Like 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:
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:
- Burn Rate
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.
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.
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.
Upside – You’ll score much higher returns
Downside – You’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.
Build Passive Income Today
Achieving Financial Independence is all about building enough passive income so you never have to work again.
I highly suggest you read my post: Ranking The Best Passive Income Streams if you really want to retire early or achieve financial independence in your life time.
Here are some other produce recommendations I have to help you boost your wealth.
Stay On Top Of Your Wealth
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About the Author: Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income. He is aggressively investing in real estate crowdfunding to arbitrage low valuations and take advantage of positive demographic trends away from expensive coastal cities.
Updated for 2020 and beyond.