Do you need a steady stream of revenue from your savings? Join the crowd: several million postwar babies now converting their 401(k) balances and brokerage accounts into cash for retirement.
There are right ways and wrong ways. I’ll show you six right ways and two wrong ones. The right ones: automatic withdrawal plans, high-coupon Treasurys, high yielding stocks, junk bonds, annuities and master limited partnerships.
As for wrong ones, there are lots to choose from. I’ll illustrate the problem with just two bad ideas for retirement. One is an expensive fund. The other is the ever-popular “covered call” scheme.
Before I deliver the specifics on income generation, I need to explain the theory. The theory is likely to surprise or depress you.
Surprise: Income, as conventionally defined, is a bad thing. It means more tax bills.
Depressing fact: Income, as conventionally defined, is no proof of what you can safely spend from a portfolio without eroding your capital. You can easily find a junk bond fund yielding 7 percent, but if you spend that whole amount you are certain to get poorer over time. Inflation and bad debt losses will deplete your wealth.
That doesn’t mean you shouldn’t own junk bonds. Maybe you should be depleting capital — if your health is poor and you intend to leave nothing to the kids. But you should know that this is what you are doing.
Bet your stockbroker didn’t describe the high-yield bond fund he’s recommending as a “capital erosion investment.”
You think you need income? No you don’t. You need cash. It’s a very different thing. You can get cash by selling securities or redeeming fund shares. Nine times out of ten, raising $1,000 by selling something is going to be cheaper at tax time than getting $1,000 in the form of a dividend or fund distribution.
There was a time when it made sense to avoid selling. Your grandparents put stocks and bonds in a strongbox and got cash only from the dividends and the coupons. Selling was expensive because brokerage commissions were stiff and mutual funds carried sales loads.
The financial world is very different today. No-load funds are ubiquitous and online brokerage commissions are $9 or less (a lot less, if you take advantage of freebies and new-account offers).
So here are the six recipes for producing cash to cover your living expenses.
Automatic withdrawal plans
The first thing is: Ignore “yield” and “distribution” and “income.” Invest for total return, which is the sum of income and price appreciation. Then find some way to convert a portion of your assets every month into deposits into your checking account.
If your savings come to $100,000 or less, get a no-load fund operator to do this conversion for you.
I think that a balanced portfolio (mixing stocks and bonds in equal amounts) can deliver a total return of 6.5 percent before inflation and 3.5 percent after, over a long period of years. (Don’t ask me to foretell what the market will do over the next year or next three.)
So, you can probably take out $3,500 a year from a $100,000 pot to cover income taxes and living expenses, and have the capital last indefinitely. Increment the withdrawals for inflation. If the CPI is up 1 percent, take out $3,535 next year.
Take out more if you need to, but know that you are probably depleting assets. This is a fine way to live if you have children that have volunteered to pick up your nursing home bills.
If you have $1 million or more, you should do your withdrawing à la carte. Buy 50 different stocks, Treasury bonds and exchange-traded funds. Get the $35,000 a year out by periodically selling losers. Then your income stream will have a zero, or perhaps a negative, tax bill.
You don’t want to be selling at what may turn out to be bottoms, so get back in with some of your money. You might exit $150,000 of loss positions over the course of the year, while repurchasing $115,000 of them. You can get back into similar positions (Chevron for Exxon Mobil, the Vanguard Megacap ETF for the SPDR S&P 500) right away, and into identical positions after 31 days. You objective is not getting caught by the “wash sale” rule limiting capital loss deductions.
Does your $1 million have to go into stocks paying dividends? Not at all. If you are in a high tax bracket you would be better off with growth stocks paying next to nothing. Mix in what I call silent dividend stocks, which are shares of mature companies that distribute their profits by buying in shares.
Through 2012, dividend taxes are fairly modest. After that, they are probably going to be pretty nasty.
Pay attention to liquidity. Individual corporate and municipal bonds are not liquid, meaning that you get hosed when you buy and sell them rapidly. Hold these bonds through ETFs. No-load funds, stocks in big companies, ETFs and Treasurys are liquid.
