Ways To Add More Income To A Retirement Portfolio

More Income In RetirementLike chasing the fountain of youth, nearly every retiree seems to be searching for the answer to one question:

“How do I add more income to my portfolio?”

We all want the perfect income-popping strategy, don’t we? Maybe in this case we’re looking for that fabled money tree, or the fountain of cash my kids tell me must be attached to my wallet.

Here’s the wrong approach. I call it “Single Product-Based Strategies”

When people talk about adding income to their portfolio (especially with brokers), salespeople naturally turn toward products, bringing you a dog and pony show about “THIS product that would boost your income stream the most!”

This discussion ends nowhere good, and could easily wreak havoc on your portfolio. Take a look:

Income Portfolio Styles Chart

Here’s the problem: the “which single product is best” approach most often leads to a single asset-heavy portfolio. Under the wrong conditions (like a bad year for the market or for your budget) this mistake sinks your retirement income strategy. If you buy stocks, you don’t want to have to touch them when the market tumbles (and it will).

If you buy real estate you don’t want to be stuck waiting for your property to sell. If you buy bonds you don’t want to harvest them three days before the ex-dividend day to make a house payment.

If you’re worried about income, you want a machine that’ll weather storms, not one that’s built on a single investment type. Let’s get building.

The Fundamentals Of Building An Income-Producing Portfolio

Start With Your Income Need….Can You Really Cover It?

Three big factors you’ll have to consider:

  • Inflation
  • Taxes
  • Burn Rate

Inflation

The problem: If you create a portfolio which cranks out four or even five percent per year in dividends, you’ll lose purchasing power without committing some of this money to growth.

Sure, you’ve heard of inflation, but I find it’s missing from many well-meaning financial plans. Just because you need $3,000 per month to live now doesn’t mean that’s what you’ll need in 15 years. As the price of bread rises, so should the asset mountain that cranks out that income stream.

You may have seen people who retire at amazingly young ages on the internet. They’ve retired at age 30 have often built an income stream for today, but could find themselves struggling later to keep up with increasing costs. Inflation is the number one problem with strategies that try to create an asset base big enough to secure enough money in dividends so you can retire….and stay retired.

The solution: Your portfolio needs income for today but may need to grow to keep up with rising costs. Move enough of your portfolio into growth investments to counteract the effects of inflation down the road.

Taxes

The problem: Have you taken taxes out of the equation before calculating your income needs? If not, you might be counting money that isn’t going to be yours.

Here’s a common scenario: you’re planning your income stream and hoping for $5,000 per month, most of it in an IRA. If you’re in the 25 percent tax bracket, that means you’ll lose between 10 – 15 percent of this money to taxes as you withdraw cash to live on. If your cash isn’t in an IRA or another tax shelter, you’ll lose even more along the way. Top financial advisor and radio host Ric Edelman talked about this on our podcast recently.

Likewise, dividends are also taxable, as is income from annuities. While municipal bond income streams aren’t taxable, they provide low returns and dividends are included in your modified adjusted gross income. That doesn’t seem like a big deal until you realize that your MAGI is used to compute the percentage of Social Security benefits which will be subject to taxation. Ouch.

The solution: Plan on enough extra income to withhold taxes. Invest some money into Roth IRA plans, if possible. While you’ll still pay taxes today, growth in the plan will accumulate tax free. Once the money is in a Roth IRA, focus on growth oriented investments to provide income you’ll lose to Uncle Sam.

Burn Rate

The problem: You might need this income stream to last longer and grow larger than you’d originally imagined.

Burn rate is the calculation that my friends in start up businesses use to determine how long their funding will last. In financial planning circles people use burn rate to make sure that they personally expire before their mountain of money does. What’s the goal when calculating burn rate? You want to know what return on investment you’ll need to counteract that burn. For example, if you’re going to spend 6 percent of your portfolio, you may need a 9% return on investments to replace that money AND still have enough to last your entire life. Don’t make the mistake of forgetting inflation and taxes….that’s why you can’t spend all the money you earn and expect to have your money last forever.

Unless your goal is to pass money to beneficiaries, many people make an assumption that costs them to save a ton of money that they won’t need. They assume they’ll never touch the principle in their money mountain, and only live on the income it throws off.

You can imagine the toll inflation and taxes play on your income stream. You’ll have to save tons of money if your goal is to never touch principal.

