Income First for Retirement

If you’re like most people, the goal of saving and investing is to eventually create an investment portfolio that can help support your lifestyle in retirement. The Beacon Pointe Income First Retirement Strategy is an investment strategy designed to help individuals live off their wealth for multiple decades, protect their assets, and leave a legacy for what is important to them.

The strategy is called “Income First” because we focus on the production and growth of income. It is not the only thing we focus on, but it’s the primary thing. The interesting thing about income is that if we can generate a meaningful amount of income from various types of investments and that income grows, we also raise the odds that the value of your portfolio will grow.

The combination of income and its growth has many positive characteristics that can be critically important to a more secure retirement. This communication aims to help you understand how these concepts work and help you make a more informed decision about how you’d like to manage your money once you retire.

Why Consider a Different Strategy When You Retire?

When it comes to money management, retirement is not a singular point in time. It’s a process that can last up to 30 or more years. Often, you’ll be investing while retired for as long as you invested before retirement, with a lot more at stake.

Second, the market, unfortunately, does not know that you have retired. It won’t “go easy on you” because you need to live off your portfolio. Market volatility can present significant challenges to your wealth once you start taking distributions.

Consider that the average bear market produces stock market declines of 35%, and in 2008 the stock market was down over 55%. If your wealth is cut in half, it becomes much harder to retire. On average, bear markets occur about every seven years, so you will likely experience multiple bear markets while retired.

If you don’t have a strategy for dealing with them, you may not be able to afford the retirement you hoped for. To help manage these risks, we use our Income First Retirement Strategy. We’ll discuss in more detail how the strategy works. Still, in general, the fundamental goal is to produce a meaningful amount of increasing annual income that can be used to “pay the bills” and then utilize capital gains for discretionary spending.

The exciting thing about income production is that if you can create a growing stream of income, it helps produce capital gains. So, the two concepts are linked and can work well for investors who must live off their money.

To get a sense of how we do this, we need to step back and look at some of the basics of investment returns to help you understand how we build income streams and create opportunities for growth while distributing assets.

Portfolio Returns: Two Parts

When analyzing your investment performance, all portfolio returns are made up of two components: price change + income produced. The combination of these two numbers is your total return. It’s usually reported to you as one number, such as you had a 7% return for the year, for example. But there are two parts…

For instance, let’s say you had a portfolio that appreciated 4% in price for the year and produced 3% income. Your total return would be 7% (4% + 3%). While most investors don’t pay much attention to how they get their total return, we pay great attention to it when clients are living off their money.

At Beacon Pointe, the income part of the return serves as the primary organizing investment principle for our Income First Strategy. Because distributing assets creates unique challenges, we lead with the production and growth of income as the foundation of the strategy.

The income return in a portfolio plays multiple roles. It helps build distributable streams of cash flow for retirement, it helps protect assets, and it helps grow asset values.

We will get into how income contributes to these objectives, but one of the essential things about income is that it can offer you greater control over your ability to build and live off your wealth. And once you realize how important income may be to your ability to live off your portfolio, you’ll see why we believe an income first strategy helps to increase the odds of healthy total returns.

Income is an essential – and sometimes overlooked – feature of investment returns. When you look at the long history of returns in the financial markets, income may well be the most crucial component of long-term wealth accumulation. That sounds odd, and you probably haven’t heard that before, but as we look at the history of both stock and bond market returns later, we think you’ll see why income is so important.

What is an Income Return?

An income return is a cash return separate and distinct from the return associated with a price change in a security. For instance, regardless of whether the security price moves up or down, you receive an income return – a cash payment. Those income returns (or payments) come from both stock dividends and bond interest.

Stock dividends are generally cash payments made by companies to their shareholders. So, for example, if you own one share of stock, and the company pays a $4 dividend per share, you will receive $4 in cash that year as a dividend, regardless of whether the stock price moves up or down.

These dividend payments allow companies to share their profits with their owners. Companies usually pay dividends every three months (quarterly). So, for instance, with a company that pays a $4 dividend per year, you’d receive $1 every three months. So, if you have a portfolio of companies, it generally means you receive some monthly dividends.

