Thursday, June 5, 2008

Income-Generating Assets in Retirement

It seems to be conventional wisdom that once you start drawing from retirement accounts, your investments should be shifted into income generating assets such as bonds and dividend-paying equities. This makes little sense to me.

Let’s consider an example. Suppose that Sam starts retirement with a million dollars in a tax-sheltered account. He invests in dividend-paying stocks and in the first year he makes $40,000 in dividends plus $60,000 in capital gains. He withdraws the cash dividends to live on and leaves the capital gains in the account.

Another new retiree, Linda, invests her million dollars in non-dividend paying equities and makes $100,000 in capital gains in her first year of retirement. She sells $40,000 worth of stock to generate cash to live on.

What’s the difference between these two cases? Not much. What matters are the returns you get and the risk you take to get these returns. In tax-sheltered accounts, the difference between capital gains and dividends isn’t important.

The two cases feel different because Linda seems to be eating into her principal. But, Linda isn’t eating into her principal any more than Sam was.

Some would argue that income-generating assets are less volatile and therefore safer. I counter that the bulk of retirement savings should go into a broad index of stocks that are likely to give the best return, rather than limiting investment to dividend-paying stocks. You can create safety by investing enough to live on for 3 or so years in short-term bonds.

1 comment:

  1. I think it all comes down to "insurance" and the worst case scenario. If you can deal with a 20% hit to your entire portfolio and then have it go sideways for 20 years like during the early 60s to early 80s interval, then by all means keep it in stock. You likely are able to afford this scenario (to some extent) if you're still working. If you're retired and on a fixed income, this nasty scenario might produce a catfood diet. It's all about what you personally feel comfortable with. I like using your age as a percentage for the fixed income amount. Even at 60 years old, you'd still be 40% in the stock market. In the worst case scenario, you'd still likely have enough money to afford Dr. Ballard's over Miss Mew. ;)