The solution: Create a controlled burn of your investment mountain. This way, you won’t have to worry about finding huge dividend-producing investments, and can instead focus on a much more attractive strategy: staying alive by growing your portfolio.

The Bucket Strategy – An Income-Popping Solution

Many pros use a tool called a “bucket” strategy to help people envision how to have more money for retirement. While tax ramification bucket strategies are a step in the right direction, you may want to go further and also think about when you’ll need each dollar.

Why? Experts say that more aggressive investments historically have safely earned higher returns over long periods. To ensure you squeeze as much growth as possible from your investments without increasing risk, we’ll start by examining when you’ll need each dollar. That’s why we calculate your burn rate.

Money you’ll “burn” during the next few years you should leave in safe havens, such as cash equivalents. While this money earns very little, it’ll allow you to safely invest the remainder of your portfolio into growth oriented investments, rather than settling for muddy 4 or 5 percent returns. This money allows you to invest your second “bucket” for intermediate years into income-producing, low risk securities (most bonds and the lowest-of-the-low risk stocks fall into this category). While these fluctuate more than cash, remember that these dollars are protected by the money in your short term “bucket.” You’ll be able to watch them grow without worry that you might have to tap into them while they’re down.

Invest the remainder of your portfolio—those dollars that you won’t need for several years, into more growth-oriented funds. These dollars are protected by both the cash assets in your short term “bucket” and also the intermediate fund “bucket.” It’s as if you have two walls of money around your more volatile investments.

The Securities and Exchange Commission says, “Stocks offer the greatest potential for growth over the long haul.” This strategy allows you to stay in parts of the market that are likely to appreciate while avoiding the risk of relying on a single investment type or having to harvest your stock portfolio while there’s market turmoil. Real estate is another excellent long term investment. Whatever you do, don’t rely on just a single type. By diversifying your funds, you’ll reduce your risk while increasing your chances for steady returns.

Worried about fluctuation still? Try this: compare the standard deviation of investments in your portfolio. This metric measures how much types of investments have historically swung from their average return. Keep the lowest standard deviation investments in your second bucket, while higher standard deviation investments should go in your third (long term) bucket.As you spend money, replenish the dollars used from cash from the intermediate “bucket” and likewise replace intermediate funds with harvested long term dollars.

UpsideYou’ll score much higher returns

DownsideYou’re subject to the whims of long term stock and real estate markets

The best news is that your downside is protected by the “bucket” strategy.

This doesn’t mean you shouldn’t consider or use income-producing investments. Traditional investments such as REITs or rental real estate, high yield bonds, or dividend paying stocks can be an important part of a well-diversified income portfolio.

While most people settle for lower returns from income portfolios, you’ll do well to examine growth investments also and their place in your portfolio. By using a more diversified approach and remembering that you’ll need far greater sums in the future than you need now (if only to maintain your current lifestyle), you’ll keep some assets in a growth position to create even bigger future income streams.

INVESTMENT PLATFORM RECOMMENDATION

Invest In Ideas Not Stocks: Motif Investing is a terrific company based right here in the San Francisco Bay Area. They’ve raised over $60 million dollars from smart investors such as JP Morgan and Goldman Sachs because they are innovating the investment landscape with their “motifs.” A motif is a basket of 30 stocks you can invest in, which are aimed to profit from a specific idea or underlying theme. Let’s say you think new housing construction is going to quicken in the US next year. You could buy a housing motif which might contains Lennar, KBH, Home Depot, Bed, Bath, and Beyond, Zillow, and more in various weightings.

You can buy a basket of 30 stocks for only $9.95, instead of buying them individually for $7.95 through a typical broker. You can build your own motif, buy one of the motifs created by Motif Investing, or buy a motif by a fellow Motif Investor with a great track record. You can even buy retirement motifs, much like target date funds, except you don’t have to pay the 1% management fee. You get up to $150 free when you start trading with Motif Investing. Given my focus on buying winning long-term ideas and ignoring the short-term volatility, I really like Motif Investing’s value proposition for retail investors.

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When Joe Saul-Sehy isn’t asking Sam to let him guest post here at Financial Samurai, he’s co-hosting the laid back financial podcast Stacking Benjamins.

