Paycheck Replacement For Retirement

Nov. 30, 2020 7:00 AM ET67 Comments

Summary

  • How to avoid the fluctuations and secure your retirement through "self-annuitization"
  • We prioritize fixed income cash flow over dividend equities.
  • Creating a safe, livable wage income stream in this low yield environment.
  • Looking for a portfolio of ideas like this one? Members of Yield Hunting: Alt Inc Opps get exclusive access to our model portfolio. Get started today »

In today's low interest environment, creating a 'safe' fixed income stream that produces a livable wage during retirement is extremely difficult. Gone are the days when you could buy a few CDs, savings bonds, and treasuries and net 6% annualized. Today, you would struggle to earn 1% with those security vehicles.

How did we find ourselves here? Well, the reason is multifaceted. For one, the Federal Reserve has reduced the Fed Funds Rate down to zero. Another reason is that investors have rushed into 'safer' securities, pushing down yields and up the price. Both have made investing in the aforementioned to create a sustainable (and livable) income stream in retirement untenable.

There are multiple ways to increase that yield. Some services (especially here on SA) will push almost any type of security and have their investors chasing yield, no matter the risk. From high-yielding dividend equities to junk bonds, yes there is an increase in yield but also an equal or greater increase in risk!

Again, back in the day, you could invest in almost 100% secure financial vehicles like CDs and government issued bonds and live a comfortable retirement with almost no risk. That coupled with social security and possibly a fixed pension, and you were set for the average 10-20 year retirement lifespan.

Today, not only have yields on those vehicles plummeted, pensions all but gone, and social security in peril, but couple with that the fact that the average retirement can now last 20-30 years average.

Using Closed End Funds

Our strategy, simply put, is to create a portfolio of fixed income closed end funds and alternative asset classes (such as REITs, Preferred Stock, and Baby Bonds) to create a risk managed approach to retirement income.

This approach can either be a standalone strategy (i.e., for most or all of your portfolio) or as a replacement for the failed 'fixed income' portion of your equity/ bond mix.

Either way, the goal is to create a safe income stream that meets as much of your monthly retirement expense needs as possible - thereby leaving the principle (as well as any equity positions) alone to grow unmolested. If selling is not necessary, we have effectively removed any or all sequence of returns risk from the portfolio.

At certain points in the life of the portfolio (obviously depending on the size of the portfolio and income thrown off), the monthly income can even satisfy the RMD requirement.

So how does it work?

Take a look at this chart for PIMCO Corporate & Income Opportunity (PTY) a fixed income closed-end fund. The price moves would make your head spin, especially someone who is near retirement and wants to mitigate volatility.

But what if you could almost completely ignore the swings of the price?

Take a look: If you purchased $1M of the fund at IPO in December 2002 at $15 per share, you would have been exposed to huge gyrations in price over the course of the next two decades. At one point reaching as high as $22 per share, and at its low, dropping by 73% to $5 per share.

However, take a closer look. Other than a one cut to its distribution in 2006 and one increase in 2012, not much else changed. You could have been in a coma for 20 years, missed all these gyrations including the 2008 Great Recession, and woke up in a better position than if you have put your money in the S&P 500. You would have collected $2.1M in income over that period! If you reinvested, your capital would have doubled every 5.2 years.

And if reinvested some or all of your distributions - perhaps banking unused monthly income and reinvesting at opportune moments (preferably those times when the fund found itself below the horizontal line bisecting the graph) your return would be even better.

ChartData by YCharts

Remember, even in the volatile market we find ourselves today, that precipitous drop in PTY still bests the S&P 500. And remember, you still collect your income payments every month.

And those income streams are realized gains, not unrealized. That balance in the S&P 500 is 100% exposed to any drawdowns in the market. The income from PTY or most other CEF is realized each month - cash in account.

At the end of graph, basically cut off when this pandemic downturn started, you would have realized $2.16M in income. That is cash in your account. Meanwhile, the fund which you initially piled $1M would now after the brunt of this downturn (as of Nov. 17) be worth $1.130M, a capital gain of $130k.

So in the income sense, this is very different than holding a one-stock portfolio of, say Amazon.com (AMZN) which is up 80,000% since its IPO in 1997. $10,000 invested in the stock at the IPO is worth over $8 million today. You see these types of headlines often. But what you don't see is that Amazon had a max drawdown of 90% at one point during that time. Ouch!

Chart

I'd be curious to know how many of the initial or really early investors had the stomach to hold through that kind of decline.

The chart below shows how the composition of a portfolio has shifted to achieve a 7.5% annual return over the last 2.5 decades. Bonds in 1995 yielded around 7.5%, though that was likely a combination of investment grade and non-investment grade bonds. Still, no equities are in the portfolio and the risk (as judged by standard deviation) is just 6.0%, slightly above the Barclays U.S. Aggregate Bond Index.

By 2005, the decline in rates meant that the same portfolio that had a goal of 7.5% would need to have shifted to nearly 50% in other asset classes beyond bonds including stocks, private equity and real estate. Another 10 years later, there're almost no bonds left in the portfolio with now larger allocations to real estate, international stocks, and real estate. The risk has now nearly tripled over the time period.

(Source: Callan Consulting Group)

In other words, getting riskier was a necessity in order to produce the same amount of return. In the 90s, you didn't have to do much to prepare for retirement. You owned a bunch of mutual funds and you let it ride, earning strong equity returns with a solid 6-7% return on your fixed income. Today, with interest rates near record lows, the market is punishing those same savers. Portfolios had to adapt to the new environment by incorporating new tools or adding risk.