The other income component comes from bonds through their interest payments. The income aspects of bonds are relatively straightforward. When an investor buys a new bond, they receive an interest payment comparable to the prevailing interest rates when they invested in the bond.

That interest is paid each year for the bond term, whether the price of the bond moves up or down.

Here is a simple example: You invest $10,000 in a 10-year bond that pays 3% interest. That means you receive $300 a year in interest, and at the end of the ten years, you also receive your $10,000 back when the bond matures. Bond interest is paid every six months. So, in this example, you’d receive a $150 interest payment twice a year.

The investment landscape has also experienced growth in what are called alternative investments. These are generally investments in either stocks (equity) or bonds (debt) of non-publicly traded funds or companies. There is a broad range of alternatives out there, and some can help enhance the goals of retired investors.

For example, some may produce more income than their publicly traded counterparts. The reason is the securities are less easily traded or redeemed. This gives the managers of these funds more flexibility to seek higher income-producing strategies.

Alternative investments can be less volatile because they are not publicly traded and therefore, potentially, not subject to the daily vagaries of short-term traders. The less volatile nature of the holdings helps to maintain a retiree’s principal value during down market cycles.

Balanced Income Approach

The Income First Retirement Strategy is a balanced approach among stocks, bonds, and select alternative investments. Accordingly, we believe in having a meaningful allocation to these three asset classes in portfolios. The balance among stocks, bonds, and alternatives serves to do three primary things.

First, the balance diversifies the income stream. During some market cycles, bonds may provide more income than stocks or alternatives, and in other market cycles, stocks may provide more income than bonds or alternatives. There are many reasons why this may occur, but allocating to these three markets helps capture the varying income levels available.

Second, the balance provides opportunities to reduce volatility in the accounts. Bond prices and alternative holdings tend to be more stable than stock prices, and the balance adds to the defensive characteristics of the strategy.

And third, the cash flow from the income production adds new savings (or capital) into your account pre-retirement, which helps you build wealth; once retired, the income serves as a distributable source of cash flow.

At Beacon Pointe, we seek income production from wherever we think it is most attractive. But, of course, income opportunities change over time as markets change, and it may be beneficial for investors to adjust as well. Sometimes, dividends on large “blue chip” companies offer the best deal. At other times, it’s smaller firms, or maybe some international companies, or alternatives.

At Beacon Pointe, we consider multiple ways to build defense into accounts, yet still position portfolios for long-term solid results.

Defense

In addition to income and growth, our Income First Retirement Strategy is also designed to provide opportunities for defense. We believe defense is integral to an investment strategy for retirement income portfolios. One key to long-term financial success is to attempt to mitigate losses.

Typically, it is pretty easy to recover from slight declines. However, significant declines take a lot more time. For instance, if you lose 10% of your portfolio value, you need about an 11% return to get back to even. On the other hand, if you lose 50%, you need a 100% return, which can take many years to recover.

Thus, the smaller the decline, the higher the odds are that you can restore, grow, and live off your wealth. Therefore, we build defense into our strategy.

The primary way this is done is through the bond allocation. Bonds can provide a healthy defense in bad markets because they are fixed-income securities. The fixed nature of the holdings helps anchor their values, and the income produced from interest can help add to a portfolio’s value during periods of stock price declines.

Alternatives can also add to stability as they generally do not experience the same price volatility as publicly traded investments.

We apply the defense concept to the stocks, as well. In general, the income produced from the dividends helps offset stock pricing declines because cash is added via dividend payments.

At Beacon Pointe, we consider multiple ways to build defense into accounts yet still position portfolios for long-term solid results.

Income as the Building Block

When it comes to investing, we want the value of our portfolios to rise over time. So, if our goal is to have portfolios grow in value, we probably should consider what aspects of investing have been the main drivers of long-term wealth accumulation in the markets. If you ask most people, they are likely to tell you capital gains on stocks, meaning the price appreciation from stocks is what makes the biggest difference in portfolio values. While that seems like it should be true, as stock prices tend to be quite volatile and the thing that most investors follow, we don’t believe it is.

