Why 4% Withdrawal Rates Are Optimistic1, 2 – we contrast our findings from episodes on Elite Endowment spending policies (EP #4) and an individual’s safe withdrawal rates (EP #10)
Marcus Schafer (00:05)
Welcome to Greenstream, where we are cutting through the noise of markets, media, and products designed to enrich others, not you. And we’re going to do that through research, evidence, and what are the trade-offs you need to make to make good decisions to put you and your family in the best possible position to succeed. This is with Pat Collins, Greenspring advisor, CEO, and Marcus Schafer our Director of Growth.
So this episode is going to be kind of a carry on to last episode where we talked about “What is Your Number?” How much money do you need to build in order to sustainably live your lifestyle in retirement? And today we’re gonna be talking about how do you think about generating that income? How do you actually make that a reality? So Pat, maybe it’d be helpful if you just recapped what we talked about last episode.
Patrick Collins (00:55)
Sure, thanks Marcus. I’m happy to be here. I think it was a great episode last week for those of you who haven’t listened to that yet is to go back and kind of the foundation of what we’re going to talk about today was last week. So we really talked about what’s my number, how much money do I need to be able to retire successfully? We also talked about how hard that is to kind of just narrow it down to one specific number. So we also talked about withdrawal rates, different types of strategies around kind of the old 4 % rule.
along with a few other spending items that we think is really important to think through in retirement. Today, we’re really gonna get into administratively and logistically, how do we generate income from a portfolio? What are some of the things that might sound great that you have to be mindful of? What are maybe some of the best strategies and how does Greenspring think about it? So I’m excited to get started on this.
Marcus Schafer (01:43)
Yeah, let’s, but before we jump in, you know, I think we also did an episode on endowments and in that, I think that was episode five, what can we learn from elite endowments? And one of the things we talked about there was elite endowments are withdrawing between 4 and 5 % of their portfolio per year. And that kind of juxtaposed with maybe what we talked about last episode where we think that a 4 % rule is kind of a little aggressive.
in order to live your life and have confidence you’re still going to have money down the road. So maybe I thought it could be helpful for us to also talk about what are some of the differences between those two groups of investors and why do we maybe opt for more of a conservative approach compared to what we’re seeing from some of the largest endowments.
Patrick Collins (02:31)
Yeah, it’s a question, obviously, because you hear different points of view there. But I think there’s some things that you have to consider when you’re thinking about withdrawal rates. So the first thing I’d say for an individual investor, a big part of your withdrawal rate is also what age you are. The older you are, the higher your withdrawal rate can be because your life expectancy is shorter. It’s somewhat intuitive that if I only have 10 years to live or somewhere in that range,
I could probably take out a little bit more from my portfolio than if I had 40 years to live. So part of that is just trying to figure out, whereas an endowment obviously doesn’t really have a life expectancy, it’s hopefully going to be perpetual. But the big thing with an endowment that’s maybe different that I think that allows them to take out a little bit more than an individual investor is individual investors in most cases, at least our clients demand a little bit more certainty when it comes to their spending.
They don’t want to get to a situation where they’re taking out four or five percent of their portfolio. The market goes down, their investments go down, and they have to take a 20 % cut to spending. So they have to build in a little bit more margin in that withdrawal rate to make sure that they can weather storms that they don’t have to reduce it, reduce their spending in a bad market environment. So I think that’s the big difference with an endowment. They’re going to tend to be a little bit more fluid with regards to
how much they can withdraw. They also have different methods where they could maybe raise some more money if the markets go down. They could tighten the belt with regards to how much they’re paying staff or other programs that they might have. So there’s a lot of different levers they can pull that are a little bit harder for individual investors.
Marcus Schafer (04:09)
Yeah, and I think the spending policy discussion is really relevant to what we talked about last time too, where it’s, hey, they are kind of hard coding this stuff in. And what we’ve seen is when we’re working with individuals, it’s very difficult to say, hey, actually this year you have to spend X amount less because of some uncertainty. And then we also have that discussion we had around risk and they might be taking a little more risk than most individual investors are comfortable.
with. But I think that kind of leads into, hey, you build up this portfolio, you work your whole life to build up a number, and now we have to do the really hard thing, which is press the sell button. 30 years, 40 years of pressing buy, buy, buy, saving more money than you spend, and now we’re kind of asking, hey, do the opposite. But I do think it’s helpful to stop and just, what is income?
The Limits of Dividends as Income 3, 4, 5 – the drawbacks of concentrating only on dividends
And this is maybe a misconception we hear in the marketplace where people are saying, hey, income is dividends. Hey, income is coupon payments. Income first and foremost is money coming in cash into your portfolio. And that takes different shapes. we’ve seen those shapes kind of evolve over time as financial science has evolved. So let’s maybe just kind of talk about what are some of the forms of income that you might experience in portfolios.
