How to Generate Retirement Income

Investors can’t agree on the best way to set up a retirement portfolio.

For some, dividends and interest payouts are the main priorities. For others, growing their portfolio is top of mind.

So, what is the best way to generate income in retirement?

Approaches to Generating Retirement Income

We’ll look at three popular approaches:

• Income-centric
• Total return
• Hybrid

Christine Benz, Morningstar’s director of personal finance and retirement planning, recommends the hybrid approach. “The idea here is that you’re kind of splitting the difference between the two approaches,” she says. “You’re constructing your portfolio for total return, but it will produce some income.”

We’ll outline the pros and cons of each approach, so you can decide which one is right for you.

The Income-Centric Approach

• Pro: Retirement income may not require selling any investments.
• Con: Dividend and income payments aren’t guaranteed and may fluctuate over time.

The key attraction of the income-centric approach is the idea that if you own securities that are paying you a stream of income, you have something that you can count on over time. This includes cash, bonds, and dividend-paying stocks. In theory, you won’t have to touch your principal if your investments are providing all the income you need.

The drawback of this approach is the fluctuations in income from securities. Whatever income you earn from bonds and cash depends on the prevailing interest rate environment, which changes over time. The same is true with dividend-paying stocks; if business conditions become tough, companies may cut their dividends. So, focusing on income alone may be less reliable than you’d hope.

The Total-Return Approach

• Pro: Your portfolio will likely be better diversified, and the strategy has built-in rebalancing.
• Con: Having to sell investments can cause retirees to underspend, and volatility is still a factor.

Many professional investors gravitate toward the total-return strategy. The basic idea is that you only focus on growing your portfolio over time, then trim appreciated securities to cover your living expenses. Any distributions are reinvested.

This approach lets you choose investments that don’t just produce income, so you’ll likely end up with a more diverse mix of securities that includes growth and value stocks, dividend-payers and non-dividend-payers, as well as bonds. Plus, trimming appreciated securities to cover expenses acts as a built-in rebalancing mechanism where you’re periodically derisking your portfolio.

The total-return approach is still affected by market volatility, and some retirees who use this strategy may underspend from their portfolios. It’s also possible to trim too aggressively and miss out on potential gains.

The Hybrid Approach

• Pro: Your portfolio will be set up for growth while still providing income.
• Con: You’ll have to be flexible about where you pull from to cover your expenses.

Benz favors a hybrid approach, which combines the income-centric and total-return approaches to sourcing retirement income. Essentially, you construct your portfolio for total return, but you own some income-producing securities as well.

Those income-producing securities will provide some of your cash flows, and you can trim appreciated holdings to fill any income gaps. This hybrid approach works well with the Bucket strategy for retirement portfolio construction.

How the Bucket Strategy Works With the Hybrid Approach

With the Bucket approach, think of your portfolio holdings in three buckets:

• Bucket 1: A couple of years’ worth of cash.
• Bucket 2: Five to eight years’ worth of high-quality fixed income.
• Bucket 3: A globally diversified, mainly equity portfolio.

On an ongoing basis, you can use income distributions to refill the cash bucket. If that’s not enough to cover your living expenses, you can trim appreciated holdings in Bucket 3 or sometimes Bucket 2. The key is to stay flexible about where you go for the additional proceeds to refill Bucket 1.

Don’t Forget About Nonportfolio Income

Benz likes the idea of staying flexible in terms of where you 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.

Consider taking steps to enlarge your Social Security income. You might augment that with other sources of nonportfolio income, like a basic annuity or taking on some kind of work in retirement. You might also have rental income.

Whether your cash flows come from your portfolio or other sources, staying flexible can help you react to different market environments.