In our view, over the long term, income production from stocks and bonds, and the reinvestment of that income, has been the most significant contributor to wealth accumulation, and by a wide margin. Unfortunately, investors may not necessarily consider this because they associate the volatile short-term returns from capital gains as the primary contributor to wealth. Instead, we believe slower and more consistent income production has led to more wealth accumulation.

Stock Returns

When it comes to investing in stocks, there are two parts to the total return. The first, and most familiar, is the price change. Generally, over the long term, that’s positive, and stock prices go up. But stock prices can be very volatile and swing wildly in periods from a day up to a decade. Stock prices, however, are the thing that most investors focus on, and it’s generally the more headline-grabbing number because they are so volatile.

But stocks also produce an income return in the form of dividends. According to Standard & Poor’s, as of January 2023, over 75% of the companies in the S&P 500 Index pay a dividend, which is very common. Yet, investors don’t always know how much in dividends they receive or how dividends contribute to their returns.

As previously mentioned, when calculating the total return for a stock portfolio, you look at the price change in the securities (which could be positive or negative) and then add in any dividends paid. That’s your total return. For instance (referencing back to our previous example), if the price change was 4% in one calendar year and the dividends paid were 3%, your total return would be 7%.

According to Roger Ibbotson, the long-term total return for the stock market is approximately 10.5% annualized; this covers the period from 1926 through 2021. As mentioned above, that return comes in two parts, the price change in the stocks and the dividends paid by the stocks.

If you look only at price change, the long-term total return is 6.4% annualized. However, when you add the dividends paid and reinvested, the annualized return is boosted to 10.5%. Thus, the income return contributes about 40% to the total annualized return.

What’s more important, however, is that if you compound that growth over the years, the value of the reinvested dividends ends up being the primary driver of long-term wealth accumulation.

For instance, according to Ibbotson, $1 invested in the stock market in 1926 would have grown to about $374 via price increases (capital gains) alone by the end of 2021. But if you include the dividends and reinvest them, that $1 would have grown to about $14,100. When you look at those figures, you’ll notice that over 95% of the wealth creation came from the payment and reinvestment of dividends.

You might wonder how dividends and reinvestment make such a big difference. Well, if the average return is 40% more each year when you include dividends, as you compound that out, the gap between price appreciation and total returns with dividends grows year over year. So, for individuals with long investing time horizons, 35 or so years while working and potentially another 30 or more years when retired, the dividends can make or break one’s ability to accumulate wealth.

That is why our Income First Retirement Strategy stocks are primarily dividend-paying. When constructing our portfolio, we generally seek to invest in two types of dividend companies: those that pay higher dividends but are more mature companies and those that pay a lower dividend but have the potential to grow faster.

We believe our flexibility to invest in both higher dividend payers and faster dividend growth companies provides opportunities for meaningful current income and higher future income. We think a combination helps build a more sustainable and vibrant portfolio. And different market cycles require a different combination of these companies.

Dividend Growth

In addition to paying a current dividend, we want to own companies that we believe have the potential to grow their dividend payments – meaning investors are receiving more cash each year because the dividends paid per share are increasing.

Dividend growth is another aspect of portfolio returns that investors may not consider, yet one that we think is relatively simple and very compelling.

The fundamental theory behind a dividend growth strategy is that a rising dividend income stream will eventually lead to rising stock prices. Consider investing in real estate as an example of the “rising income drives rising prices concept” that may resonate with you. For example, let’s assume you pay $1 million for a commercial building in town, and your neighbor also invests $1 million in another building.

The future value of these buildings for the next buyer comes down to how much rental profit you can generate from each building.

Now, assume that after ten years, your building is generating $100,000 in rental profits, and your neighbor’s is only generating $50,000. Which property do you think would be more valuable to the next buyer? It’s the one that produces more income for that buyer. A buyer wouldn’t pay the same amount for the building that produces only $50,000 of rental income as the one that produces $100,000.

