Retirement Income: Success Starts With Portfolio Design

Includes: KO, NLY
by: Doug Meeks

Retirement income portfolio design is an individual study. Each investor has different financial needs and goals for a portfolio. I have been asked many times what percentage of this company and what percentage of that company goes into these things. Good question, I know it is a good question because it makes my head spin.

I love the on-going debate about high yield and low yield. Annaly (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) are very popular right now. Maybe too popular, time will tell. When an investor looks at the 13% yield from NLY and then sees the very boring, sleepy 2.6% yield from Coke (NYSE:KO) I can understand the temptation to get overweight in the high-yield area.

I have seen much cheerleading about Annaly and the other mREITs and BDCs. I have also seen some really nicely balanced articles. I want to show a few very simple portfolio design using just Coke and Annaly .

Minor background items.

Annaly has been around though lots of interest rate markets. The history of a company like Annaly must be evaluated to understand the performance of the structure in changing rate environments. The current comfort levels with Annaly may be from a feeling of stability in the U.S. interest rate markets. Yes, the short-term rates are about as low as they can go, but I do caution that long-term rates could drop and flatten the curve even more. But I digress into worry.

Annaly can handle rate changes; it has paid dividends for a long time. The dividends are healthy, in that NLY will adjust payout reflecting underlying performance. This has resulted in many dividend cuts and increases.

My second component is Coke . These guys need no introduction, the dividend policy from KO is solid, stable and rising. Coke is a great dividend growth play with dividends rising at almost 10% each year for a decade.

Blended $20,000 Portfolio, Quarterly Dividend chart for Annaly and Coke:

An investor seeking stable income to spend, not re-invest, will be drawn to the red line. This line represents 95% Coke with 5% NLY. This level of stability will produce a total dividend payout of $6659 dollars over the last 10 years. Contrasted to the total payouts of a 50/50 blend being at $14,258 for 10 years. Income stability, like hedging, just costs money.

Let's look at capital appreciation.

Your $20,00 investment in each model after 10 Years:

00% KO / 100%NLY- $22,000 Total Dividends paid: $ 22,687

50% KO / 50% NLY - $26,000 Total Dividends paid: $14,258

75% KO / 25% NLY - $29,000 Total Dividends paid: $10,037

90% KO / 10% NLY - $30,000 Total Dividends paid: $ 7504

95% KO / 05% NLY - $31,000 Total Dividends paid: $ 6659

100%KO/ 00% NLY 0 $32,000 Total Dividends paid: $ 5804

Stability is very important to a person who is retired, but less important to a person with some time before retirement. Also the prediction of a multi-year dip in income level is very difficult to time out. So as time frame becomes compressed investors should move toward stability and away from the higher, but less stable yield. An investor with a 50/50 blend here would have had to wait almost three years during the big turn down in this chart (2005-8) to return to former income levels, taking a 40% reduction in income at the worst point. An investor holding the 95/5 blend would have waited three quarters to return to the original level of income. Tolerance of income fluctuation in retirement is something every investor needs to understand in portfolio design. Very few retirees have a tolerance for a loss of 40% of their income even if it's temporary. This kind of income set back can bring about the need to withdraw part of the capital investment. This in turn requires the addition of more risk (higher yield) or a shortening of the duration of the planned income level.

This blend is optimal around 85/15 where an investor would give up capital gains for an equal amount of income, while still having a greatly improved stability. As stability becomes less important to an investor, one would began to focus more on Annaly as a larger component based on this simple blend. Higher capital gains, such as seen in McDonald's (400%) or Phillip Morris (90%) would shift this blend away from Annaly over this time frame.

Please note that these are simplified numbers, no re-investment. I have used a total capital appreciation for Coke of 60% over the last 10 years and 10% for Annaly.

I picked Coke to underscore the vast difference between these companies, one very low and steady yield vs. one very high and volatile yield. This chart would move up substantially if I picked McDonald's (NYSE:MCD) or Phillip Morris (NYSE:PM) instead of Coke. I picked Annaly because it has the experience and history to make a model more relevant. Investors with a strong need for income stability should understand that high yield has historically had volatility. However, that volatility can be well rewarded with return.

Disclosure: I am long KO, PM, MCD. A long position in Annaly (NLY) may be added to portfolios at any time.

Disclaimer: Caution is advised in these markets. Investors participating should be prepared to bear loss. This article is for educational purposes only, it is not individual investment advice. Please consult a qualified professional who has specific knowledge of your investment needs and risk tolerance if you need advice.