Retirement Planning, Part 3: Retirement Income from Bond Interest & Dividends

I spoke with a client earlier this week who called to make sure he’s doing everything needed to retire on time.  He was recently surprised to hear that a family member who retired a few years ago needed to go back to work.  My client wanted to make sure he’s on track and saving enough because, rightly so, he said he never wants to be in the position of needing to return to work at some point after retiring.

This client has always been smart with his money and is a good 10 years or so away from retirement.  It’s great that we’re having this conversation now and not the year that he wants to retire (or worse, after he retires!) because the best way to ensure success is to perform your planning years in advance.  I reassured him that he’s in great shape and we had a brief conversation about the process of transitioning into retirement, utilizing one’s assets to generate their retirement income and ultimately what everyone’s goal should be when it comes to retirement.

From a financial perspective, if we look at life like a game, we’ll say that everyone’s ultimate goal should be to win the game which we can define as total financial independence and being able to successfully retire as you wish.  This game of life is all about cash flow.  You have money coming in (income) and money going out (spending).  When you’re young, you work for an income so you have money to spend.  However, once you retire you no longer have employment income so you need to generate income from other places – namely your assets, which are things like stocks, bonds, investment real estate, annuities, and maybe some income on the side from a hobby or part-time work.

In order for you to accumulate these assets, during your working years you need to keep your spending less than your income so you can afford to save and invest.  The equation looks like this:

                Income = Savings + Spending

There’s really nothing else you can do with your money – you either save it or spend it.  In order to win at the game of life you need to reach the point where the annual income from your assets is equal to or greater than your annual spending.  Essentially you can live off of the income and never touch the principal.  This is why you’ve heard a million times before to start saving early.  The earlier you start, the easier it becomes and the earlier you win the game.

Now let’s tie this back to our different sources of retirement income to discuss two of the most common – stock dividends and bond interest.

Dividend paying stocks have become increasingly popular as a source of portfolio income since the Fed lowered interest rates to virtually zero a few years ago.  A dividend is simply part of the company’s profits that they choose to return to shareholders in the form of a cash payment (sometimes extra shares of stock but typically cash) instead of retaining the earnings in the company to reinvest for future growth.  I love dividends as a source of income because they receive a more favorable tax treatment than bond interest and unlike bonds, they’re not fixed income.  As profits grow, companies will correspondingly raise their dividend payout.  This makes for a great way to combat inflation as your annual spending rises.  Typically the biggest concern I hear about investing in stocks is the volatility they bring.  However, if you’ve won at the game of life by living off of the income only, you don’t need to worry about the fluctuations in the stock price!  All you should really care about is the sustainability and future increases of the dividend.  This allows you to ignore the month-to-month and year-to-year fluctuations while enjoying the long-term benefit of compounding growth.

As great as stock dividends are, especially in today’s market environment, retirees also need some money in stable fixed income investments like bonds.  A bond is simply a loan to an entity where you receive interest on the loan and repayment of principal at maturity.  A CD is a loan to a bank, a government bond is a loan to a government, and a corporate bond is a loan to a corporation.  An investor will typically receive fixed interest over the life of the bond which can be a good thing if interest rates fall in the future or a bad thing if rates rise or if inflation picks up.  The interest rate you receive, when compared to similar maturity bonds, will either be lower or higher based on the amount of risk you’re assuming by lending money to a specific entity.  Low quality corporate bonds (a.k.a. high yield bonds) typically pay some of the highest rates, followed by investment grade corporate bonds, government bonds and lastly CD’s since they’re usually insured.  As a side note, it is this author’s opinion that CD’s and US government bonds are a rip-off.  Always have been, always will be.  They simply tell you that they’re safe/guaranteed investments to pay you lower interest each year and then repay you with inflated dollars.  I tend to prefer investment grade corporate bonds as our high quality bonds.  But I digress…

Knowing how much an investor should put in bonds vs. stocks entails many factors and is usually dependent upon and tailored to each specific situation.  The key is to determine how much you should set aside in principal as a stable “reserve” for emergencies, big purchases in the near future above your general lifestyle spending or to have available to purchase stocks if/when they fall to attractive prices.  If someone decides to retire before they win the game of life, which I would say that most people do (winning is the goal, not a necessity to retire), bonds are then used for various strategies to match cash flows with annual spending.  Many of the more common strategies involve segregating your money into “buckets” based on when you’re going to spend it and laddering the maturity of bonds so you have principal being repaid to you every 6 months or every year to use for your spending.

Stock dividends and bond interest are two of the most common sources of retirement income.  I would say this is due to the fact that they’re easily understood, and stocks and bonds have the longest history of investments being available to retail investors.  However, today’s investment world contains numerous sources of income-oriented investments that are readily available to investors.  This is great because it gives investors additional options in which to invest as market conditions change.  The next post in this series will discuss one of my favorite sources of income in today’s low interest rate market that is a great alternative to bonds.

Thanks for following!

-Nick

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