolios (or buckets) plus a cash bucket.

Bucket/Portfolio

Portfolio Initial

Amount

Total Return targets

Target Income

Effort level

1.

DGI Portfolio

$350,000

(35% of total)

10%

Dividend

Income 4 - 4.5%

=$15,000

Initial setup, thereafter minimal.

2.

High Income Portfolio

$250,000

(25% of total)

10%

Distribution/

Income 7%

=$17,500

Initial setup, thereafter minimal.

3.

Risk-Adjusted Rotation Portfolio

$300,000

(30% of total)

10%

Withdrawals 6%

=$18,000

Minimal effort every month.

4.

Cash/CDs/Money-market

100,000

(10% of the total)

2.5%

Income 2.5%

=$2,500

Insignificant

TOTAL (from Investments)

$1,000,000

9.0% (average)

Yearly Income = $53,000 (5.3% average)

5.

Social Security

(similar to Annuity income)

-

$36,000 (average for a couple)

Total disposable income

$89,000 a year (approx.)

If you are a retiree and depend on the income generated by this portfolio, assuming an investment capital of $1 million, you could generate an annual income of roughly $53,000. Add Social Security benefits of roughly $36,000 (or more) for a couple, and this would be a total of $89,000 a year, which is a very decent amount for a couple to retire comfortably in most places.

If we were to assume that you had a smaller amount of initial capital, say $750,000, it would generate an income of $40,000. After adding $36,000 yearly income from social security for a couple, the total disposable income would become $76,000. However, these assumptions will vary from person to person. One size does not fit all. You need to look very carefully at your basic expenses and other sources of income like Social Security and then decide what the appropriate amount of savings would be for you.

Bucket/Strategy 1: DGI

This is our core bucket, made up of solid, blue-chip dividend-paying, and dividend-growing companies. In our view, everyone, especially retirees, should have this bucket.

How many stocks should we have in this bucket? It depends on your situation, preference, and portfolio size. But we think anything between 20 and 30 companies, with an average portfolio yield of roughly 4.0%, would be appropriate. All the companies that we select for this bucket should be dividend paying and have substantial dividend-growth history. For this article, we will select 20 companies from various sector/industries, representative of most sectors/industries:

Sample DGI Table:

Stock Symbol

Company Name

Industry

Dollar Amt.

Yield 9/24/2019

Div Amt.

KO

The Coca-Cola Co (KO)

Beverages

$17,500

2.95%

$516

ADM

Archer-Daniels-Midland Co (ADM)

Consumer - Farm Products

$17,500

3.47%

$607

PG

Procter & Gamble (PG)

Consumer Staples

$17,500

2.42%

$424

UL

Unilever (UL)

Consumer Staples

$17,500

3.04%

$532

LMT

Lockheed Martin (LMT)

Defense

$17,500

2.27%

$397

XOM

Exxon Mobil (XOM)

Energy Major

$17,500

4.82%

$844

ENB

Enbridge Inc (ENB)

Energy/ Pipelines

$17,500

6.28%

$1,099

VLO

Valero Energy Corp (VLO)

Energy/Refinery

$17,500

4.28%

$749

WFC

Wells Fargo (WFC)

Financials/ Banking

$17,500

4.17%

$730

PRU

Prudential Financial, Inc. (PRU)

Financials/Insurance

$17,500

4.46%

$781

JNJ

Johnson & Johnson (JNJ)

Healthcare/Drugs

$17,500

2.89%

$506

ABBV

AbbVie Inc. (ABBV)

Healthcare/Drugs

$17,500

5.87%

$1,027

MMM

3M Company (MMM)

Industrials - Diversified

$17,500

3.45%

$604

DWX

S&P International ETF (DWX)

Int'l Dividend ETF

$17,500

4.58%

$802

WBA

Walgreens Boots Alliance (WBA)

Retail/Pharmaceutical

$17,500

3.37%

$590

LYB

LyondellBasell Industries (LYB)

Specialty Chemicals

$17,500

4.76%

$833

TXN

Texas Instruments Incorporated (TXN)

Technology-Semiconductors

$17,500

2.82%

$494

T

AT&T (T)

Telecom

$17,500

5.43%

$950

VZ

Verizon (VZ)

Telecom

$17,500

4.09%

$716

D

Dominion Energy, Inc (D)

Utility

$17,500

4.54%

$795

TOTAL/ AVERAGE

$350,000

4.00%

$13,993

Bucket/Strategy 2: High Income Bucket

High-Income CEFs, REITs and BDCs:

Unless you have a very large portfolio in excess of say $2-3 million, a DGI portfolio alone cannot generate enough income. Since we are considering a portfolio of $1 million, we need a High-Income bucket. This bucket takes most of the risk to provide the most income. But there's no need for alarm as the risk with this bucket is only as high as the broader market, for example, S&P 500. Still, to mitigate risks, you should invest in 15-20 different instruments including CEFs (closed-end funds) from diverse asset-classes, REITs, and BDCs. Also, you should defer your investments over a period, say in four to eight quarterly installments. Each time we should invest only 10%-20% of the total amount earmarked for this bucket. The installments can be invested quarterly or bi-annually, depending on the individual's situation, portfolio size, and investor’s risk profile.

