Retirement Best Practice: Active Income Vs. Passive Income

Summary

• 41% of people currently say it will be a miracle for them to be prepared for retirement.
• It's a daunting task under the current circumstances for many.
• In the following piece, we discuss some primary strategies for creating a retirement income stream and their respective pros and cons.
• This idea was discussed in more depth with members of my private investing community, The Winter Warrior Investor. Learn More »

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Overview

Presently, many discerning retirees and those preparing for retirement are looking for solutions to fill the ever-widening gap between their income and expenses. If this gap has become negative for you, (as it has for many affluent retirees), you’ll need more cash flow from your investments to ensure your golden years are spent in the style you have become accustomed to, and deserve.

Creating and maintaining a balanced retirement portfolio composed of a diversified set of assets and sources is a must in turbulent times such as these. In the following piece, we will detail some top ways to create income streams that will last a lifetime. There are two primary categories of income streams you can derive from the stock market - passive income and active income. The first thing you need to do is come up with a realistic budget of what you believe you will need to live a dignified life in retirement. Then begin working on creating the income streams to achieve that goal.

Passive Income

Passive income streams are characterized by requiring little to no effort to manage or earn. When it comes to stocks and bonds, the only true “textbook” example of a passive investment strategy is buying an index fund. It has been proven over time to be hard to beat a cheap, well-constructed index fund.

Years ago, retail investors picked and managed their own portfolio of stocks and bonds. This proved costly and risky in terms of fees and under-diversification. In 1975, John "Jack" Boglefounded the First Index Investment Trust, which grew quickly and eventually became the Vanguard S&P 500 Index Fund (VOO). This essentially paved the way for the investment management industry. Presently, investors can enjoy diversification and low fees and passively match the market's average return with a single ticker. A few low-cost index stock and bond ETFs for example include the: Vanguard Total World Stock ETF (VT), Vanguard Total Stock Market ETF (VTI), SPDR S&P 500 ETF Trust (SPY), Invesco QQQ ETF (QQQ), iShares U.S. Treasury Bond ETF (GOVT), and the iShares Core U.S. Aggregate Bond ETF (AGG). It's not all pros and no cons though when it comes to index investing.

The Pros

The benefits of index investing are many. Indices make it possible to measure beta, a vital component to consider during portfolio construction. An index generates market exposure difficult to replicate and available at a significant discount to fees required by active management. Nonetheless, it's not all butterflies and rainbows.

The Cons

Index investing began to have problems when the strategies became widely adopted. The funds themselves began influencing the markets. Investment decisions began to be made solely based upon broad socioeconomic trends as opposed to business fundamentals. The index can become decoupled from the performance of the underlying businesses that reside within the fund. What’s more, the benefits of index investing can be undermined as index grows as well due to a multitude of issues that creates for the market’s writ large. Now let’s turn our attention to active income strategies.

Active Investment Income Strategies

The following is a list of “active” investment income strategies. Over the years, many have begun to associate some of the types of investments as “passive” in nature. I can assure you they are not. If someone is selecting individual securities of any type and creating a portfolio of holdings, this is the definition of active management and investing. Some actually advocate devoting 100% of your retirement portfolio toward certain classes of investments, which substantially increases risk by reducing diversification. Let’s review the sub categories of investments.

High-Yield Dividend Stocks

High-yield dividend stocks are an attractive choice for many investors and retirees alike. High dividend stocks offer an increased income payments to shareholders due to an increased yield. Nonetheless, don’t be fooled, the higher the yield, the higher the risk. Before you opt for a portfolio full of dividend stocks, you should consider the risks. High dividend stocks are a category unto themselves. They tend to fall in and out of favor, like all other categories of stocks. Relying solely on high yield dividend stocks can leave your portfolio under-diversified.

Ideally, you want to create as much wealth as possible in your portfolio so, you don't have to reach so far out on the risk spectrum for income. I advise not having more than 20% of a retirement portfolio dedicated to high-yield stocks for an investor with an average level of risk tolerance. My father's entire goal was to create so much wealth that he was able to live off the income from his SWAN portfolio alone, which he did via his Diversified Cash Flow Method. Furthermore, you can't really count on these types of stocks to increase your nest egg over time. Why? Because they're paying out a majority of the profits to shareholders rather than reinvesting them in the business, which is the genesis of capital appreciation.

