Income - An Easily Abused Concept

Jim Williams

It is common, particularly in publications directed toward seniors, to see many advertisements of various financial institutions proclaiming the need for "income" from your investment portfolio. While the need for income as broadly defined is fundamental to most retirees, the "income” implied in these ads is usually pretty specific and narrowly defined. Usually these ads contain promotional material for things like fixed income strategies (bonds) or annuities.

While our view is that bonds are an appropriate part of well-managed portfolios, the reason for including them is for capital preservation and stability, not primarily for income. And when the bond portion of the portfolio is set to produce higher income, the result may be a short- term win with a long-term cost.

Annuity payout percentages are frequently conflated, sometimes intentionally, sometimes mistakenly, with interest rates. They are very different things, and the annuity payout always includes the return of principal. While the return of principal is not income, the fundamental exchange in an annuity transaction is to give up an amount of capital (principal) in exchange for a stream of income. So, the cash distribution stream from an annuity is appropriately considered income only in the sense that the principal is gone. While annuitization of an amount of capital may be appropriate in some circumstances, the purchase of an annuity must be done based on thorough analysis of the payout and a clear understanding of the purpose for the transaction.

The emphasis on "income" as narrowly defined, leads investors to mistakes and substantial long-term detriment. This impulse is rooted in the old concept of "hold onto principal" and "only spend income".

It is not hard to see the origin of the income vs principal concern. In the times that preceded the capital markets we now enjoy, the principal might in more cases than not, be the farm itself. It is easy to see how the aversion to selling off bits of the farm to live on, rather than finding a way to live on the income from the farm, supported the preservation of legacy. In that example, principal was the property itself, and income was the yield made possible from the property.

Another example to illustrate how the principal vs income distinction can be useful is the situation where a trust is established that allocates income to one or more beneficiaries, and principal (or remainder) to another group of beneficiaries. In this circumstance, it is incumbent on the trustee to make careful accounting of what is income and what is principal. For the most part, that boils down to the following: Principal is the underlying property including its increases or decreases in value (gains and losses) and income is the interest and dividends (yield) from the property. Think about how the income beneficiaries and the remainder (principal) beneficiaries have interests that oppose each other. The income beneficiary wants interest (or dividends) to be as high as possible and as predictable as possible. The remainder beneficiary wants growth of principal and may be willing to engage some short-term risk to principal.

The conflict inherent in these two positions is as follows: Generally, higher income brings along a diminishment of principal growth. Investment solely in bonds affirmatively assures that the principal cannot grow. This can be pushed to an extreme wherein an investment in higher yielding bonds exposes principal to much higher risk of non-repayment. So, even at the baseline, the principal in a bond portfolio is frozen. Now if the emphasis is growth and maintaining purchasing power of the principal, that will necessarily diminish the income (dividends and interest) available to be distributed. Curiously, when an individual investor decides on a "hold principal and only spend income" strategy, that investor has positioned him/her- self in opposition to his/her own best interests. Even in the highly structured world of trusts, some states and some trust documents allow for the trustee to mitigate this misalignment by "adjusting" between principal and income so that both parties can come out ahead.

Even in more recent eras of the capital markets, where holdings were more likely individual stocks and individual bonds, the prospect of selling off a few shares of any given stock or a single bond out of a portfolio rather than the entire holding is psychologically difficult and may have incurred trading costs that were unacceptable. Although these kinds of transactions are now more feasible, they still feel quite awkward. Contrast that with holding hundreds of different stocks or bonds in a single security. This is the concept of pooled investment vehicles - mutual funds. Mutual funds can be and are bought and sold in fractional shares as readily as making change at the grocery store. This simple difference obviates both the practical and psychological imperatives of "holding onto principal" and "investing for income".

In today's financial markets, the only functional difference between interest, dividends and capital gains is the tax treatment. And the tax treatment generally favors investment in stocks. The policy we recommend is to seek a long-term total return commensurate with the investor’s tolerance of short-term volatility. "Income" can include not only dividends and interest but also gains in principal (capital gains).

The optimal strategy is to moderate withdrawals from the portfolio as a function of portfolio value (say 4% or 5% of the value at each year-end). Depending on the desire to maintain a financial legacy and the need or desire for current income, the percentage of withdrawal may step up with age (like the Required Minimum Distribution amounts from an IRA or other qualified plan). A portfolio designed to achieve total return, and a withdrawal strategy keyed to changes in the portfolio value (changes that will occur) can be designed to have the prospect of maintaining purchasing power, and provide cash flow for current needs, and, if desired include the tradeoffs necessary to produce a financial legacy.

Again, the pursuit of "income" as defined as interest and dividends, is a concept that is long past its "sell by" date. The pursuit of income (narrowly defined) leads folks to make several kinds of investment mistakes, most notably the freezing of the portfolio in bonds to the detriment of any prospect of keeping up with inflation.

This quarter, we welcomed Adam Van Wert to our team. Adam is a Lakewood native with a degree in Personal Financial Planning from Colorado State University (2017). Adam passed the CFP® Certification Exam in 2017.

Welcome aboard Adam!

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The table below shows the returns through June 30, 2019 for selected investment asset classes. In most cases, the results below are appropriate benchmarks for the related mutual funds in your investment portfolio.