For the sake of illustration, here is a sample/example:

  • First Investment in October 2019 - 25% of this bucket capital
  • Second Investment in January 2020 - 25% of this bucket capital
  • Third Investment in April 2020 - 25% of this bucket capital
  • Fourth Investment in June 2020 - 25% of this bucket capital

This is how we created our "8% CEF Income" portfolio staggering the investments for over more than two years from October 2014 to 2016.

CEFs:

We will have CEFs in this portfolio that belong to at least six asset-classes. We will also have at least two securities of each kind. The most conservative investors could avoid the last two categories.

First, four of these categories are conservative and invest mostly in income-generating securities. We do not imply that these categories have no risk, but it's certainly less than in some others. They usually generate enough income to at least meet 60%-80% of the distributions. The rest may come from capital gains and sometimes from "return of capital [ROC]." Most of the chosen securities have a long history, impressive track record in terms of NAV performance, and high enough distributions.

Please note the majority of the CEFs use some amount of leverage, usually between 20% and 40%. This leverage helps them generate higher levels of income than make other investments. However, leverage can work both ways, and that's why these investments are considered riskier than, say, a DGI stock. But we see no reason to worry, as this is our income bucket and as long as the income is preserved, the rest will take care of itself in the long run. For the safety of the income, we are invested in conservative categories like municipals, utilities, real estate, and preferreds. Moreover, our back-testing models indicate that this portfolio is no riskier than the overall market, at least on a long-term basis. Our prior work on this can be seen in our other articles, which provide evidence of the robustness of such a portfolio.

REITs/BDCs:

  • Equity REITs (examples: O, OHI, STOR, IRM, VTR)
  • Mortgage REITs (examples: NLY, NRZ)
  • BDCs (examples: MAIN, ARCC)

So, in the high-income bucket, we should have at least 12-15 securities.

Here's the list of 15 securities selected from CEFs, REITs, and BDCs. We have tried to select the best funds from each category based on their track record. Also, please note that not all these securities are cheap today. In fact CEFs have done very well in 2019, and we can expect a reversion to the mean sometime. However, mREITs have lost value in 2018 as well as 2019, while equity REITs have performed very well. That’s why we recommend building such a portfolio over at least one year, preferably more.

High-Income TABLE:

CEFs:

Ticker

Name

CEF Category

Distrib. Rate

5-YR Ann. RTN ON NAV

Since Incep. RTN ON NAV

Inception Date

Discount / Premium

Distr. Freq.

Market-Cap

Leverage %

(QQQX)

Nuveen NASDAQ 100 Dynamic Over

Covered Call

6.95%

10.92%

10.29%

1/30/2007

-0.66%

Q

$834 MM

--

(EOS)

EV Enhanced Equity Income II

Covered Call

6.97%

10.21%

8.02%

1/26/2005

2.59%

M

$811 MM

--

(DMO)

Western Asset Mortgage Def Opp

Mortgage Bond

8.42%

10.24%

14.16%

2/24/2010

7.55%

M

$228 MM

32.94%

(PCM)

PCM Fund

Mortgage Bond

8.67%

8.90%

9.25%

9/2/1993

9.93%

M

$133 MM

35.04%

(JPC)

Nuveen Pref & Income Opps Fund

Preferreds

7.26%

6.88%

6.32%

3/26/2003

-0.98%

M

$1,041 MM

36.32%

(FFC)

Flah&Crum Pref Secs

Preferreds

6.48%

8.12%

8.12%

1/31/2003

2.48%

M

$883 MM

36.05%

(JRI)

Nuveen Real Asset Inc & Growth

Real Estate (US)

7.37%

7.23%

10.27%

4/26/2012

-10.70%

M

$477 MM

29.40%

(RNP)

Cohen & Steers REIT & Pref

Real Estate (US)

6.10%

10.02%

9.15%

6/27/2003

-1.30%

M

$1,026 MM

26.92%

(BBN)

BlackRock Taxable Muni Bond

Taxable Municipal

5.45%

8.20%

9.97%

8/27/2010

-1.13%

M

$1,328 MM

37.12%

(GBAB)

Guggenheim Taxable Muni Mng Du

Taxable Municipal

6.30%

6.69%

9.19%

10/27/2010

4.32%

M

$414 MM

17.64%

(UTG)

Reaves Utility Income

Utilities

5.83%

9.52%

11.34%

2/24/2004

-0.38%

M

$1,724 MM

22.36%

(UTF)

Cohen & Steers Infrastructure

Utilities

6.82%

9.06%

7.24%

1/21/1987

0.00%

M

$2933 MM

27.79%

Average

6.89%

8.83%

9.44%

0.98%

25.13%

REITs/ BDCs:

(O)

Realty Income Corp.

Equity REIT

3.60%

(OHI)

Omega Healthcare Investors

Equity REIT

6.41%

(VTR)

Ventas, Inc

Equity REIT

4.39%

(IRM)

Iron Mountain, Inc.