If you have between $100,000 and $1 million, the right way to draw out cash depends on your patience for online trading and tax paperwork.
A ten-year T note yields not quite 4 percent. What if you want to spend more than that? And don’t want to pay mutual fund fees to hold Treasurys for you? You could buy a Treasury with an abnormally high coupon. It will, of course, be trading at a premium price, and the premium you pay will erode over time. But if you know what’s going on, this is a perfectly good way to create an automatic cash withdrawal feature.
Example: You have $200,000 in your IRA, you are 80, and the IRS demands that you withdraw $10,000 a year. Buy the Treasury with an 8.5 percent coupon that matures in February 2020.
You will only be able to afford $143,000 (par value) of the bond, which means that, come 2020, $57,000 of your capital will have evaporated. But this Treasury will generate the cash you need. At 8.5 percent, a $143,000 position will have $12,000 a year in coupon payments.
High yielding stocks
I think the stock market will deliver a real return of 5 percent a year over time. This is with dividends included and inflation subtracted.
My preferred method of extracting this 5 percent is to own a diversified portfolio of individual stocks and to sell selectively (see “Automatic withdrawal plans” above). But if you must, you could buy a collection of stocks that happen to have gigantic dividends.
You’ll probably wind up with electric utilities that are under constant assault from rate regulators, some ragtag phone companies that aren’t doing a good job of covering their dividends, drug companies confronting patent expirations and cigarette vendors. Examples: AT&T, Altria, Pfizer.
Quite a contrast to the Googles and Apples of the glamour stock universe. But in expected total return, the high yielders are pretty close to the low yielders. So if you love dividends and can tuck the fat yielders away in a tax sheltered account, take this route.
As noted, you shouldn’t be buying these one at a time. There’s a reasonably priced ETF that holds them: JNK (expenses: 0.4 percent). There are also some fine no-load funds available.
You might get a “yield” of 7 percent, from which you should deduct an expected capital loss (from companies going bust) of 1 percent a year, for a total return — before inflation and taxes — of maybe 6 percent. Higher yields come with higher capital losses.
Junk is a fine option for an IRA, since it will generate cash for those required minimum distributions without forcing you to put in constant sales orders. But don’t put more than 25 percent of your bond money in junk. And know that you are eroding capital.
If you want to leave the world penniless, buy immediate annuities from an assortment of top-rated insurance companies. The product automatically converts capital into spendable cash and guarantees that you won’t outlive your savings. But you have to take steps to cover the rise in the cost of living.
Master limited partnerships
These holdings make sense for the taxable accounts of high-bracket investors. Most MLPs are invested in energy assets, so don’t overdo this sector if you own a lot of oil company shares. The peculiar tax treatment is such that MLPs make particular sense for older investors who expect to leave the shares to heirs.
Yields are in the vicinity of 5 percent and at the outset are largely sheltered from taxation by depreciation writeoffs. Over time, I would expect both the share prices and the distributions to keep up with the cost of living. In other words, your real total return is going to be that 5 percent or maybe a little more—the same as the real total return you are likely to get on stocks.
Now here, briefly, are two bad ways to generate income in retirement.
One is to buy expensive mutual funds sold for their “income.” To cite one example: Oppenheimer Champion Income, B shares. Its 2 percent expense ratio consumes at least half the real total return you can expect on a junk bond fund.
The other is to get captivated by covered-call investing. With this scheme you buy stocks and write call options against your positions. You buy Intel at $22, say, then write an option allowing someone else to take it away from you at $25. If Intel goes to $40 you don’t own it. If it goes to $5 you do own it, and you paid $22, less a few bucks of option premium.
The system generates cash, because you have the option premiums coming into your brokerage account. Does it generate wealth, beyond what you could get just owning stocks? No.
Just why writing options does not increase your expected return from stocks is a complicated matter. Perhaps this simple point will persuade you that there is no magic in the option game: A covered call is mathematically equivalent to a naked put. You collect a premium and in return agree to take bad stocks off people’s hands at high prices.
If trading costs were zero, covered call programs would be harmless. Alas, options often trade at gaping bid/ask spreads. The overall effect of options is to make investors a little poorer and brokers a little richer.