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Investing for Retirement Income: Straw, Sticks, or Bricks? Thumbnail

Investing for Retirement Income: Straw, Sticks, or Bricks?

If there were an appropriate analogy for investing for retirement, it would be the classic fable of The Three Little Pigs. As you may recall, those three little pigs tried three different structures to protect against the Big Bad Wolf. Similarly, there are at least three kinds of “building materials” that investors typically employ as they try to prevent today’s low interest rates from consuming their sources for retirement income: 

  1. Dividend-yielding stocks
  2. High-yield bonds
  3. Total-return investing

Part I: Dividend-Yielding Stocks – A Straw Strategy

We understand why bulking up on dividend-yielding stocks can seem like a tempting way to enhance your retirement income, especially when interest rates are low.

Safe, easy money, or so the fable goes. Unfortunately, the reasoning doesn’t hold up as well upon evidence-based inspection.

Dividend Income Incurs a Capital Price

It’s common for investors to mentally account for a dividend payout as if it’s found money that leaves their principal untouched. In reality, a company’s dividends have to come from somewhere. That “somewhere” is either the company’s profits or its capital reserves.

This push-pull relationship between stockholder dividends and company capital has been rigorously studied and empirically assessed. In the 1960s, Nobel laureates Merton Miller and Franco Modigliani published a landmark study on the subject, “Dividend Policy, Growth, and the Valuation of Shares.” In Capital Ideas (a recommended read on capital market history), Peter Bernstein explains one of the study’s key findings: “Stockholders like to receive cash dividends. But dividends paid today shrink the assets of the company and reduce its future earning power.”

So, yes, you can find stocks or stock funds whose dividend payments are expected to provide a higher income stream than you can earn from an essentially risk-free government bond. But it’s important to be aware of the tradeoffs involved.

“Safe” Stocks? Not so Fast.

Dividend-yielding stocks may not be as sturdy or as appropriate as you might think for generating a reliable retirement cash flow.

The evidence is clear, and it has been for decades: Stocks are a riskier investment than bonds. This, in turn, has contributed to their higher expected long-term returns to compensate investors who agree to take on that additional risk.

In “The Dividend-Fund Dilemma,” Wall Street Journal’s financial columnist Jason Zweig explains it similarly: “When you buy a Treasury, you collect interest and get your money back (not counting inflation) when the bond matures. When you buy a dividend-paying stock, you collect a quarterly payment – but that certainly doesn’t mean the stock price will be stable.”

Your Essential Take-Home

Our capital markets rarely offer a free ride. If you’re taking stock dividend income today, you’re likely paying for it in the form of lower share value moving forward. And if you’re invested in the stock market, you expose your nest egg to all the usual risks (and expected returns) that come with that exposure. That’s how markets work.

Part II: High-Yield Bonds – Sticks and Stones Can Break You

Another popular tactic is to move your retirement reserves into high-yield, low-quality bonds. However, we don’t typically recommend this approach, either.  We understand why it would be appealing to try to have your bonds pull double-duty when interest rates are low: protecting what you’ve invested and delivering higher yields. The problem is, the more you try to position your fixed income to fulfill two essentially incompatible roles at once, the more likely you will underperform at both.

Risk and Return: The Same, Old Story (Sort of) 

The relationship between risk and expected return is one of the strongest forces driving capital markets. But decades of academic inquiry help us understand that the risks involved when investing in a bond are inherently different from those associated with investing in stocks. These subtle differences make a big difference when combining stocks and bonds into an effective total portfolio.

Because a company’s stock represents an ownership stake, your greatest rewards come when a company’s expected worth continues to improve, so you can eventually sell your stake for more than you paid for it and receive “profit-sharing” dividends along the way. Your biggest risk is that the opposite may occur instead.

A bond is not an ownership stake; it’s a loan with interest, which defines its two biggest risks:

  1. Bond defaults – If all goes well, you get your principal back when the loan comes due. But if the borrower defaults on the loan, you can lose your nest egg entirely.
  2. Market movement – You would like your bond’s interest rate to remain better than, or at least comparable to those available from other, similarly structured bonds. Otherwise, if rates increase, you’re left locked into relatively lower payments until your bond comes due.  

