Monday, November 19, 2012

Potential Dangers of Investing for Income

I've mentioned before that the American College is in the process of building a great resource of interviews about retirement income topics for its new Retirement Income Certified Professional (RICP) designation program, which it is slowly rolling out as a part of its he New York Life Center for Retirement Income. I'm very fortunate to have the opportunity to provide the world premiere for some of these videos. I could probably spend a year doing this daily, but I will try to be selective. 

Recently, I've seen a lot of references to people interested in using a strategy to invest for income and live off of their income in retirement.

Today's video is an interview with Colleen Jaconetti, a senior investment analyst at Vanguard, in which she describes some of the potential pitfalls of income investing. This is not to say that no one should try it, but just to make sure that you are clear about the risks you are taking. Anyone interested in investing for income should take the 20 minutes needed to watch this interview.

The issue is that your retirement income strategy can be based on a total returns perspective, or based on investing for income.

First of all, in some cases, these strategies can be the same. If your asset allocation is designed from a total returns perspective and you are able to live off the income provided by the portfolio and other income sources from outside the portfolio (Social Security, etc.), then everything is fine.

The problem is what to do in the case that the total returns portfolio does not provide as much income as you like. 

[The video shows a shocking graphic about how the income provided from a total returns portfolio has fallen so dramatically in recent years so that this may be a bigger problem now than it ever was before, see the analysis beginning at 2:20 in the interview] 

With the total returns perspective, what you do is maintain your strategic asset allocation but also consume some of your principal. 

With the income perspective the last thing you want to do is consume some of your principal, so you instead re-arrange your investments so that they provide enough income that you don't have sell any assets to meet spending needs. In other words, you chase for higher yields. Often this means either shifting to higher yielding dividend stocks, or shifting bond holdings in the direction of greater maturity or increased credit risk.

No one is saying that you should not do these things, but there are risks involved and you need to be aware of what you are doing, and whether you might ultimately be better off by using a total returns investing approach.

Risks for dividend stocks:

Makes portfolio less diversified relative to total stock market

Understand that dividend stocks are not bonds, the value of a portfolio is still highly correlated with the stock market and a stock downturn can still decimate the portfolio value

Dividend approaches tend to overweight value stocks relative to the broad market

Portfolio becomes more concentrated: the top 10 holdings in a dividend fund take up a much higher percentage of the total fund

Dividend stocks are currently priced rather high relative to future earnings and so have more potential to drop

There is a misconception that higher dividends means higher returns. The value of the portfolio drops by the amount of the dividend. Total wealth is not affected by a dividend payment. But the dividend may be taxed at a higher income tax rate rather than the capital gains rate. Higher yielding dividend stocks have historically provided about the same total return as low dividend stocks.   
Risks for higher yielding fixed income:

Switching to higher yielding longer-term bonds leaves investor more exposed to capital losses if interest rates increase. Long-term bonds are more volatile.

With current low yields, a small increase in interest rates will result in capital losses that cancel out the higher interest income. See the amazing chart at 13:45, which shows, for instance, that a 0.23% increase in long-term interest rates would wipe-out the benefit of holding them instead of holding Treasury bills. Note: this is a really scary aspect about holding a long-term bond mutual fund today. 

Switching to higher yielding corporate bonds leaves investors more exposed to default risk; if the stock market drops then corporate bonds also tend to drop as increased default risk works its way into interest rates     

More general risks

The income approach is less tax efficient, as where to take income with a total returns perspective is based more on tax considerations and allows for offsetting capital losses and capital gains

As she says: In essence, investors are trading higher current income for a higher risk to future income