February 2019 Comments: Spending Income or Spending Total Return

Sam Ngooi Comments

Most clients, when starting to use their investment portfolios for part or all of their spending, have as an objective to spend the income but not the principal. We would like to take this opportunity to discuss this objective and why it is so difficult to achieve in a low-interest rate environment.

First, some definitions:

  • Income is interest on bonds/bond funds and dividends on stocks/stock funds.
  • Total return is income plus or minus the changes in the value of your portfolio. During periods when stock and/or bond prices are higher, total return will likely exceed income. During periods when stock and/or bond prices are lower, total return will likely be less than income. Note also, stock and bond price changes sometimes move in the same direction in the same time frame but sometimes do not, and that stock price fluctuations are far greater than bond price changes.
  • Required Minimum Distributions (RMDs) from retirement accounts are not simply income, even though they are taxed as ordinary income. They are a combination of income and principal based on the composition of the portfolio.
  • Higher-yielding bond-like investments carry more price fluctuation risk than basic bonds, which is why they pay more interest.
  • Annuity payouts are part income and part return of principal, not all income (a subject all its own).

Next come some necessary facts to relate to the issue of income and total return:

  • Over the last 19 years (early 2000 to year-end 2018), the stock market (as measured by S&P 500 price change only), has gained a surprisingly low 2.6% annualized (S&P 500 index change from 1527 to 2507). If, however, you measure the price gain from the 2009 low (677), the annualized gain is an unusually high 14%. The ten years from 2000 to 2009 were basically flat, with two multi-year periods of very large price declines (2000 to 2002, and October 2007 to March 2009). Assume also that dividends added approximately 2% annually to stock returns over the entire 19-year period.
  • As for bond prices, they also fluctuate, but much less than stock prices. Bond price changes are mostly in response to changes in market interest rates. When rates decline, prices rise, but the interest received is lower. Conversely, when rates rise, prices decline, but interest received also rises. From the years 2000 to 2009, rates declined and prices rose, and the annualized total return approximated 6% (a far better return than stocks in the same ten-year period), with at least half the return coming from interest rates and the other half from rising prices. But at some point, the rate declines stop, and that is essentially what has happened from 2010 through 2018 (with a few years of modest exceptions). Although rates have recently increased slightly, investors have been left collecting relatively little interest income (approximately 2.0% to 2.5% annually on the Vanguard Intermediate taxable bond fund), and are no longer seeing the rise in bond prices.

Putting all this information together, you can see that, over the last 19 years, annualized price gains/declines have been quite erratic, and income much more stable. No matter what your allocation to stocks and bonds, for every $1 million in total portfolio value, the annual income was likely to be no more than 2.5%, or $25,000. If the spending need from your portfolio was more than $25,000 per $1 million of capital, some of your withdrawal must have come from the principal value of the portfolio, which is fine as long as portfolios are gaining in value more than the withdrawals. Problems arise when markets and portfolio values decline, and spending is coming from income plus the declining value of the principal. The recent history (since 2000) of market price changes has indicated that there are gains to be expected, especially after periods of decline. But the periods of decline can be quite scary to people living off their investment portfolios.

We often see investors trying to earn more income from their portfolios, but there is always some tradeoff with the risk being incurred. We think it makes more sense to acknowledge that principal will likely be spent, unless your principal value is large enough to generate the spending need all from income. (For example; a $3 million portfolio could reasonably be expected to currently generate $75,000 of annual income at 2.5%. If $75,000 is the annual withdrawal needed, then the income may be sufficient).

PPA can run illustrations to show how long your funds are likely to last, spending both income and principal, based on assumed investment returns and inflation-adjusted spending amounts. Please let us know if we can be of assistance on this very important matter.