Last week somebody asked me the question that most conversations about living off savings start with: How do we get the portfolio to pay us an income without touching the principal? It usually shows up right when a paycheck is ending, which is exactly when it feels most urgent.
I understand the instinct. For decades the rule was simple. You earned it, you saved some of it, and you never dipped into the pile. Then one day the job is to do the opposite, and nobody hands you a new set of rules.
So people go looking for yield. If the interest and the dividends cover the bills, the thinking goes, the principal stays whole and everything’s fine. It’s a tidy picture, and I’d gently suggest it leaves out a big part of what your money does.
It’s helpful to envision a different world. A diversified portfolio can earn its keep in two ways. Some of it shows up as interest and dividends, and some of it shows up as growth in the value of the principal (what you own). Both are returns your money produced. Put together, they’re called total return.
Once you see it that way, selling a little of something that has increased in value looks different. It can feel like raiding the principal, but most of the time you’re collecting part of what the portfolio produced, and as such it’s okay to do it. The line between income and principal matters a lot less than whether the total return can keep supporting you.
Chasing yield has a cost of its own. A portfolio built around whatever pays the most today can leave very little room for growth. In practical terms, it comes down to the balance between growth and interest/dividends. The questions are (1) how much risk you can handle emotionally, and (2) how much avoidance of risk you can afford financially. Retirement can last a long time, and a portfolio that never grows has a hard job.
Now for the catch. Markets don’t cooperate on a schedule. Perversely, things sometimes do well when it seems like they shouldn’t, and do poorly when it seems like they should. And if your property tax bill lands in a month when the stock market is down, you don’t want to be selling stocks at a loss just because that bill arrived during that period.
That’s what cash is for. Cash includes CDs, savings account and money market mutual funds, and it’s a good place for money you know you’re going to spend within the next year. When that money is sitting in cash or a money market fund, a rough stretch in the market becomes something you can watch with equanimity, and you’re not forced to sell at a loss.
The cash cushion does a second job, and it may be the more important one. I don’t want anybody lying awake at night, and that includes the nights when the portfolio is doing great. Making money while you’re nervous as heck is not a great situation. Knowing the next year’s expenses are covered tends to quiet that down.
In practice, it works like this for our clients. When the cash needs refilling, we look at what has grown past its predetermined share of the portfolio and bring you a suggestion, and nothing gets sold until you’ve said yes. Where the money comes from matters for taxes as well. Withdrawals from a taxable account and from a retirement account are generally taxed differently, and a lower income year can change which source makes sense. That depends on your own situation, so talk it through with your tax professional.
Before any of this, though, somebody has to look at the numbers, and I don’t mean me. Adding up what you really spend isn’t most people’s idea of a good time, and it’s extra not fun when things feel tight. If you’ve done it anyway, pat yourself on the back. Everything else we do rests on that number. (Modern cash tracking programs can make this a breeze, by the way.)
So here’s something to do this week. Add up what you expect to spend over the next twelve months, the regular bills along with the lumpy ones like taxes, insurance, and the trip you’ve already promised somebody. Then look at how much you’re holding in cash. If the two numbers are close, a bad month in the market doesn’t have to change your plans. If they aren’t, that’s the first thing to plan for, possibly with the assistance of a trustworthy financial advisor.
Disclosures: This commentary is for informational and educational purposes only and is not individualized investment advice, nor a recommendation to buy or sell any security. Market and economic conditions can change rapidly. Past performance is not a guarantee of future results. All investing involves risk, including possible loss of principal.