Retirees, here is an example of converting capital gains to an income stream

This will save you the headache of chasing dangerous products that have high dividend yields

I have written a number of articles on why it is important to focus on total return instead of just looking at dividend yield of an investment. I even did a video on this. In this article, I want to provide an example of why total return approach is important for a retiree. It is a practical example because the example can be done in real life. This article is also suitable for non-retirees because I will touch on the impact of dividends reinvestment.

Retirees need constant streams of passive income to meet their expenses. Passive income can come in various forms such as:

1. Property rental;
2. Annuity like CPF Life;
3. Pension from previous companies they worked for (not applicable for most Singapore residents); and
4. Investment income.

I want to focus on the 4^th point – investment income.

Most retirees thought that investment income means collecting dividends and coupons from bonds. As a result, they would focus on instruments that pay out dividends. For aggressive retirees, they look at REITs and stocks. For conservative retirees, they would look at anticipated endowments and annuities. In either case, they just look at the dividends or coupons from the products. I would like to advocate a total return approach.

I use an example product – a unit trust which is a balance fund investing in Asia. Due to compliance restrictions, I cannot disclose the actual name of the unit trust as that would be perceive I am recommending the product without needs analysis (on the other hand, many self-professed gurus bloggers and seminar trainers can say anything they like including misleading and false advertising because they are not subject to any form of regulatory oversight since they are unregulated persons. It also means they take no responsibilities in what they say as the objective is to generate traffic for google ads and making money from investment course fees).

The data I use is from 31 July 2003 (around the time the fund was launched) until 31 March 2014. Assuming an initial investment of $1,000,000, the dividend yield was around 3% throughout the period. Dividend yield is defined as annual dividend collected divided by the market value. Note that it is not divided by the cost price. Those who are crazy over dividend yields would find this dividend yield of 3% to be too low. So they will ignore such investments.

Scenario 1: Over the period, the total dividends collected were $454,241.  At the end of 31 March 2014, the value of the fund was $1,503,665. In other words, the price appreciation was $503,665.

Scenario 2: If the dividends were reinvested (without cost which is possible) instead of consumed, the value of the fund would be $2,094,711. In other words, the profit would be $1,094,711.

If you look at the figure closely, under Scenario 1 the total profit was $454,241 (dividends collected) + $503,665 (capital appreciation) = $957,906.  Under Scenario 2, the profit was $1,094,711. The difference between Scenario 1 and 2 = 1094711-957906 = $136,805.  This is what we called reinvestment income which in this example consists of a whopping 12.5% of the total return (see table below). Reinvestment income is only available for those who reinvest their dividends. If all the dividends are consumed (i.e. not invested), the reinvestment income is not available.

The line labelled as ‘A’ assumes all dividends are reinvested at no cost. The line labelled as ‘B’ assumes all dividends are spent. Click to enlarge image.

Here are 3 lessons:

1. Retirees will have a lower total returns of their investments compared to another person investing in exactly the same instrument but reinvest the dividends. This is due to the loss of reinvestment income available only for those who reinvest the dividends.  I always tell my retiree clients not to expect high returns from their investments even if they are super aggressive investors. Very often, I found they actually cannot retire due to them overestimating their investment returns. Since they only come to meet me when they just retired, it is often a sad case that it was too late for them to do anything since they could only live once. The standard advice I gave them is to look for a job and don’t ever retiree. The retirement age for them is not applicable anymore. That is why I always advocate that retirement planning is only applicable for those who are young as time is their friend.
2. Young adults who are working should ensure any dividends are reinvested because they do not need these dividends. They should not be solely looking at dividends. When dividends are reinvested, they will benefit from the reinvestment income.  In fact, I did a video on Why high dividend yield stocks are not suitable for young investors. Do check out the link.
3. For both retirees and young working adults, never ignore the capital price appreciation. In other words, they should look at both dividends and capital appreciation (i.e. total return approach).

Problem with total return approach

One of the common objections of total return approach for a retiree is how to generate a sufficient income stream if the dividend yield is too low. In the above example, 3% dividend yield is too low for most retirees to meet their personal expenditure. The good news is that in today’s technology, it is possible to convert capital into a stream of income so that it looks like ‘dividends payout’. Such a technology is already available for many years and does not even cost a single cent to implement it.  The reason why this is not popular is due to lack of awareness. Of course, nobody will invest $1 million into a single fund but to a diversified portfolio of funds. Nevertheless, the technology is able to support converting a portfolio of funds into income stream. How does it work?