The same concept applies to stocks; generally, the ones that produce more long-term income for their owners become more valuable. And the main way stock investors receive their share of income is through dividend payments.

But what can make this hard to see in stocks is turbulent price movements that overwhelm income returns in the short term. But once you move beyond shorter-term cycles, the value of the stocks will be primarily linked to the amount of income they produce for their owners.

We know from research on the stock market in general, and our research on dividend growth stocks, that there is a high correlation between the growth of the dividend and the growth of a stock’s price.

According to Ned Davis Research, 10- to 12-year cycles, the correlation between dividend growth and stock price appreciation has been approximately 80%, and over 25-year cycles, it’s close to 90%.

That means as the dividend grows, the price grows at roughly a similar pace over the long term. That’s why we focus so much on dividend growth. We believe, if we do that right, we are likely to see the stock’s price appreciate, as well; this is where the control aspect of the portfolio comes into play.

Investors can sometimes feel that the stock market is an uncontrolled, mysterious beast and that they are simply subject to the whims of market returns. But if you link the value of your stocks to the income produced and focus on building that income, you may see long-term price appreciation.

The main reason to invest in dividend-producing stocks is that the dividend helps raise the odds of a favorable long-term total return. It helps provide a solid foundation for valuing the stock, and dividend growth drives future returns. Without a dividend and its growth, the future price for a stock becomes more speculative.

While there can be no guarantees regarding this correlation between dividend increases and price increases in the future, it’s a common-sense approach in many ways.

For example, if you have a stock that produces income, the fact that it pays real cash to investors creates a certain value. And as the income grows over time, that rising cash flow can pull up the stock’s price as investors insist on getting paid more to own a stock that delivers more income.

This all works because companies cannot grow the dividend for extended periods unless their profits are growing. Thus, the dividend is an expression of the company’s long-term growth prospects, and that fundamental business growth increases the value of the business.

Moreover, once retired, we can distribute those dividends and growing dividends to help pay your bills. So, you can see how stock income production can play a significant role in retirement income portfolios.

Bond Returns

In one way, bond returns are more straightforward to understand than stock returns. When an investor buys a new bond, the investor is generally paid an interest rate for the bond term, and then upon maturity, the investor receives their money back.

At that point, the investor has another opportunity to invest in a new bond at the prevailing interest rate. The bond is more secure because you have a guaranteed interest payment every year and a guaranteed return of your principal at the end of the bond, provided that the issuing company doesn’t default on its payments. They are called “fixed income” investments because the bond contract fixes the terms.

But what can make bonds hard to understand is that bonds can be traded in the financial markets. When they are traded, the prices are constantly changing to adjust to changes in interest rates. As rates change in the markets daily, the bond values change to adjust each bond to the current rate. This doesn’t impact you much if you intend to buy and hold bonds to maturity and invest passively, meaning you aren’t trying to trade bonds based on price movements.

While bond prices can move around daily to adjust to interest rate changes, over the long term, the main driver of returns from the bond market is the interest (or income) payment. Again, according to Roger Ibbotson, from 1926 through 2021, for intermediate-term government bonds, the total annualized return is 5% per year, and only 0.6% of that comes from any price change in bond values. As with stocks, income (and the reinvestment of that income) is the primary driver of long-term wealth accumulation for bonds, and the short-term price changes are mostly noise.

Income as a Wealth Builder

So, you can see from the historical data on the stock and bond markets that income – in the form of dividends and interest – and the reinvestment of that income, has been the primary driver of long-term wealth accumulation.

While there can be no guarantees that this will occur in the future, it’s important to consider what aspects of investment returns have helped investors build wealth over the decades, from the boom years to the bust years.

Thus, if you have a balanced portfolio and dividends are the primary driver of wealth in stocks and interest payments in bonds, wouldn’t it make sense to organize your portfolio around those income features –meaning that you focus on producing, growing, and reinvesting income? It makes sense to us and is why Beacon Pointe uses income as the primary building block of our Income First Retirement Strategy.

