Generating Income

Conventional wisdom tells us that in retirement we need income producing investments. I believe you need to understand how to challenge that conventional wisdom. To this end a discussion about cash flow and income is warranted.

Bonds and bond type of securities (called fixed income) are designed to or can provide the owner income. Wages and salary are also considered income. Investment real estate can provide income as can pensions, social security and annuities. They all can provide income. But I would also suggest that “income” is more of a definition for taxation than using the concept of “cash flow.”

You and I can only spend our after tax cash flow - just because it is income does not make it spendable to support a standard of living. Our standard of living is really defined by how much cash flow we have after taxes have been paid. Therefore instead of thinking in terms of income let us think in terms of “cash flow.”

Now the world changes because not all cash flow is subject to taxes or some can be subject to lower tax rates than taxable income which is usually grouped together for tax reporting.

Question: If you need $5,000 or $10,000 or $25,000 per month to live on do you really care if it is income or if it is “cash flow” you can spend? When I ask this question I have always received the same answer. “It makes no difference; I just want the cash flow” to support my standard of living.

With this thought in mind our view of portfolio management changes and we believe it changes for the better. Instead of a focus on income we can now focus on total return and have as a stated objective “an after tax rate of return greater than inflation” This is important for two reasons: 1) Historically fixed income investments have not provided an after tax return greater than inflation. In retirement this may mean you are systematically reducing their purchasing capacity as your cost of living increases. 2) Greater tax planning and rate of return opportunities may exist from a total return approach to portfolio/wealth management. This latter point is subject to the composition of one’s investment structure.

The main point is to understand that any portfolio can be designed to provide/generate cash flow to support a standard of living. Yes dividends and interest can be part of the cash flow, but if we can go beyond conventional wisdom and think in terms of total return the possibility of an after tax rate of return greater than inflation is enhanced. If that goal is achieved then a designated standard of living can be maintained for a longer period of time specifically if the withdrawal rate of cash flow is not greater than the rate of total return produced by the portfolio.

Portfolio design is a key to making this process work, but for those seeking lifetime income during a 20-40 year period of retirement, thinking beyond conventional wisdom has the ability to enhance this period of one’s life.

Investing involves risk and investors may incur a profit or loss. There are special risks associated with investing in bonds such as interest rate risk, market risk, prepayment risk, credit risk, reinvestment risk, and unique tax consequences.