The Best Ways to Generate Income in Retirement

Key Takeaways

• Income-centric approaches for generating retirement income are a steady source of income, however, this may be volatile depending on interest rates.
• A portfolio with a total return approach for retirement income is assembled without regard to income characteristics.
• A hybrid approach to retirement income constructs a portfolio for total return while still producing some income.
• If you use a Bucket approach, you combine cash, fixed income, and equity to keep balance in your portfolio.
• Diversified cash flows can help you be more nimble in different market environments.

Margaret Giles: Hi, I’m Margaret Giles with Morningstar. Thanks to higher bond and cash yields, it’s getting easier to generate a livable stream of retirement income from a portfolio. Joining me to discuss the best ways to generate income in retirement is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning, host of The Long View podcast, and author of the bestselling book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement. Thanks for coming, Christine.

Christine Benz: Margaret, it’s great to see you.

Attractions and Drawbacks to an Income-Centric Retirement Income Strategy

Giles: All right, let’s get into it. The two main strategies that we often hear about for generating retirement income are an income-centric approach and a total return approach. Let’s start by discussing the income-centric investors. We have a lot of dividend aficionados on Morningstar.com. What are the key attractions of that approach, and what are the potential drawbacks?

Benz: Yeah, so we do have a lot of dividend aficionados. And the key attraction is the bird in the hand, the idea that if you own securities, whether stocks or bonds, that are paying you a stream of income, well, that’s something that you can count on or should be able to count on to varying extents over time. And the other key attraction for retirees is the idea of, well, if you can just hold your principal steady and invest in something that pays you income, you don’t have to touch that principal. So I know a lot of retirees are attracted to that idea because they want to maintain principal to give to heirs or whatever the case may be.

The key trade-off, the key drawback, is that we see some volatility in income from securities. So whatever income you earn from bonds and cash will tend to depend on the prevailing interest-rate environment, right? And that changes over time. We’ve seen some of those changes in stark relief over the past few years. And the same is true with dividend-paying stocks, where if business conditions become tough, it’s not unprecedented for companies to cut their dividends. So we had a big slew of dividend cuts back in the great financial crisis, where banks had been historically major providers of dividends in the market. Well, banks were at the epicenter of that financial crisis. And so a lot of banks did have to cut their dividends, in some cases cut them entirely, during that period. So there is a level of unreliability about focusing on income production alone.

Pros and Cons to Total Return Approach

Giles: All right. How about a total return approach? It seems like a lot of professional investors gravitate toward that strategy. What does it entail? And what are the pros and cons?

Benz: Yeah, the basic idea, if you’re using a total return approach to your retirement income, is that you are just going to focus on growing your portfolio over time. And then you’re periodically going to poke your head up and say, well, what in my portfolio has gone up the most? And what could I trim to provide my living expenses?

The key reason that academics and other firms like our firm at Morningstar tend to like the total return approach is that you’re assembling the portfolio without regard to income characteristics. So you’re not artificially constraining the set of securities that you would use to populate that portfolio. You don’t care if they are generating income or have growth potential; you have a good blend. And then there’s a built-in rebalancing mechanism, if you’re using a total return approach, that I think is also pretty attractive from the standpoint of retirement income in that you are harvesting those appreciated securities. That means you’re periodically taking risk out of your portfolio. So for retirees today, for example, with stocks and bonds in their portfolio, well, bonds haven’t done great. Stocks have done very, very well. You can trim those appreciated equity holdings to supply your cash flow needs, leave your bonds alone, leave your cash alone, and sort of optimize the portfolio on an ongoing basis.

Hybrid Approach Benefits for Sourcing Retirement Income

Giles: Christine, you favor a hybrid approach to sourcing retirement income. Can you explain what that means, and what are the benefits in your view?

Benz: Yeah, the idea here is that you’re kind of splitting the difference between the two approaches. So you are owning some income-producing securities, and you are trimming or you’re pulling those income distributions on an ongoing basis, using them to supply your living expenses, but you’re not constructing the portfolio exclusively for income generation. You’re constructing it for total return, but it will produce some income. So you’re spending that income as you go, and then you’re using appreciated holdings to kind of make up the difference. So if you’re looking at a portfolio today, kind of a balanced stock/bond portfolio would have an income of like 2.5%. Well, most people want to live on more than 2.5%, so they would maybe pull the other 1.5% from trimming appreciated securities. So that’s kind of how the hybrid approach would work on an ongoing basis.

Hybrid Retirement Strategy and the Bucket Approach

Giles: Let’s talk about how this hybrid strategy could work with the Bucket approach, which you’ve written about pretty extensively.

Benz: Yeah, so in the Bucket approach, which people have heard me talk about a lot, you are holding a couple of years' worth of cash, five to eight years' worth of fixed income, kind of a high-quality fixed-income portfolio, and then all of the rest of the portfolio would go into a globally diversified, mainly equity portfolio. So on an ongoing basis, I might be using my income distributions to refill that cash bucket. If I’m spending from it to supply my living expenses, well, it’s getting sort of organically refilled. If my bonds are paying me income, my cash is paying me income, and I might have some dividend income as well. But if that’s not enough to supply my living expenses, well, that’s where I would trim my appreciated holdings in Bucket 3 or maybe sometimes it’s Bucket 2, but I’m being a little bit flexible about where I go for the additional proceeds that I might need to refill that Bucket number 1.

What Does a Holistic Retirement Income Strategy Mean?

Giles: You also think it’s important to think of retirement income holistically. What do you mean by that?

Benz: I really prefer the term cash flow to income, Margaret, because I think that income can get people into some funny-looking portfolios where they’ve built the portfolio all in the name of generating current income. I like the idea of staying flexible, staying a little bit eclectic in terms of where you will go for your cash flows on a year-by-year basis. And the name of the game with those cash flows is to diversify them. So ideally, you would take steps to enlarge your Social Security income. You might augment that with other sources of nonportfolio income, like you might have some basic annuity or you might keep working and generate some income from that. You might have rental income, and then you have your portfolio cash flows as well, and those can come from either those organically generated income distributions or they might come from trimming appreciated securities. But if you stay flexible, I think that just helps you be a little bit more nimble in different market environments. It helps you react to different market environments.

Giles: Well, this is really helpful, Christine. Thanks for giving perspective on these different approaches. And thanks for being here today.

Benz: Thank you so much, Margaret.

Giles: I’m Margaret Giles with Morningstar. Thanks for watching.

Watch Navigating the Future of Retirement Income: Trends, Strategies, and Insights for more from Christine Benz.