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Some Caution About Retirement Income and English Gentlemen

Some Caution About Retirement Income and English Gentlemen

“A mere madness, to live like a wretch, and die rich.”
—Robert Burton, The Anatomy of Melancholy, 1621

My mother used to say that a gentleman lived on the interest from his principal. That didn’t apply to our circumstances, not by a long shot (substitute “sweat of brow” and you’re closer to fact). I suspect this comes from the English notion of the landed gentry in the era of Edmund Burke, and has been in decline for quite awhile, as the popularity of Downton Abbey attests.

We’re a long way from Dicken’s Micawber who spelled the difference between happiness and misery as saving forty pence from his annual income of twenty pounds. Dickens didn’t have a $250 monthly FiOS bill, tennis lessons, a travelling soccer league, and three cars to finance.

The Landed Gentry, Living Off Principal
But the notion lives on, strikingly so, with many as they traipse into retirement. The idea is to look for high yield, whether in stocks or bonds, and live off the interest and dividends without ever touching their principal, and so never risk running out of money. At least that’s the theory.

Like many financial ideas, especially those that are weak on their own, this idea works best if you have lots of money. And eat kibbles and bits for lunch and dinner so your expenses will never reach a level of concern.

This notion has such strength among some that sound strategies designed to extend a portfolio and decrease longevity risk are dismissed out of hand—like spending down tax-deferred (401(k) and IRA) savings while deferring Social Security until age 70, ahead of the Required Minimum Distribution tax bite, to maximize lifelong inflation-adjusted benefits you cannot outlive. No! Not my principal, you’ll have to pry it out of my cold dead hands! I’d rather run out money first (paradoxically, but we’ll get to that)!

Never mind that RMDs after age 70 can push Social Security benefits up to the level of full taxation (85%) while raising income over the Part B Medicare threshold into higher premium land. Maybe there is perverse “logic” in taking dramatically lower Social Security benefits early (75% less than if deferred to age 70!) so there won’t be enough Social Security income to worry about taxes.

Hopefully, you recognize this is back-asswards. If you have lots of money (for the sake of argument, let’s say north of $3 to $5 million), you can ignore this and go on with whatever it is that got you to this point. Congratulations. For the rest of us, let’s acknowledge the dangers in the interest-first, principal-never approach.

The Fading Dividend Aristocrat
Some put their trust in dividend stocks, and are shocked when their blue chip gets blue lighted by the market. Then, at just the wrong time after a significant drop in share price (“principal”), the company cuts its dividend, and with it their income. To make it up, they have to sell something, perhaps at distress prices. If you don’t have a plan to use your capital (principal) effectively, you may end up squandering it at the worst of times. What Shakespearean irony to run out of money because you hoarded it so dearly until the market snatched it away!

Dividends are not forever. Long time paying dividend “aristocrats” that some favor may actually be getting a bit long in the teeth, like an old country house, competitively speaking. The essential problem with a dividend stock strategy is that your income depends on unhedged, risky assets that are not well-diversified. The hook you’ve hung your income hat on is totally exposed to business risk.

I remember the jet mechanic quoted in a Forbes article I read long ago who shrugged and said, “There will always be a Pan Am,” and so I bought another round lot. It’s still around here somewhere, if you want it. It was a cheap lesson. The well-funded don’t need to gamble with their future—and most don’t. So why do those who aren’t so well-funded feel compelled to gamble in the name of preserving principal?

Then there is the allure of interest bearing bonds, somewhat less alluring now that investment grade issues pay little more than gas money. At least that’s improved somewhat in the last month—the gas money part, not the interest payments, quite the opposite. Once again, for the well-funded, it’s a no-brainer. A ladder of TIPS bonds buys inflation protection and risk-free income for the duration. For the fortunate landed gentry, this is how our proverbial gentleman lives.

The Yield Chasing Fox Hunt
But the rest of us are probably not so fortunate that we can live off the scant interest from whatever capital we’ve accumulated. Those obsessed with hoarding principal are left chasing after high yield, pushing out on the credit curve, buying junk bonds, junk loans, and junk preferred stocks, like a crazed hound chasing the fox. And as with equities, when the inevitable crisis comes and the market falls, so does the high yield and, sadly, the principal along with it, with same potential for a bad ending.

High yield (junk) debt is just inches above equity in the corporate capital structure. When push comes to shove, it falls like a bad stock, and punishes invested capital in the same way. The fox is the market, and it just ate your lunch. That’s no way to live in retirement.

The issue isn’t dividends and interest—every properly diversified portfolio will have both as a matter of course. The issue is that a retirement income plan should not be built on a diet composed solely of dividends and high yield while hoarding capital that could otherwise be used to securely fund the household lifestyle. It’s just not a reliable way to pay for the future.

The smart thing to do is to put the household capital to work. All of it. Many are fearful of doing that, if only because they’re not sure how to do it—and don’t have a good plan—and so are more than reluctant to do anything except “live off principal” following the footsteps of the long-gone English gentry.

The irony is that while desperately trying to prevent the loss of capital, chasing yield and investing in high dividend payers, they put that capital at risk and the income stream it must provide to sustain the retirement period. It goes almost without saying that those “planners” and “advisors” who are pushing high-yield products like non-traded REITS or junk funds with a high sales load should be avoided like the plague they are, even if they dress like aristocrats.

Living Off the Household Balance Sheet
A good plan starts with the household balance sheet, not dividends and interest. The plan looks at all future income and expense cash flows, and determines how well covered those expenses are, and how much capital is needed to cover them beyond Social Security, pensions, and any earned income. The amount of capital needed to cover all future expenses is called the Income Floor.

Any capital above the Floor plus some amount for Reserves is Upside. Upside can be sensibly invested in the market for growth without jeopardizing the household lifestyle. Depending on the strength of the balance sheet (how much Upside is available), the Floor is invested in risk-free and guaranteed assets such as CDs, Treasury bonds, and simple income annuities. If there’s plenty of Upside, then the Floor can be invested at-risk in bond funds like a conventional balanced portfolio.

If the Floor is under-funded, then we know that some additional planning work is needed—cutting expenses, working longer, and so on. Retirement is all about having a dependable, safe plan for the Floor, not one that only works for dead English noblemen.

You can learn more about allocating Upside, Floor, Longevity, and Reserves from the household balance sheet by checking out the reading list at the Retirement Income Industry Association.

If you’d like more information about goals-based planning and lifecycle savings and investing from the household balance sheet, please feel free to contact me at [email protected].

Michael Lonier, RMA®

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