There are two ways which a portfolio of funds can be converted to an income stream. One method is based on generating an income based on a fixed dollar. Another method is based on a variable method.

How to generate a fixed dollar method income stream?

Back to the $1 million investment example. Let’s say the retiree wants to get $50,000 of annual income from it to meet his expenditure. This is equivalent to 5% pa of the initial investment or $4167 monthly. This can be done automatically without human intervention once the standing order is done. The following is the chart showing the illustration of the value of the fund over the period when $4167 was withdrawn every month. Since the dividends on most years were less than $50,000, it implies there was capital liquidation.

The value of the fund based on fixed dollar withdrawal of $4167 a month. Click to enlarge image.

Advantage of fixed income stream method:

• Fixed dollar means easy for budgeting. No month to month surprises.
• Full automation through computerization. No need to decide how much capital to sell. The system decides the amount of capital to sell based on the dividends received (which can be different from month to month).

Disadvantage of fixed income stream method:

• No inflation adjustment. Still need to amend standing order (say every few years) to adjust the income stream in line with inflation.
• During the bear market, more units will be sold in order to achieve the same monthly income stream. In other words, the capital will depreciate faster during the bear market.

How to generate an income stream based the variable method?

This would mean that the income stream is based on the percentage of the portfolio at the point of liquidation. This method cannot be automated and so will involve a manual sell transaction. Fortunately in the age of technology, this can be done online. The following chart is an example of the retiree liquidating 5% of the market value of the fund at the end of every year. Any dividend declared during the year is automatically reinvested.

Value of the fund when 5% of the market value at the end of every year is liquidated to meet the retiree’s expenditure. Dividends were reinvested during the year. Click to enlarge the image.

Advantage of the variable method:

• Receive a higher income stream when market is good (bull market).
• Avoid selling large number of units of the fund when market turns bad.
• Potentially inflation adjusted income stream assuming the fund appreciates in value over the long-run.

Disadvantage of the variable method:

• Volatile income stream as it depends on the market performance during the year. Difficult to budget. Sudden reduction in payout when market crash.
• As it involves a manual sell at the end of the year, it is doomed to failure. By my experience, anything that requires human intervention will fail. Likely the retiree will take a look at the portfolio at the end of the year and start to do something funny like investing in the favour of the month or try gambling at the IR. If the market is in the bear market, the retiree may just sell 100% of the fund (instead of 5%) because he panics. Remember, investors always buy high and sell low regardless of asset classes.

Given a portfolio, how to automatically sell to create an income stream?

At this point, you probably realized that the recommended income stream method is the fixed dollar method because it is largely automated.

Nobody would invest all their money into a single fund. Very often it is a combination of diversified funds. There are three selling algorithms available:

1. The automated liquidation is based on the fund that has the lowest volatility. The rationale of this method is regular liquidation of the high volatility fund tends to increase the failure rate. See this related article: Improving the success rate of the retirement portfolio (link available from 13 May 2014 and after). Failure means the entire portfolio becomes zero before the retiree is called home to paradise.
2. The automated liquidation is based on the fund that has the highest return. The rationale is ‘sell high’.
3. The third option is to explicitly select the funds to liquidate and the amount required.

In real life, all three methods mentioned above have their purposes. However, the optimum selling algorithm depends on the asset allocation methodology which calls for another article for another day.

Conclusions

1. Retirees will have a lower total returns of their investments compared to another person investing in exactly the same instrument but with dividends reinvested. This fact cannot be change.
2. Young adults who are working should ensure any dividends are reinvested because they do not need these dividends.
3. For both retirees and young working adults, never ignore capital price appreciation.
4. Technology allows a portfolio to be converted into an income stream either using fixed dollar approach or variable income approach.
5. Three selling algorithms are to be chosen depending on the asset allocation methodology.

You can also view a video from Vanguard which basically speaks of similar strategy. However, Vanguard do have a modified approach which they mentioned at the end of the video:

See this link for our Passive Income Planning for Retirees service.

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