That means that since income is the foundation of our strategy, we primarily evaluate securities for their ability to produce, maintain, and, in terms of stocks, potentially grow their income. We believe that if we can produce and grow a meaningful income stream, we’ll also experience healthy total returns through income production, reinvestment, and price appreciation.

Consistency of Returns

One aspect of living off your wealth that investors may not generally understand is the value of consistent returns.

Because individual investors generally take money out of portfolios during their retirement years, the consistency of their portfolio returns can have a major impact on their ability to live off their wealth.

The benefits of “consistency” may not be well understood because of the way portfolio returns are calculated.

For example, mutual fund and index returns (like the S&P 500) are reported without the impact of when investor money goes into or out of the investment (i.e., “time-weighted return”).

If returns were consistent, the timing of money going in or out of a portfolio wouldn’t impact investor wealth as much. But because returns are volatile, the timing of investor distributions combined with market volatility can have a huge impact on your actual wealth.

Here is a simple example: Between 2000 and the end of 2019, the total return for the S&P 500 Index was about 6.1% annualized, according to Ibbotson. Now assume that you retired in 2000 and wanted to withdraw 4% of your portfolio every year adjusted for inflation of 2% per year. Well, since the returns were 6.1%, you’ve got a 1.6% cushion.

But the market did not return 6.1% each year. Instead, it had two major crashes and a couple of considerable recoveries. What the annualized return actually measured was how $1 performed when invested from January 1, 2000 to December 31, 2019. It doesn’t tell you anything about the path the $1 took over those 20 years, so let’s take a look at that…

To simplify the math, we’ll assume you had a $1 million portfolio on January 1, 2000. If you were retired and taking money out, your account would have been severely impacted by the timing of your distributions.

Because there were two stock market crashes between 2000 and 2010, the distributions compounded the losses. By the end of 2019, you would have only had about $455,000 left. Thus, even though your annualized return of 6.1% was higher than your 4% distribution, you would have lost over half of your wealth.

Now, if you had earned 6.1% consistently each year, you’d have ended up with about $1,423,000 during those 20 years. That’s almost three times more wealth than the volatile cycle. So, you can see how consistency can make a big difference.

The point is that when analyzing returns, it is not just the annualized total return that matters. It’s the path that total return took. The more volatile, the higher the odds you’ll risk depleting your portfolio when taking distributions.

Again, the total return doesn’t tell the entire story. When you are removing money, as most investors are every year once retired, the consistency of the returns can impact your wealth just as much.

Since we do not know what the future holds in terms of returns, all else being equal, we believe investors would be better off focusing on smoother, more controlled returns if they want to raise the odds that they can live off their money for several decades.

The reasons that dividends help with this process is that they tend to be relatively consistent from year to year and are always a positive return. Most of the volatility you see in stock market returns is from price movements, not the stream of dividend payments.

Dividends are paid by company management and tend to be rationally based on company profits. That’s why they are much less volatile than stock prices, which are set by traders in the markets daily. Thus, we believe investors can rely on dividend payments far more than they can on the speculative short-term price movements of stocks to meet distributions.

It is important to understand that dividends can operate independently of price movements in the short term. For example, market prices can go down for several reasons, but dividends can continue to be paid and even increase. This was the case for many companies during the 2008 financial crisis.

Even though stock prices fell because investors reacted to the banking crisis, many companies continued to pay and raise dividends because they were performing well financially.

Low Turnover and Strategic Liquidations

Our Income First Retirement Strategy is generally a low turnover approach. Our goal is to buy and hold securities for the long term and reduce the impact of capital gains taxes on accounts. While we do make periodic changes, we do them after careful consideration with an eye toward our long-term goals. Tax management is essential to long-term returns because the less you pay in taxes, the more you have available for distributions.

But because retired investors are distributing money to support their lifestyles, there are times when markets may provide significant returns, and we decide to recognize and “bank” some of those gains for future distributions. As you know, market gains can disappear quickly when investor sentiment changes. Strategically liquidating and re-balancing holdings in anticipation of future distribution needs is another unique feature of our strategy. If you wait and only liquidate when funds are needed each month, you may find gains you had last year are no longer available.