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. nbsdmp says

    I’m probably in the camp of savers who are overestimating the amount that they will truly need. I’m of the Don’t Touch The Principle philosophy, but I’m starting to wonder if that is the best plan. Frustrating to read about charities that are crooked or are completely inefficient at using the money for the true purpose, better to give the money away personally as you see fit to who you see fit. Sorry…a little off topic, I’m definitely a bucket strategy guy here.

    • says

      One of my biggest findings in early retirement was this: You need much less than you think. You’ll find many ways to save money, and you’ll see so many cheaper entertainment and food options once you get to spend the weekdays doing your own thing.

      But, it’s better to overestimate how much you need than underestimate!

      • nbsdmp says

        Sam, I completely agree about spending your money wiser and finding better deals when you have your time to yourself to find them. I’m totally guilty of doing the easy thing and spending more money than I should on stuff because I still have a strong income stream.

        What areas did you find that you saved them most on compared to what you expected? Travel? Entertainment? General stuff?

  2. Austin says

    I like the buckets. Great way to diversify risk.

    I don’t see why more people don’t set up a long-short and then sell calls against their long. Seems like a pretty easy way to average a 5-10% return annually.

  3. getagrip says

    I’ve always been of the opinion that if my spouse and I die early, than the heirs get lots of money. If we die later, they shouldn’t need our money for their retirement. So I have no problem hitting the principal since it does make a huge difference in what you have to save.
    If you need $40K a year and want to reduce the probability of hitting principal with the 4% withdrawl strategy, you need $1M. If you figure on drawing it down to zero over 30 years, you need about $730K. That’s a good sized difference. If you’re still worried about heirs, I’d rather put $5K a year for ten years into my adult kids Roth IRA while they’re still young and I’m still working and telling them that’s their inheritance than have them waiting for me to hurry up and croak in my 80’s so they can retire on my money.

    • says

      Love that idea. I’ve never understood people who wanted children to have money “after they die.” If you have enough why not watch them enjoy it? If not, send it my way and watch me enjoy it! Ha!

  4. says

    I’ll have to pick your brain sometime, Joe, about our retire by forty plans…

    We’re putting most of our money into index stocks and, more recently, rental real estate. I’m hoping they’ll be our workhorses, while the small percent we have in bonds (25%) is sufficient stability.

    The problem I don’t know how to solve is whether to treat myself like a 33 year old (and keep a low allocation of bonds), or, since we’re trying to retire in the next 7 years, if I should have an asset allocation of a 58 year old…

    • says

      My thought? Treat yourself like a 33 year old. Use the last dollars you save as that “first bucket” so you can continue to reap the long term rewards that come with being young. You won’t get that chance again later.

  5. getagrip says

    I also like the buckets idea. I think a 5-7 year of expenses in cash and short term ladders should take you through most market downs and is fairly conservative. The longer you go without refilling the bucket because the market is not recovering, the tighter you should be pulling your belt to give your investments time to recover.

  6. says

    Diversify your investments so you have some armor when the markets or life happens. Inflation, taxes, and running out of money all need to be factored in, great advice on the “solutions” you mentioned.

  7. Bill says

    Sam, I’ve been following your website for some time now. Your articles and experiences have given me the courage to do a trial early retirement. Im 43. I’m three weeks into my month long trial. In these 3 short weeks I’ve learned a lot. First, I don’t need nearly as much money as I thought. I find myself questioning even the smallest of purchases. Secondly, I miss my usual routine. My friends are all working during the day, and even though my wife and I have a great relationship we are getting a little tired of being together 24/7.

    My goal has always been to retire early so I’m going to compromise with myself. I plan on going back to work 3 days a week instead of my normal 5. Your articles have been truly life changing for me. For that I’m truly grateful!

  8. Lin says

    Hi Sam,
    Is your place at squaw creek resort Tahoe available to rent from 8/4-8/9? I saw an article long time ago you advertising your place. If so, please private message me. I don’t know how to contact you other than posting a comment. Great blog!

  9. says

    Joe,

    I know we are in a low interest environment but where do you see SPIAs and their newish cousins Deferred Income Annuities playing into this? There are other cultures who love the SPIA (one example I wrote about was the Chileans where 60%+ of retirees buy one) but in the US they are shunned upon.

    It seems that for most retirees it should be at least considered for one of the buckets, no?

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