When You Need to Draw from a Portfolio
Preparing your portfolio to cover living expenses is an anxious task. If you are navigating such a transition right now, your discomfort is probably rooted in the unfamiliar feeling of relying on investment income instead of employment income. For many, the former feels less reliable than the latter. Further, today’s low interest environment means today’s retirees sail into their golden years with a lower base level of income per dollar saved than previous generations. How do you gain comfort?
Securities that pay higher income, in the form of dividends or interest, are a popular solution. Here the expected income component of an investment’s return is implicitly elevated in importance over its expected total return (income plus capital gains). We think this can distract from the real issue – what is the right risk tolerance for your portfolio and how can we best design a portfolio to optimize total returns for that level of risk? We hope an extended example will show that it generally does not matter if those optimized returns arrive in the form of income or capital gains. Spending out of dividends or share sales leads to the same end.
Should I Prioritize Income over Capital Gains?
By way of example, let’s compare two strategies that share enough characteristics to reasonably substitute for one another in a portfolio but differ with respect to the level of dividends they pay. The Vanguard Growth ETF (ticker VUG) owns large U.S. growth stocks that tend to reinvest more of their earnings rather than pay them out as dividends. The Vanguard High Dividend Yield ETF (ticker VYM) owns large U.S. stocks that are more value oriented and, as the name suggests, pay higher dividends.
These two strategies can generate different results, but we deliberately selected a long period for this analysis – 2007 to 2016 – over which they are statistically quite similar. Risk was close: VUG had an annualized standard deviation of 16.5% while VYM was at 15.3%. In the worst period for each (the part of the financial crisis that overlaps with our data set), VUG lost 46% while VYM lost 49%. The two ETFs were 88% correlated over the period and generated a total return of 95%. Keel Point portfolios are calibrated to a risk target – for this period either ETF would have contributed about the same risk and total return, thus functioning as near substitutes.
The key difference is how the return was earned. VUG generated about 12% from dividends whereas VYM contributed 29% from dividends. If you were an investor that planned to start drawing from your portfolio at the beginning of 2008, and had the incredible prescience to know that VUG and VYM would effectively be substitutes, which of the following is the better strategy for you: a) hold VYM and spend the higher dividends or b) hold VUG, collect the lower dividend, and sell enough each quarter to match the cash generated by option a)?
If you started with a $1 million VYM portfolio (option a) you would have purchased 19,569 shares on the last day of 2007. We estimate that those shares would have generated $287,000 in dividends for you over the following nine years, or about 3.2% per annum measured against your $1 million cost basis. We imagine that you withdrew all dividends when paid (meaning you didn’t reinvest them). At the end of 2016 your 19,569 shares were worth $1.48 million.
Alternatively, if you started with the same $1 million in VUG (option b) you would have claimed 15,509 shares at the beginning of the period. Those shares would have only generated an estimated $127,000 in dividends across this period, or 1.4% per annum. To have lived like an option a) investor you would have needed to sell some shares every quarter. Figure 1 shows the cumulative dividends for each strategy; option b) investors needed to sell enough to cover the difference between the lines. There are times when sales would have felt just fine (e.g. at the end of 2013 when VUG was up 32%). But there are also times when the sales might have seemed foolish (e.g. at the end of 2008, underwater by 38%).
Had you followed the sales strategy, at the end of the period you would have owned 13,355 shares of VUG, about 86% of the starting balance. But Figure 2 has some good news – those shares were worth enough to make you no better or worse off than the investor who selected option a). The ending market value of your reduced VUG shareholding was the same as that of the untouched option a) VYM shares. The higher price appreciation offset the partial whittling away of your shareholding over the period so that there was ultimately no real economic difference between the two options over this period. The example shows you should be indifferent (on a pre-tax basis) between two strategies with equivalent total return expectations even if they offer a different mix of gains vs. dividends.