Summary

Our Income First Retirement Strategy is designed to raise the odds that you can comfortably live off your money for multiple decades while still growing principal, protecting your assets, and leaving a legacy for what’s important to you.

As a private wealth manager, we work directly with our clients on the construction of their portfolios; additionally, we have the flexibility to adjust to changing markets and the changing needs of our clients. While the Income First Retirement Strategy provides the framework for managing the assets, we can adjust for individual client objectives and risk profiles. We’d be happy to discuss our strategy and service model with you in person.

Download our Income First Retirement Strategy Brochure

Interested in learning more about our Income First Retirement Strategy?

Connect with our advisory team to learn more about how this investment approach may be a good fit for your retirement goals.

***
Because all investing involves risks, please carefully read all Disclosures and Disclaimers.

*Disclosures and Disclaimers:
The Income First Retirement Strategy is a balanced strategy that consists of a list of equity, fixed income, and alternative securities. Securities for the Strategy are selected at the discretion of Beacon Pointe and are subject to change at any time. Past performance is no guarantee of future returns. Investing involves multiple risks, including but not limited to the potential for the permanent loss of principal. Stock dividends are not required to be paid and may be reduced or eliminated at any time at the discretion of company management. The Income First research material is for informational and educational purposes only and does not serve as a recommendation. Consult your individual financial advisor for guidance specific to your situation before making any financial decisions.

Investors cannot invest directly in an investment strategy or an index, and the Beacon Pointe strategy does not represent an actual security. Investment strategies and indices do not reflect investment management, trade, transaction, tax, and other costs of actual portfolios, and such costs would reduce a portfolio’s return. Beacon Pointe portfolios may or may not hold the securities in the Income First Strategy, and portfolios may not follow the Strategy, depending on client directives.

There can be no assurances that attempting to follow the Income First Retirement Strategy in an investment portfolio would produce returns that are sustainable for retired investors or provide investors with better protection against investment losses. Moreover, there can be no assurance that any distribution rate from a portfolio is sustainable. Distributions materially increase the risk of portfolio depletion.

Equity or bond statistics mentioned herein are estimates and obtained from sources we deem reliable. Any current yield data for the Beacon Pointe Income First Strategy are estimates and are developed from internal Beacon Pointe reports. We deem the data to be accurate, but errors in data transmission, downloads, and interpretation can and do occur. We can thus make no representation as to the accuracy of the data.

1Ned Davis Research researched the correlation between dividend growth and stock price appreciation at the request of Beacon Pointe. The research covered approximately 35 years, starting in 1980 and ending on 01/31/2015. Dividend growth companies consisted of those that had paid and raised dividends in 6 out of the last 7 years, had a yield of at least 75% of the S&P 500 dividend yield but no more than 350%; and were equally weighted with no dividend reinvestment. Data from such research is available upon request.

References to the Standard & Poor’s 500 Index are for education purposes only. Data for the S&P 500 Index and the intermediate-term government bond market were obtained from sources we deem to be reliable, such as the 2021 SBBI Yearbook, Stocks, Bonds Bills, and Inflation, Roger G. Ibbotson. Still, errors in data transmission, downloads, and interpretation can and do occur, and we can thus not represent the data’s accuracy. The S&P 500 Index is a list of 500 of the largest U.S. publicly traded companies. The index is maintained by Standard & Poor’s, and you cannot invest in an index. Index returns do not include any trade, transaction, tax, management, or other costs associated with portfolios. Past performance is no guarantee of future returns.

The time-weighted return formula generally seeks to neutralize the impact of cash flows into or out of portfolios. To assess the impact of cash flows, one would need to run a money-weighted return or what is also called an internal rate of return. There are multiple formulas for running portfolio returns, and each can produce different results on portfolio performance. Therefore, it is prudent to view both time-weighted and money-weighted return concepts and their various formulas when assessing the appropriateness of any portfolio strategy or historical returns.

Copyright © 2024 Beacon Pointe Advisors, LLC®. No part of this document may be reproduced.