Much of the need to change is stemming from changes in the interest rate environment - or the bond side of the portfolio. Investors who were the most risk-averse could earn high-single digit yields simply by investing in short-term CDs. The chart below from JPMorgan (JPM) shows how much income was earned in each year by investing in six-month CDs. You can see the utter collapse of those returns starting in 2009. Those yields were wholly insufficient to even cover inflation and provide a real return.

What is Self Annuitization?

A semi-popular way to create a steady stream of income during retirement that is almost 100% guaranteed is through an annuity. You pay an upfront sum for a series of payments that start immediately or at some point in the future, usually for the rest of your life. These are usually attractive to retirees for the main reason that they are more secure and outside the gyrations of the equity market.

But annuities are not 100% secure and they do have their downsides. The guarantees of an annuity contract depend on the issuing company’s claims-paying ability. Annuities have contract limitations, high fees, and charges, including account and administrative fees, underlying investment management fees, mortality and expense fees, and charges for optional benefits.

So how can we recreate the most attractive aspects of the annuity, without the cost or other downsides?

What if we could recreate the annuity ourselves, without the contract or fees nor the liquidity lock-up?

A typical $500,000 joint and survivor annuity might pay out $2,500 a month. A portfolio of 8-10% yielding fixed income closed end funds would yield approximately $3,750 per month.

More importantly, many of the cons of an annuity would no longer be present. There are no surrender fees - you can sell your portfolio and go to cash at any time for any reason. There are no contract fees. And at death, your heirs will receive the full principal that was invested.

So how does it work?

By creating a basket, or portfolio, of CEFs with the proper guidance, we can create an income stream of between 7-9% a month, with a fraction of the downside risk of the equity market. While the market moves up and down with world events - your income stream will remain more or less steady over the long term.

Investors can take that monthly cash flow and reinvest it for increased future earnings - or use it for their day to day living expenses. You basically recreate your paycheck in retirement. Or, you basically recreate an annuity - but one that is completely under your control. One that can be liquidated when you want, can be increased or decreased when you want. And most importantly, one that will not be surrendered for any reason to an insurance company. Remember, you will collect the roughly 8% cash flow every month - But upon your death, your heirs will receive your initial outlay, not the insurance company.

Remember, in the example above, a married couple laid out $500,000 to receive about $2,500 per month. There is no risk for them in that monthly payment. However, the risk for them is early death, at which point the insurance company wins. Using the Yield Hunting Core Portfolio, that $500,000 could earn over $3,500 in income streams per month. The biggest difference isn't the $1,000 plus per month received, it's the fact that the initial $500,000 will still be yours!

Full disclosure - going back to the PTY chart, it could mean that the $500k is now worth $250k, but it may also be worth $750k.

But as a retired income investor, the capital appreciation and/or price fluctuations of the fund should be the last thing you think about. It is the consistent income streams the fund is providing you to live on, on a monthly basis.

The last point to make on this is that many funds are not 'buy and hold'. By having a CEF expert guide you along the way, you can swap out of one fund and into another when the opportunity strikes. This could help investors avoid a distribution cut, or a fund that has a similar payout but less risky basket of securities, lowering your overall risk exposure. Or it could be to a similar fund that has a usually large discount where a capital gain opportunity is present. Small moves create small gains - but they can make a big difference in the long term, increasing both your monthly cash flows as well as your overall portfolio balance.

Our Yield Hunting marketplace service is currently offering, for a limited time only, free trials and 20% off!

Our member community is fairly unique, focused primarily on constructing portfolios geared towards income. The Core Income Portfolio currently yields over 8% comprised of closed-end funds. If you are interested in learning about closed-end funds and want guidance on generating income, check out our service today.

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This article was written by

Alpha Gen Capital profile picture
16.31K Followers
Targeting 8+% Income Stream using CEFs, ETFs, Munis, Preferreds and REITs
Yield Hunting: Alternative Income Opportunities is a premium service dedicated to income investors who are searching for yield without the high risk of the equity market. We are one of the top experts in closed-end funds ("CEFs") in the country having spoken at many national conferences on how to incorporate CEFs into client portfolios. We manage four portfolios that investors can follow:



- YH Core Income Portfolio: yield ~8%
- YH Flexible Income Portfolio: yield 7.53%
- YH Taxable Core Portfolio: yield 5.24% (some tax free)
- YH Financial Advisor Model

Plus: Muni CEF Shopping List.


Our team includes:

1) Alpha Gen Capital - I am a former financial advisor and investor. Not someone from another career doing this on the side. My analysis is meant to provide safe and actionable insight without the fluff or risky ideas of most other letters. My goal is to provide a relatively safer income stream with CEFs and mutual funds. We also help investors learn about investing and how to properly construct a portfolio.

2) George Spritzer - Another career financial guru who runs a registered investment advisor with a specialization in closed-end funds for individuals. George uses the following investment strategies:1) Opportunistic Closed-end fund investing: Buy CEFs at larger than normal discounts to NAV and sell them when the discounts narrow. 2) Exploit special situations: tender offers, fund terminations, fund activism, rights offerings etc.

3) Landlord Investor- spent his career as a management consultant for public sector clients at a multinational consulting firm in the DC area. He has transitioned to a new career as a full time landlord. His investment portfolio is comprised of two parts -- broad-based index funds and income plays such as preferred stock, CEFs, and REITs. He also owns individual/baby bonds which he buys on margin to boost total return. Landlord is our 'individual preferred stock' expert analyst.

www.YieldHunting.com


Disclosure: I am/we are long PTY. 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.

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