Which Makes More Sense for Retirees: A Total-Return or Income Portfolio?

Total-return investing focuses on building diversified portfolios from stocks and bonds to seek greater long-term investment growth. By focusing on total return, the objective over the long run is to produce a greater and steadier amount of income relative to what could be obtained by investing for income by focusing solely on interest and dividends to support spending without the need for a principal drawdown.

Nonetheless, investing for income is quite popular in practice. Many do-it-yourself retirees and advisors recommend investing for and living off of income in retirement, shifting away from a total-return perspective. Such methods have yet to receive much academic scrutiny, as it is difficult to obtain good data on historical returns for portfolios that tilt toward higher-yielding sub-sectors of the market.

Colleen Jaconetti, a senior investment analyst at Vanguard, has taken care to discuss the issues and pitfalls of investing for income. In a 2012 interview, she spoke with The American College on these matters. I will summarize her key points here.

A retirement income strategy can be based on one of two things: total return or income. In some cases, these strategies are the same.

If your asset allocation is designed from a total-return perspective, and you can live off the income provided by the portfolio and other income sources from outside the portfolio (e.g., Social Security), then everything is fine.

The problem is what to do when the total-return portfolio does not generate the desired income. In such a situation, a total-return perspective would have you maintain your strategic asset allocation while consuming your principal.

From an income perspective, the last thing you want to do is consume your principal, so you would re-arrange your investments to provide enough income so you wouldn’t have to sell any assets to meet spending needs. In other words, you chase higher yields than a total market portfolio (capitalization-weighted on all investable assets) can provide. Often, this means either shifting to higher-yielding dividend stocks or shifting your bond holdings toward greater maturity or increased credit risk.

Shifting away from a total market portfolio comes with risk. For higher dividend stocks, the investment portfolio becomes less diversified relative to the total stock market. Dividend-based approaches tend to overweight value stocks relative to the broad market. Portfolios become more concentrated as the top ten holdings in a dividend fund take up a much higher percentage of the total fund. It is also important to remember that dividend stocks are not bonds, so the value of these assets is highly correlated with the stock market.

A stock downturn can decimate the portfolio value of dividend stocks. Also, the misconception persists that higher dividends result in higher returns. In fact, the value of the portfolio drops by the amount of the dividend. Total wealth is not affected by a dividend payment. Actually, the dividend may be taxed at a higher income tax rate rather than the capital gains rate, diminishing after-tax returns with dividends.

Higher-yielding dividend stocks have historically provided roughly the same total return as lower-dividend stocks before considering taxes. As for higher-yielding bonds, the idea is to shift toward longer-maturity bonds or bonds with greater credit risk. Switching to higher-yielding, longer-term bonds leaves investors more exposed to capital losses if interest rates increase, and long-term bond prices are more volatile.

When yields are low, a small increase in interest rates will result in capital losses that cancel out the higher interest income. Consider that in January 2017, one-year Treasury Bills yielded 0.89%, and thirty-year Treasury Bonds yielded 3.04% (let’s also assume a coupon rate of 3.04% to simplify the analysis).

If the thirty-year bond is sold after one year, its return consists of the coupon payments matching 3.04% of the principal plus any capital gain or loss. If interest rates for thirty-year bonds rise just eleven basis points to 3.15%, the capital loss experienced would reduce the total return to the same level as the Treasury bill.

A bigger interest rate increase would lead the thirty-year bond to underperform. A capital loss can offset the additional yield with just a small rate increase for long-term bonds, wiping out their potential higher returns.

As for higher-yielding corporate bonds, this leaves investors more exposed to default risk; when the stock market drops, corporate bond prices tend to do the same, as increased default risk works its way into higher interest rates.

This credit risk must be considered alongside any potential for increased yields.

Jaconetti summarized the matter perfectly in her interview: by reaching for yield, investors trade higher current income for a greater risk to future income. This risk must be accepted when moving away from a total-return portfolio.