For those familiar with stock exchange protocols for dividend paying companies and ETFs this conclusion might have been obvious. When a company pays a dividend, the exchange adjusts the price of its shares down by that amount. For example, a $100 company that pays a $5 dividend adjusts to $95 on the exchange. Seen this way, a dividend is effectively a sale whose timing is dictated by the company rather than the shareholder. If a similar $100 company pays a $2.50 dividend and you sell $2.50 of shares simultaneously you end up in the same place: $95 in securities and $5 in cash.
For those skeptical, the conclusion may have been obvious for a contrived reason. If the example felt cherry-picked to make our equivalence point – of course you should be indifferent between two investments with the same return – your gut is correct. We could have picked a period where VYM outperformed VUG in which case option a) is better. Conversely, periods when VUG outperforms, even with its lower dividend, make option b) better. But we believe this only supports the broad portfolio management point – investments with a higher expected total return, no matter if their income component is higher, improve your outcome.
The reason the option b) sales strategy works is the level of liquidity in the market. Under the same risk and return equivalence assumptions, if you were choosing between two private companies, you prefer the dividend payer because that is the only way you can monetize your investment. If you were choosing between two lightly traded stocks, you probably prefer the dividend payer again, because the spread you pay to sell will eat away at the math here. But in highly liquid situations, there isn’t a clear reason to discriminate. If an investment pays insufficient dividends, you can create your own dividend by going to the market and selling. In fact, taxable investors should prefer this approach as their tax rate on gains is likely less than their rate on income. They are no worse off pre-tax with a sales strategy and get to keep more of the return thanks to the preferential treatment of gains in the U.S. tax code.
Thinking along these lines informed our recent Income model rebalance. We blend our conservative model (75%), which is managed on a total return mandate, with a bond ladder to address near-term cash needs. The ladder owns 5% each in investment grade corporates maturing in 2019, 2020, 2021, and 2022. The remaining 5% is in cash.
This moves the focus of 75% of the portfolio to total return, which allows for a wider universe of investments, and we believe a better chance for success, than allowed under a minimum income constrained process. We recognize that the conservative portfolios’ risk, roughly equivalent to a 35% equity / 65% fixed income blend, may present a drawdown challenge for a typical income investor. The financial crisis dropped such a portfolio about 20% below its peak. For that reason, we think the comfort, and risk reduction, of five years in a corporate bond ladder improves the journey.
The mechanics of drawing for living expenses work as follows. The 5% cash is available for 2019 needs. At the end of 2019, another bond matures, generating cash for 2020’s income requirements. We then rebalance the conservative model and take out enough funds to buy the fifth-year-from-now bond (2023 in this example). Thus, the five-year ladder exists for as long as the conservative model can fund it.
When you make an investment you stake a claim to a future, uncertain cash flow. Some cash flows, like those from a corporate bond, are more certain (less risky), and therefore work well in a ladder to cover near-term needs. Others, like real estate investment trusts (REITs), are riskier but substantially paid out to you. Still others are usually reinvested by the companies earning them (VUG companies for example) and only unlocked when you sell. We think the last two categories are best judged on their total return merits. Even though higher dividend payers may feel more appropriate for retirement needs, in liquid markets there are likely many cases when it is better to have a more broadly diversified portfolio including companies that don’t pay out. Income portfolios should recognize the liquidity advantage, and likely tax advantage, afforded them and focus on total return.□
This material is distributed for informational purposes only.
The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this re-port are obtained from what we believe to be reliable sources including Bloomberg, but their accuracy, completeness or reliability cannot be guaranteed. An index is an unmanaged weighted basket of securities generally representative of a certain market or asset class. An investment cannot be made directly in an index. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. No conclusion should be drawn from any chart, graph or table that such illustration can, in and of itself, predict future outcomes. You may request a free copy of Keel Point’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged.
Past performance is not an indication of future returns.
Securities offered through Keel Point Capital, LLC, Member FINRA and SIPC. Investment Advisory Services are offered by Keel Point, LLC an affiliate of Keel Point Capital. Keel Point does not give tax, accounting, regulatory, or legal advice to its clients. The effectiveness of any of the strategies described will depend on your individual situation and on a number of complex factors. You should consult with your other advisors on the tax, accounting, and legal implications of these proposed strategies before any strategy is implemented.