How to live off your money in a low-return world

Retired investors are facing some difficult choices in the financial markets these days. If you are retired, you know you need to take distributions month after month regardless of what’s happening on Wall Street to support your income needs. With interest rates hovering around 2.5 percent, it’s hard to find safe assets that can help meet your lifestyle expenses. So what’s a retired investor to do?

Well, you have to turn to the stock market. It really offers the only opportunity to produce returns above 5 percent, which is what most retired investors need to produce a meaningful distribution and outpace the long-term effects of inflation. But wait, you’ve probably heard the saying that “if you need your money at any time during the next five years, you shouldn’t be in the stock market”.  How do you reconcile these two things? How can you invest in stocks to pay your bills, if you shouldn’t invest in stocks to pay your bills?

The reality is that in most years, stock returns are positive and can serve as a source of distributions for retired investors. The problem is you can’t predict which years will be positive and you also have to accept the risk that stocks can fall significantly at any time.

We just experienced two 50 percent declines in the last 16 years – one in the technology-inspired crash starting in 2000 and the other in 2009 when the banking crisis occurred. The trick is figuring out how to harness the power of good stock market returns to help meet your distribution needs, while protecting yourself from the big declines that could quickly wipe out your investments.

To achieve this goal, you have to build a financial bridge over the stock market crashes. The bridge should allow you to live off other assets and give your stocks time to recover. When you were working, the pay from your job was that bridge. If markets declined, it didn’t matter much because you didn’t need to rely on the stock returns to pay the bills.

Buying bonds is one way to build that bridge. As boring as they are and as little return as they provide today, they can build a critical financial bridge to wait out stock market crashes. If you held high-quality bonds, like U.S. Treasury bonds and investment grade corporate bonds, prior to the financial crisis, you could have turned to them as markets were crashing. Historically, high-quality, shorter-term bonds have been one of the only asset classes that isn’t correlated with big stock market declines. Meaning when stocks zig, bonds tend to zag.

The second thing you can use are stock dividends. Most investors don’t understand that stock dividends often perform differently than stock prices. Although dividends are not required to be paid, even if stock prices are falling, many well-run companies continue to pay dividends to their investors. Those dividends can also be used as a source of “bridge” financing.

Once you build the bridge, you can then more confidently invest in stocks for their potential higher returns and ability to meet your distribution needs. So how long does your financial bridge need to be? Is six months or a year enough? No, the bridge has to be at least five years.

The financial crisis starting in 2008 lasted about four years. And we’ve had other bear markets that have lasted that long and longer, so at a minimum, you should be thinking about a five year bridge.

Let’s look at a simple example. Assume you want to distribute 4 percent of your portfolio value each year, which is a typical benchmark for retirement distributions. Your typical portfolio today that is invested in the general stock and bond markets is probably only producing 2 percent in combined interest and dividends.

If you want to distribute 4 percent a year, then you should anticipate needing to consume about 2 percent to 2.5 percent of bond principal each year to meet your distribution needs. Thus, you should roughly plan on using 10 percent to 15 percent of your bond portfolio to bridge a five-year gap.

Then you need to build some insurance into the plan, in case the decline lasts longer than the previous ones. I’d throw on another 15 percent in bonds for a cushion, otherwise if the decline last five or more years, you’ll have no stable money left. Don’t get too cute with calculating the exact amount in bonds. Financial markets are far too uncertain to allow for precise risk calculations. As the saying goes, you’d rather be roughly correct than precisely wrong.

Moreover, you can also look to the stock side of your portfolio to enhance your bridge. Although the general stock market only produces about 2 percent in dividends today, there are many high-quality companies that pay dividends of 3 percent or more. Additionally, those dividends tend to grow year over year faster than the rate of inflation.  As a retired investor, bumping your dividend cash flow by 1 percent and getting annual dividend increases can make a significant difference in your ability to bridge the next financial crisis.

While reasonable minds can debate the exact strategy for bridging stock market declines when retired, the basic point is you need a strategy you can rely on. Once you’ve got the bridge, you can venture out into stocks. In today’s markets, stocks offer the primary opportunity to generate the returns needed to meet your distributions, but you’ve got to control the risk.