As such, two factors contribute to your bond portfolio’s risks and expected returns:

  1. Credit premium – Bonds with low credit ratings (“junk” or “high-yield” bonds) are more likely to go into default. To attract your investment dollars despite the higher risk, they typically offer higher yields.
  2. Term premium – The longer your money is out on loan, the more time there is for the market to shift out from under you, leaving you locked into a lower rate. That’s why bonds with longer terms typically offer higher yields than bonds that come due quickly.

Bond Market Risks and Returns

Just as we do with your stock holdings, we must identify the best balance between seeking higher bond yields while keeping a lid on the credit and term risks involved.

Taking on extra bond market risk is not expected to add more value than could be had by building an appropriately allocated stock portfolio. Moreover, it is likely to detract from your bond holding’s primary role as a stabilizing force in your total portfolio - and it often does so just when you most want to depend on that cushioning stability.

For example, in “Five Myths of Bond Investing,” Wall Street Journal columnist Jason Zweig dispels the idea that “investors who need income must own ‘bond alternatives’” (such as high-yield bonds). He cites BAM ALLIANCE Director of Research Larry Swedroe, who observes that “popular bond alternatives provide extra income in good times – but won’t act like bonds during bad times.”

Your Essential Take-Home

If you must accept higher risks in search of higher returns, take those risks on the equity (stock) side of your portfolio; use high-quality fixed income (bonds) to offset the risks. 

The most important step you can take with your retirement income is to adopt a portfolio-wide approach to money management instead of viewing your income and principal as two isolated islands of assets.

Part III: Total-Return Investing for Solid Construction 

If you think it through, three essential variables determine the total return on nearly any given investment:

  1. Interest or dividends paid out or reinvested along the way
  2. The increase or decrease in underlying share value: how much you paid per share versus how much those shares are now worth
  3. The damage done by taxes and other expenses  

Total-Return Investing, Defined 

Instead of seeking to isolate and maximize interest or dividend income, i.e., only one of three possible sources for strengthening your retirement income, total-return investing looks for the best balance among all three, as they apply to your unique financial circumstances. Which strategy is expected to give you the highest total return for the amount of market risk you’re willing to bear?

If you’re thinking this seems like nothing but common sense, you’re on the right track.

In “Total-return investing: An enduring solution for low yields,” Vanguard describes the strategy as follows: “Many investors focus on the yield or income generated from their investments as the foundation for what they have available to spend. The challenge today, and in the future, is that yields for most investments are historically low. We conclude that moving from an income or ‘yield’ focus to a total-return approach may be the better solution.”

The Related Role of Portfolio Management 

The tool for implementing total-return investing is portfolio-wide investment management. Decades of evidence-based inquiry informs us that there are three ways to manage your portfolio: to pursue higher expected returns, more stable preservation of existing assets, or, usually, a bit of both. The most powerful strategies in this pursuit include:

  1. Asset allocation – Tilting your investments toward or away from asset classes that are expected to deliver higher returns but with higher risk to your wealth as the tradeoff
  2. Diversification – Managing for market risks by spreading your holdings across multiple asset classes in domestic and international markets alike
  3. Asset placement– It can be more tax-efficient to have a total return strategy in your portfolio because capital gains are typically taxed at a lower rate.

By focusing on these key strategies, we can manage a portfolio’s expected returns. This, in turn, helps us position the portfolio to generate an efficient cash flow when the time comes.

Your Essential Take-Home

The bottom line? There is no such thing as a crystal ball that will guarantee financial success or a happily-ever-after retirement. But we believe that total-return investing can offer the best odds for achieving your retirement-spending goals – more so than pursuing isolated tactics such as chasing dividends or high-yielding bonds without considering their portfolio-wide role.


Erickson Braund is the Founder and Chief Financial Officer at Black Walnut Wealth Management. He is a Certified Financial Planner®️ professional and a Chartered Retirement Planning Counselor®️. Eric brings over 20 years of experience working with high net-worth individuals and families, helping them achieve their goals of protecting and growing their wealth for retirement and for generations to come. Because Eric is a CFP®️ professional, he adheres to high ethical standards and engages in at least 30 hours of approved continuing education in the financial industry each year.

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