Finally, as the saying goes, "never put all your eggs in one basket." Furthermore, when trouble arises, usually the first thing to happen is the stock price implodes, depleting your principal and leaving you trapped in the investment. The next thing, that more often than not occurs, is the dividend is decreased, suspended, or cut completely. This has been well documented and happened time and time again during times of market duress such as the 2000 and 2008 bubbles, as well as the COVID-19 crash of 2020.

Bonds

Bonds' lower volatility compared to stocks is an attractive attribute for investors with a low risk tolerance. The dependable and predictable yield of bond coupons offer a consistent and dependable source for your retirement income needs. The downside is lower returns for the dependable payouts. Employing too much of a safe fixed income strategy can lead to you running out of money later in life.

REITs

REITs provide a great source of income. Yet, to qualify as a REIT, a company must distribute at least 90% of its taxable income annually in the form of dividends. Often, the stock will actually drop by the same amount as the dividend paid in the following days. It's logical since the company is giving away an asset. Furthermore, since they have to give all the profits away in the form of dividends, any potential growth prospects are usually financed by taking on debt or diluting shareholders with additional stock offerings. For the most part, the upside promised by those endorsing these types of investments is often dangled, yet seldom delivered. That's why you diversify into growth stocks for capital appreciation. Some examples of REITs are Realty Income Corporation (O), and Global Net Lease, Inc. (GNL).

MLPs

Master Limited Partnerships, MLPs, are partnerships mainly focused in the midstream segment (pipelines and storage) of the energy and natural resources sectors. MLPs often return the majority of their cash to unitholders. It's a passthrough organization that offers an increased yield based on the fact the profits are not taxed at the entity level. The unitholder also receives tax-favored distributions, as they're considered a return of capital until your initial investment is reached. So, for example, if the MLP you buy yields 10%, you may not get hit with any taxes for 10 years. The downside of MLPs is they are partnerships which can create significant tax issues if held within a tax favored account such as an IRA or 401K plan. I'm not a tax expert, but based on my own research, I do not hold MLP positions within a retirement account. Besides, the distributions from the MLP are already tax favored, so I would be wasting the benefits, as it were. Some top MLPs are MPLX LP (MPLX), Energy Transfer LP (ET), and Enterprise Products Partners L.P. (EPD).

Taking Profits Winners

Selectively selling stocks for cash flow can help you maintain a well-diversified portfolio appropriate for your goals and objectives. This is why you need a portion of your retirement portfolio dedicated to growth and value stocks focused on capital appreciation as well as those focused on income generation. If you really want to create wealth over the years, it’s important to allocate a portion of your portfolio to growth and deep value stocks that reinvest their profits rather than return them to shareholders. This strategy has the additional benefit of being a flexible, potentially tax-efficient way to generate cash flow via tax loss harvesting. Nonetheless, selectively selling stocks requires extensive research, which can be time-consuming and daunting for an inexperienced investor simply looking to enjoy a comfortable retirement. Some of my personal best performing picks over the past decade are Microsoft: A Fat Pitch With Home Run Written All Over It (MSFT), Don't Trade Apple, Treat The Stock As An Investment (AAPL), The Time Is Now To Buy Bank Of America (BAC)

The Bottom Line

Maintaining a balanced retirement portfolio composed of a diversified set of securities selected from a wide spectrum of market sectors, structures, and asset classes is a must in turbulent times such as these. Being highly diversifying in only the best-of-breed securities provides a robust margin of safety which increases the likelihood of capital preservation. Never put all your eggs in one basket, as the saying goes. Furthermore, implementing a long-term buy and hold strategy is the best way to ensure you never run out of money. It's "time in" the market, not "timing" the market that creates true wealth. Quality income and wealth producing investments are the heart of a solid, well-constructed retirement portfolio. Finally, there are other forms of income that can be derived from sources such as, pensions, social security, annuities, owning a business, rental properties, and continuing to work a part time job. We will cover these opportunities in a future article.

Final Note

There's a fine art to investing during highly volatile markets such as these. It entails layering into new positions over time to reduce risk. You will want to have plenty of dry powder if the stock you’re interested in continues lower. As a Veteran Winter Warrior of the US Army's 10th Mountain Division, the attributes of patience and perseverance were instilled in me, hence my investing motto "patience equals profits."

Winter Warfare training Ft. Drum, New York (Personal)

Take your time and build new positions slowly, dollar cost averaging in. Moreover, use articles such as these as a starting point for your own due diligence before putting your hard-earned money at risk. Those are my thoughts on the matter, I look forward to reading yours.

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Disclosure: I/we have a beneficial long position in the shares of MPLX, MSFT, AAPL, BAC, ARCC either through stock ownership, options, or other derivatives. 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.