The Total Return Approach to Retirement

Income in retirement can come from more than bonds and dividends, explains Morningstar's Christine Benz

Ruth Saldanha 25 February, 2021 | 4:38AM
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Ruth Saldanha: When investors think of retirement income, they think of bonds or dividends. But there is another way to generate an income stream by dividing your portfolio into buckets and taking advantage of total returns. Morningstar's Director of Personal Finance, Christine Benz, is here today to talk about that.

Christine, thank you so much for being here today.

Benz: Ruth, it's my pleasure. It's great to see you.

Saldanha: Well, let's start by talking about the bucket system. Now, the bucket system doesn't depend on bond yields or dividends. Can you explain how it works and why it's a good retirement solution?

Benz: I think it's a good retirement solution because the basic idea is that when you embark on retirement, you don't know how the market will behave. So, bond yields are really low. They could go higher in the future. Stocks have been great over the past decade. They may not be so great in the time period that you're retired. So, there's a lot that you don't know. And the basic idea with the bucket structure is that you're setting aside pools of money to tide you through various scenarios. So, when the simple three bucket structure that I often talk about – you've got a cash bucket that is composed of a couple of years' worth of portfolio withdrawals. And then, you have a bond bucket and that's there to supply you with cash flows if you've spent what's in your cash bucket, but stocks still aren't performing well.

And finally, you have stocks and other longer-term assets in your portfolio. Those are really the growth engine of your portfolio. That's bucket three. But the reason why you wouldn't want to make that your whole portfolio is that we know that there are periods where stocks go down and stay down for long periods of time. So, you've set aside these various buckets of money to provide you with your cash flows depending on what's going on in the market. But the basic idea is that you're setting up protection so that if stocks endure a rough Patch and especially early on in your retirement, that you have cash flows that you can rely upon to provide your living expenses and hopefully supply you with some peace of mind during a long-running bear market for stocks.

Saldanha: So, the way it works is, as you use up your first initial cash bucket, you keep replenishing it from the other two, is that right?

Benz: Well, it really depends on the market environment. So, for retirees today, yes, if they're spending from their cash bucket, they would probably use appreciated equity holdings to replace cash as they've spent it. In other market environments, maybe you don't want to pull from your stocks. You would spend from your cash and then move on to your bonds. So, the idea is that you're being flexible, you're being opportunistic. You're letting yields and equity market returns help dictate where you go for cash on a year-by-year basis and how you refill that cash bucket.

Saldanha: So, this is a total return approach. Now, I know the retirees in my life are loads to sell anything, especially stocks or bonds that have done well for them in the past. How would you address these concerns?

Benz: Yes. It's very much a concern on the minds of many retirees, Ruth, I think not just your family members. But I think one thing I would say is that if you're using income to provide your cash flows in retirement, in a way, that's a type of withdrawal, even though it doesn't feel like it. But if you're not reinvesting your income and dividends, you are effectively reducing your portfolio's return potential. So, my advice is to not get overly hung up on where your cash flows come from. It's really important to think about how much you're taking out of your portfolio, but whether your cash flows come from dividends and income or they come from selling appreciated securities. At the end of the day, it doesn't really matter as long as your withdrawals are reasonable. So, I would say that.

And the other point I would make on the whole bucket system is that I personally think it can be fine if retirees have portfolios that are providing organically generated dividends and income, go ahead and use them for your spending and then use maybe selling appreciated securities to provide additional cash flow for living expenses. So, your income can provide a baseline of income. The problem is, in today's environment, with yields as low as they are, it's not enough for most retirees. So, that's the idea. Open yourself up to the idea of trimming appreciated securities, and then you won't have to stretch so far to get whatever yield it is that you think you need.

Saldanha: And what are some of the potential downsides of this approach?

Benz: A couple of things. One is that the bucket system, even though I think it's a sensible way to approach retirement, it is not going to protect you against a shortfall. So, if you haven't saved enough and your withdrawal is too high, no system, bucket or otherwise, will protect you in that environment. And then, another quite big caveat here is that the bucket strategy does entail holding some cash. Given how low yields are today on guaranteed investments, you really need to be careful about not overdoing it. So, I typically talk about parking a couple of years' worth of portfolio withdrawals in cash. Any more than that really to my mind, there's a substantial opportunity cost. And you need to take great care because inflation could eat up every bit of the tiny yield that you're able to earn.

Saldanha: Thank you so much for joining us today with your perspectives, Christine.

Benz: Thank you, Ruth. It's my pleasure.

Saldanha: From Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha

Ruth Saldanha  is Editorial Manager at Follow her on Twitter @KarishmaRuth.


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