And then we can talk about how is Greenspring kind of aggregating these to build portfolios that are robust providing income in terms of cash into the portfolio, but also are not super limited by just focusing on one of these characteristics or not.
Patrick Collins (05:46)
Yeah, the dividends, interest, those are your traditional forms that I think everybody, to a large degree understands interest is coming from bonds. They’re paying you a set interest rate for you to lend your money out. Stocks oftentimes will pay dividends. Dividends are basically them taking some portion of their earnings and paying it out to you in this form of a dividend. And I think one of the things at least,
We’ve been in this business a long time. When I started in this business 25 years ago, those are really the ways that you set up portfolios to generate kind of income for retirees. So they would come to you and you’d say, well, let’s invest your money in bonds or stocks, and they’re going to generate a set amount of dividends. And those dividends are what you’re going to live on or interest is what you’re going to live on. And I think that’s evolved over time. And I think maybe we want to take a few minutes.
to talk about why that’s evolved and maybe why there’s some, what we believe is some better ways to approach generating income from a portfolio.
Marcus Schafer (06:45)
Yeah, yeah. The evolution, think, is critical. mean, just take bonds, right? Everybody’s familiar with interest coupon payments. Well, what about zero coupon bonds? This is an evolution where it’s, hey, I’m going to give you $90 in five years, give me $100 back, but there’s nothing in between. So you can still use those bonds. You can kind of build a bond ladder. It’s just a different form of investing.
And you kind of, you we talk about diversification is important. You don’t want to limit your opportunity set too much. So that’s just like the easiest example for bonds around the evolution of some of this and maybe why, hey, just focusing on the interest rate or the coupon rate doesn’t make as much sense. And then you also have to think about, especially with bonds, what’s risk relative to return, right? It’s, we can get you a higher number for your yield, for your coupon rate.
The world is not risk free. That comes with a trade off. That comes with more risk.
Patrick Collins (07:46)
Absolutely. Yeah, I think bonds are a great example. These zero coupons versus regular interest paying bonds. I recall early on in my career, many people building bond ladders out of zero coupon bonds as the way to generate income and retirement because you could kind of exact it down to a number. I can have a hundred thousand dollars of bonds maturing on this date and you’re going to use that for your upcoming, you know,
upcoming kind of expenses that you might have for the year. I think what I hear more often tends to be around dividends. ⁓ As retirees get closer, one of the things that I hear closer to retirement, what I tend to hear is, why don’t we invest in more dividend paying stocks, higher dividend paying stocks so that I can start generating income and retirement? I think it comes back to that longstanding kind
Marcus Schafer (08:20)
Mhm
Patrick Collins (08:36)
idea that when you’re retired, you need to invest in high yielding investments, high dividend paying stocks. And there’s a lot of, you know, kind of positives around that as a retiree, you know, you can conceptually get around this idea that if I have X, if I have $5 million, and it’s generating a 5 % dividend on average across all of my stocks that I own,
Well, shoot, I never have to sell anything. I got $250,000 of income coming in every single year. I think one of things we found is, and I found this out, I guess I’ll tell a quick story. I found this out early on, maybe not that early, but in 2007, 2008, 2009 was a great example where anyone that had that strategy going into a down market, to that down market specifically,
really struggled because in 2009, after all of the kind of economic crisis that hit, over 50 % of the stocks in the global universe either cut or eliminated their dividends. And so when you think about the timing of that, okay, the stock market is down. At that point, stock market’s down 50 % and all of a sudden my income now gets cut. So what do I need to do if I want to continue spending the same level that I have? Well, now I have to sell stocks.
Well, I’m selling them at a 50 % discount to where they were a year or two ago. So I think there’s all sorts of problems. Companies tend to cut their dividends at a time when their stock prices are depressed. So it’s kind of like this double whammy. So if you take that approach that I’m going to invest in companies that pay dividends, that’s going to be my primary way of generating income. Then I think you have some issues around the sustainability of that. Also the fact that there’s a very good chance when a company gets into trouble.
that they’re gonna cut their dividend. And that’s almost the exact time you don’t want that to happen. There’s other issues too. Maybe you could talk about any other issues you see with kind of just primarily focused on trying to generate income from dividends in a portfolio.
