One of my colleagues in the financial planning business, Michael Kitces, recently wrote a really good article on the four pillars of retirement income in retiree investment portfolios. The gist is that dividends, interest, capital gains, and principal all make up important parts of a retiree’s income portfolio, and it’s critical for retirees to properly and efficiently manage these four sources of income from a total cash flow standpoint. Historically, investors have relied on “income” portfolios, and have mainly focused on dividends and interest, but capital gains and principal now play an equally critical role in retiree distribution planning. It’s my belief that the “income” portfolio is largely a myth and can actually increase the likelihood that a retiree will run out of money during retirement. This is because an “income” portfolio places arbitrary constraints on how the portfolio needs to be allocated, and it increases the risk that the portfolio will not sufficiently grow and be able to keep pace with inflation. As we work with retirees on a daily basis, it’s becoming increasingly clear that the accumulation strategy that got many retirees to the point of retirement should not be the same strategy that unwinds the portfolio and creates net-net cash flow during retirement (net of taxes and net of expenses). This, as Kitces rightly points out, is because managing interest, dividends, capital gains, and principal needs to be done in a tax-efficient manner:
…ultimately, the modern retirement portfolio will really rely on four pillars for retirement income – interest, dividends, capital gains, and principal. Or stated more accurately, the four pillars of retirement cash flows – since the treatment of the pillars as “income” for tax purposes can vary depending on both the pillar itself (interest is taxable and principal liquidations are not), and the varying types of retirement accounts (from pre-tax IRAs to tax-free Roth accounts).
In fact, liquidations from the modern retirement portfolio will likely shift amongst all four pillars from year to year and decade to decade. In some years, the biggest drivers to total return are from interest and dividends, which can be taken and spent. In other years, a bull market means ample capital gains that can be liquidated for retirement spending instead, especially in times of low yields from interest and dividends. In “bad” years, it may be preferable to tap principal, in order to leave the rest of the portfolio invested for a hopeful future rebound. In fact, diversification across the four pillars of retirement income can be a highly effective way to protect against the potential stressors that can adversely impact a retirement plan.
In sum, retirement income planning is fairly complex and should always be done in conversation with a broader financial planning strategy. I’m afraid that many retirees who attempt a do-it-yourself income strategy during retirement will ultimately set themselves up for failure.