Total Return And The Transition From Saving to Spending

We spend a lot of time helping clients transition from saving and building an investment portfolio to using that portfolio to support their needs for the rest of their lives. For some this comes in the form of a typical retirement and a complete transition out of working and earning money to a life spent pursuing other activities. For others that might simply mean scaling back to a less demanding role or a more fulfilling job that doesn't necessarily cover their full cash flow needs but will still help pay some of the bills. This transition is different for everyone so there is no perfect recipe for how to do it successfully. We work with our clients to help them envision the life they want to live and figure out what they need to do to get there.

When the time comes to make that transition, the most difficult part will likely be the emotions involved in leaving a job and a career they might have been working at for many years. Next to the emotional aspect of the transition, the next hardest part will probably be the financial implications. For years you have been making money and hopefully putting a portion of what you make into saving for the future. Now that future is here. Taking away the security of a paycheck and suddenly needing to rely on your savings to cover your expenses will shed a bright light on what your expenses really are and how much you have really saved.

Even if you have done a great job of managing your expenses and have been a diligent saver who has amassed a portfolio that should easily last you through your retirement, the transition still won't be easy. You will have a psychological attachment to your savings and you probably won't really want to spend it down. You have worked hard for years and years to build this portfolio so it can be stressful to see your account value start to decline instead of grow each month.

At this point you might start to think about your portfolio in a different way. You'll want the portfolio to produce regular steady income that will cover your expenses so you never have to dip into the principal of what you saved. Unfortunately there are a few major problems with this thinking:

1. The reason you saved for all those years was so that you could support this next phase in your life. As long as you have a plan in place for what you can afford to spend and how you will spend it, you shouldn't be afraid to do just that.
2. Interest rates are at all time lows so it is very hard right now to support even modest living expenses with a low-risk income-oriented portfolio. Many investors are reaching for yield by moving into more risky assets like dividend stocks, MLP's and REIT's. While we believe these assets should be a part of a well diversified portfolio, you need to understand the additional risk they bring and not attempt to use them as a safe "bond replacement" in your portfolio.
3. Inflation is very low right now but it likely won't remain that way forever. Even modest inflation can severely impact the "real" return you earn on already lower return assets like bonds. Stocks have historically had a much higher annual return and this higher return is necessary to keep up with inflation over the long-term.
4. Focusing only on income-oriented investments decreases the tax efficiency of your portfolio. Taxes are one of the most significant costs incurred when investing so being able to utilize tax-efficient strategies can be incredibly powerful. 

What do I mean by "total return"? Put simply, it means you build a diversified portfolio consistent with your risk tolerance, risk capacity, time horizon and investment objectives. You keep a cash reserve of 2-3 years of cash flow needs and you rebalance the portfolio regularly so that you are always in line with your target allocations. Sometimes you might be selling large cap stocks and adding to cash, other times you might be selling bonds and adding to REIT's. The point is that you don't worry about whether you are taking cash from "income" or if it's coming from "principal". Your TOTAL portfolio is what will support you for the rest of your life so you should be taking cash from the TOTAL portfolio in a balanced way.

This can be much more challenging in practice than it is in theory. One way we have found to make this easier for clients is to set a monthly "allowance" of cash distributions from the portfolio. We determine how much you need to cover your cash flow needs each month and set that as a regular distribution. This helps ease your mind when the regular paychecks stop coming in. Let us handle the regular rebalancing that keeps your cash reserve in check so that you don't have to deal with the pain of selling an investment and eating into your "principal". By removing yourself from the process you are less likely to make an emotional decision that won't be in your best interests.

Switching from an "income-only" mindset to a "total-return" mindset can be just as challenging as the transition to retirement. However, the benefits are hard to ignore and many studies have found this to be the superior approach. If you'd like to learn more about how we help clients make this transition, please get in touch with usand we'd be happy to have the conversation.

 

 

Please see Additional Disclosures more information.