Income Streams

Modern technology aside, I like to use a very simple approach when developing an income distribution plan. I take a sheet of paper and draw three circles representing bags of money. One bag represents equities (stocks), which will be our growth component of the portfolio. The second bag represents debt (bonds or bond-like) investments for long-term income. The third bag represents cash for liquidity to cover your immediate needs.

The three bags are independent of one another but work together to create an overall allocation and distribution strategy. The dollar amount in each bag is determined by available investable assets, risk tolerance, and annual income needs.

The cash bag will provide monthly income. There is limited market risk for these assets. Returns are generally more predictable in short-term investments despite market fluctuations. These dollars will earn short-term interest rates, and I don’t really care what that rate is as long as the principal is safe. This provides a security blanket. Regardless of what happens in a 12- to 18-month period, our retirees know they have steady income for that time period.

The fixed income bag will consist of assets that generate income such as bonds, utilities, or real estate investment trusts. A well-balanced allocation strives to replenish the immediate cash distributions with a consistent income stream. As we know, there is more volatility in the stock market in the short term, so this approach allows the stocks in the growth bag to remain in place to go through the ups and downs of market cycles. The goal is to never take money out of the equity market to generate income. The risk in doing so would be that someone would need money when the market is down. Ideally, money comes out of the equity market only when there’s been appreciation that has been captured and moved to the bond portion to generate income or in some cases directly to the cash account. In this way, the bags work together in a specific manner.

An Example

Let’s take a client who has $1 million in assets and $35,000 in income from Social Security and a pension. We have determined that he has a lifestyle that will need an additional income of $48,000 to cover all of his expenses.

First, we’ll take $96,000 and put it into a cash account. Typically, this will be a money market account, where the return may be low but the dollars are safe and easily accessible. The Social Security and pension checks come to an additional $35,000 a year, $70,000 over two years. Combined, that $166,000 provides for two years of income. Regardless of what happens, our clients know they have two years of secure income. Wouldn’t this added security make you feel good?

Because we are starting with two years of income in the bank, we will look at how to generate an income of $24,000 from the fixed income portion. Bonds are a solid means of income and are typically “safer” investments, so we look at the fixed income bag where we typically find bonds. If we calculate that bonds have historically generated a 6% rate of return, then we need to determine how much money at a 6% rate would replace $24,000. Using our handy calculator, we would get $400,000. Therefore, we would put $400,000 into bonds or income-generating investment vehicles. The remaining money ($1,000,000 - $400,000 - $96,000 = $504,000) would go into equities for growth. From day one, we know we have three years of income, with the additional $24,000 of income being generated from fixed income. This gives us at least three years to take appreciation from the stock portfolio to enable us to continue providing income.

Remember that taking appreciation from stocks is also a strategy for providing income but not one that should be counted on from month to month, only over time. If the stock market has not provided any appreciation, such as from 2000 through 2002, then the principal of the bond portfolio may need to be invaded. But if our retiree is monitoring his portfolio on a regular basis, he will not arrive at the fourth year without having considered other options along the way. Also, we will need to adjust for inflation as time goes on and for any changes in tax laws. Again, with constant monitoring, there should not be any surprises.

Therefore, the 6% rate of return on the bonds will be used to replenish the cash while the equity portion continues to grow. Because many retirement funds are in IRAs or 401(k) accounts, there is no concern about capital gains taxes on the money accumulating from the equity portion of the portfolio.

Turning our attention back to asset allocation and the percentages allocated, in this example, we ended up with a 55-40 split of bonds (income) and equities (growth) with a very small portion (5%) in cash for the purpose of liquidity.