The research on the optimal strategy to generate retirement income from a portfolio has been evolving for decades.
In the 1950s and 1960s, with the initial rise of a portfolio-based retirement, the leading strategy was simply to buy bonds and spend the interest (by literally “clipping the coupons” from the bearer bonds of the time). Until the inflation of the 1970s ravaged the purchasing power of bond interest.
The harsh consequences of inflation on bond portfolios led to a dramatic shift by the 1980s, as retirees increasingly purchased high-quality dividend-paying stocks instead, counting on the ability of businesses to raise prices and keep pace with inflation… which also helps their dividends to rise and keep pace with inflation as well.
The dividend strategy was popular until eventually retirees realized that owning stocks and focusing on the dividends, while ignoring the capital gains, just leads to large retirement account balances that could have been spent along the way. As a result, by the 1990s, retirement portfolio strategies shifted again, to consider a more holistic “total return” approach that incorporates interest, dividends, and capital gains as well.
Unfortunately, though, capital gains may be one of the largest drivers of total return in the long run, but it’s also one of the least stable, forcing the retiree to periodically rely on the portfolio principal as well. Of course, in the end, retirement principal that is unspent is arguably a wasted spending opportunity – where the “optimal” retirement portfolio is for the last check to the undertaker to bounce. On the other hand, given the uncertainty of a retiree’s time horizon – not knowing when you’re going to die – means in practice, the principal can and should be used more dynamically, spending from it in some years but leaving it untouched in others.
Which means ultimately, the modern retirement portfolio will really rely on four pillars for retirement income – interest, dividends, capital gains, and principal. Or stated more accurately, the four pillars of retirement cash flows – since the treatment of the pillars as “income” for tax purposes can vary depending on both the pillar itself (interest is taxable and principal liquidations are not), and the varying types of retirement accounts (from pre-tax IRAs to tax-free Roth accounts).
Nonetheless, the fundamental point is simply to recognize that a retirement portfolio has multiple ways to generate the desired cash flows for retirement. And in fact, in a low yield environment, it can be especially important to diversify across all four pillars – or retirees take on additional risks in stretching for yield, from interest rate and default risk (from longer-term or lower-quality bonds), to the concentration risks of buying just a subset of the highest dividend-paying sectors (which, as the financial crisis showed, can expose the portfolio to severe risk along the way!).