This is the last in a three-part series of articles designed to help you better understand how to create a sustainable stream of income in retirement. Here is how we’ve organized the sections by topic:
- It’s not about returns; it’s about your account balance (read it here)
- It’s not how much you earn; it’s how much you keep (read it here)
- It’s not about cash; it’s about cash flow
You’ve heard the saying that “cash is king,” but when it comes to planning for retirement, cash flow is king. The transition from accumulating wealth to living off of a portfolio requires a significant change of mindset and strategy. It involves assessing how prepared you are for a recession as well as developing a proactive strategy to minimize taxes (by using the Retirement Tax Filter® we outlined in section two). The third and final consideration is what we call the “Productivity of Assets.”
Productivity of Assets
For purposes of analyzing your investments, the “productivity” of those assets refers to how much cash flow is being created relative to your overall need for income. By way of example, let’s consider two very different types of real estate:
- Raw land which generates no income but has significant appreciation potential
- Rental properties that have little appreciation potential but provide stable and recurring income every month (which far exceed any expenses related to the property)
Let’s also assume that an investor has 20% of her total portfolio in each of those two types of real estate. The first – raw land – contributes nothing to her overall income need (since it generates no cash flow), while the second – the rental properties – provide one-third of the income needed to meet her ongoing living expenses (or 33% of her overall income need).
In this scenario, the raw land is a low productivity asset whereas the rental properties are a high productivity asset. We are not saying that one is “good” and the other is “bad.” It is completely dependent on individual circumstances, goals, and risk tolerance as to whether either of these is a wise investment. But, as you approach retirement, we recommend making that transition with an eye toward improving the productivity rate of your assets. This will help to create a more sustainable plan for income and also give you the ability to withstand downturns in the market without being forced to sell in order to meet your cash flow needs.
Sequence of Returns Risk
In the first part of this series, we showed how important the timing of returns becomes when you are transitioning into retirement. Average rates of returns over long periods of time are misleading when you are relying on income from a portfolio to fund your living expenses. That is due to the fact that volatility in your portfolio becomes a much more important factor. Losses in your investment account balances become harder to recoup if you are taking withdrawals at the same time.
One way to mitigate this danger – sometimes referred to as sequence of returns risk – is to create a portfolio that is designed to meet your cash flow needs. A portfolio that generates all of the income you need to live will provide you with the ability to not have to sell investments an inopportune times (i.e., when the values are down) because the portfolio is generating enough income to pay for your living expenses.
For an example of how that works, compare the following two portfolios. Assume each of these is worth a total of $5 million and has to cover an investor’s annual income need of $180,000:
- Portfolio A is comprised of raw land, private equity, and a stock portfolio of mostly growth stocks. All of these assets provide the opportunity for significant capital appreciation, but do not provide much cash flow. In other words, they are all low productivity assets. As a result, only 30% of this investor’s total income need is being met by the ongoing income generated from this portfolio. Therefore, assets will need to be sold periodically in order to create liquidity that is needed to pay for their expenses in retirement.2. Portfolio B is comprised of a rental property, a balanced portfolio of stocks and bonds, and alternative investments that are income-oriented (examples of these types of investments could range from MLPs to annuities with income benefit guarantees). These assets provide the opportunity for some capital appreciation, but are primarily intended to provide ongoing cash flow and reduced level of risk. In other words, they are all higher productivity assets. This investor’s entire income need is being met by the ongoing income generated from this portfolio. As a result, assets are not required to be sold periodically in order to create liquidity that is needed to pay for their expenses in retirement.
By following the advice laid out in the series, we hope that you have gained more confidence in how to create a stream of income that will last for several decades and keep up with inflation. The best way to do that is to:
- Reduce longevity risk by realizing the importance of the timing of market returns
- Reduce tax risk by strategically controlling which buckets are providing for your income needs
- Reduce market risk by incorporating high productivity assets in recognition that cash flow is king
Disclosure: Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.