Equity REIT

7.60%

(STOR)

STORE Capital Corp.

Equity REIT

3.76%

(NLY)

Annaly Capital Management

Mortgage REIT

11.33%

(ARCC)

Ares Capital Corp

BDC

8.48%

(MAIN)

Main Street Capital

BDC

5.60%

Average

6.40%

AVERAGE YIELD of 20 securities

6.7%

Bucket/Strategy 3: Risk-Adjusted Rotation Portfolio

So, what is a Risk-Adjusted Rotation strategy, and why invest in it? There are many reasons that we can point out in favor of this kind of strategy. But foremost, this is our insurance bucket (or hedging bucket), which also would provide a decent return, good income, and preserve capital, all at the same time. This strategy rotates among a set of chosen securities and uses “relative momentum” of each security to determine which one to invest in for the next holding period, usually a month.

There can be several strategies or variations that one could employ. We provide one example below.

An Income Oriented Rotation Strategy with QQQX:

We are essentially looking for a portfolio that meets the following objectives:

  • Provide protection during nasty market corrections and limits drawdowns.
  • Provide high growth during both stable and bull-market environments.
  • Generate roughly 5% income on an average basis.

Most portfolios can meet one (or maybe two) of the above goals, but it's tough to meet all three at the same time. Our Income-Oriented Risk-Adjusted Portfolio attempts to meet all three.

We will use three securities in this portfolio:

  • (QQQX) Nuveen Nasdaq 100 Dynamic Overwrite Fund
  • (AGG) iShares Core U.S. Aggregate Bond ETF
  • (IEF) iShares 10 Year Treasury Bond ETF

QQQX has a reasonably long history going back to January 2008, which incidentally covers the last recession. It invests mainly in the top 100 Nasdaq stocks. We will provide the back-testing results using the QQQX/AGG/IEF. Since QQQX is a CEF and provides a quarterly distribution of roughly 7%, we will likely generate a substantial income whenever we are invested in QQQX. Our back-testing shows that from 2008 to the present, we were invested for 86 months in QQQX out of a total of 141 months, more than 60% of the time.

AGG is the Total Aggregate Bond fund that invests in the total U.S. investment-grade bond market. It also provides a distribution of roughly 2.7% on a monthly basis.

IEF is the 7-10 year Treasury Bond ETF that invests 95% of its assets in U.S. Treasuries with a maturity of 7-10 years. It currently provides a yield of roughly 2.20% on a monthly basis.

Every month, we will compare the relative performance of these securities over the previous three months. We will select only one security (out of three) that has performed the best for the next month's investment. We will repeat this process on a monthly basis.

Since January 2008, this strategy has provided an annualized return of 14.5%, compared with 8.25% of S&P-500. Another big difference is in the drawdowns. The strategy had a drawdown of about -16% compared to a whopping drawdown of -48% in the case of the S&P 500. The worst year performance since 2008 for the strategy was -4% compared to -37% for the S&P 500.

Performance Chart - QQQX Rotation Strategy vs. S&P500:

The first chart shows the performance in dollar terms (growth of $100,000), whereas the second chart shows the same chart with the impact of inflation-adjusted 6% withdrawals.

Now, if were to withdraw 6% income from the portfolio, the difference between the performance of QQQX model and S&P 500 becomes highly pronounced in favor of the Rotation model. It highlights the fact that if you were to withdraw income in a year that has a big drawdown, it might have a very serious negative impact on the recovery of the portfolio. This is where the Rotation portfolio wins hands down due to very limited drawdowns.

Here's a snapshot of performance comparison (from January 2008 – August 2019) of our Rotation strategy with the S&P 500 Index.

Strategy Name

Securities used

Annualized Performance

from 2008-2019

Max. Drawdown

Worst Year

Rotation Strategy: 3-Months Relative Performance

Using

QQQX /AGG/IEF

14.53%

-18.90%

-3.98% (2010)

S&P 500 Index

(Buy & hold)

SPY

8.25%

-48.47%

-37% (2008)

Conclusion

We admit that deploying and maintaining a three-bucket portfolio (as described above) requires some work, especially in the beginning. Some may complain of this being overly complicated. It may look a bit complicated at first glance, but we believe it's quite simple to implement, and two thirds of the portfolio would run on autopilot once properly set up. We do recognize that some folks may not have enough time, interest, or desire to do this. However, if you want to take control of your investments and want to avoid the stress from the roller-coaster ride of the broader market indexes, it could be worth the time and effort. We do not imply or recommend that anyone should change to a multi-bucket system overnight, as it requires quite a bit of planning. Rather, one should make a gradual change.

To sum up the investment strategy described in the article, we present below an investment allocation pyramid model for retirees. We believe in diversification not only in terms of investment in multiple stocks but also in terms of different strategies and asset classes. The multi-basket portfolio with some cash reserve, as presented above, will balance out the income flow and improve overall returns while minimizing the risks and drawdowns.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, STAG, STK, UTF, VTR, WPC, TLT. 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.

Additional disclosure: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.