Marcus Schafer (10:35)
Yeah, well, it’s, you know, if you’re buying it because you want dividends, why are all the other investors buying those dividend paying stocks? Because they also want dividends. So it’s not just, hey, stocks broadly are falling, but the stocks that you are specifically buying for a dividend or cutting their dividend, that might mean different effects on the price. Right? So I think you have to view this from the investor preference center where
If people are buying these because of a preference for dividends, when there’s a rough time period and you’re not getting that preference, you really don’t like that investment. We saw the same thing in COVID. COVID was a much shorter market downturn, but in the US, your dividend rate was cut by 22%.
If you think about what that means internationally as well, that was over 40 % of a decrease in dividends. So almost half your dividends that you were receiving, ⁓ now you’re getting those back, right? So this is a really, really painful thing. And to your question, what are some other components, there is a lot less companies that are choosing to pay dividends, and that trend is continuing over time.
And right now it’s about 38 % of companies in the US are paying dividends. Those are mostly concentrated in large cap securities. So you’re kind of increasing your concentration, maybe without even knowing it. And any times you increase concentration, you’re increasing risk to a certain type of exposure, reducing diversification, which should help you navigate an uncertain future.
Patrick Collins (12:14)
And if you think about, it’s a great point, because if you think about the companies that don’t pay dividends, I mean, the majority don’t from what you’ve mentioned, but specifically the companies that aren’t paying dividends have been the best performers over the past 10 plus years. That doesn’t mean that’ll continue. But what I would say is, is that when you do limit your diversification, there is a decent chance you’re leaving a lot of stocks and investments on the table that could have great performance.
And you look at the, you know, the Amazons of the world and the Googles of the world and the Facebooks and the Teslas and yeah, obviously they’re volatile. But if you look at the last 10 years, they’ve been some of our best performers in the US and you would have basically neglected those if you had just focused on a dividend strategy. So I think it’s something to consider is this idea of you are limiting your diversification if that’s your focus.
Marcus Schafer (13:07)
Yes. And this goes all the way back to 1961 is kind of when some of the first research around should investors even care about dividends versus other forms of how they get capital out of a company. And the professionals will tell you, no, we don’t care. We’re indifferent between dividends or say a share repurchase. It just doesn’t matter to us. We care about the cash flows of a company.
But investors seem to have a different preference and during different time periods, they increase or decrease that preference. So during low interest rate time periods, they tend to favor dividends as well. And if you just think about the math of this, that by the way, favoring dividends and low yield time periods drives up demand, lowers expected return.
maybe somewhere two plus percents, you could be leaving on the table. But if you just think about the math for a dividend, if a company is valued at $100 and they pay a $1 dividend, what do you expect their new value to be? $99. That’s right, $99. And if you look back, I pulled some numbers, 2021 through 2023.
Patrick Collins (14:20)
$99.
Marcus Schafer (14:30)
If you look at the top 100 dividend stocks in the S&P 500, they are paying on average $0.76 of a dividend per quarter. Now, what do you think their stock dropped by? $0.76? $0.79! If you pulled the top 10 from 2018 to 2023, they paid $1 in dividends on average per share. Their stock dropped
the day after, right? So that’s telling you something that, investors tend to be favoring receiving a dividend, and as such, they’re getting lower expected returns. And this isn’t to say that there’s no ways to get income from a portfolio. The shift has been actually towards share repurchases, where companies are kind of doing
the same methodology, they’re saying, hey, instead of giving investors this money, we’re going to buy our shares back, which is going to increase future returns to the remaining shareholders. The math works out to be the exact same thing for some tax reasons and some investor preference reasons. A lot of companies are preferring this. So as dividend payout ratios are being cut and the percentage of firms that are doing it are dropping, there’s more more share repurchases kind of making up for that.
Asset Allocation for Retirement – start with how many years of expenses can be covered by your bond allocation
So if you’re just thinking about the world when you grew up learning about investing, it was all about dividends. But how finance is transitioning is it tends to be more about, okay, dividends are fine, they’re great. A lot of companies still do them. They might signal to investors that there’s a lot of future confidence in a company if they’re willing to pay dividends. But also at the same time, hey, there’s this new form essentially of a dividend that gives you the same thing.
just it’s a little more efficient and a little more preferred by the companies doing it. And as investors, we should say, okay, we’re gonna be open to those companies as well.
Patrick Collins (16:31)
Yeah, when you think about it, you know, I could own in your example before I could own a company that’s worth $100 or after they pay a dividend, I could own a company that’s worth $99 with a dollar of cash. The alternative I have if I want that dollar of a cash is I could just sell 1 % of that company instead of getting the dividend. And I have the exact same outcome and it’s the exact same tax outcome too. So I do think that there’s options here. And I think that’s what we want to get into.
is maybe a little bit more of the framework that we use here at Greenspring on how to generate income from portfolios. Because I think this could be really helpful for our listeners to understand, especially as they approach retirement, how do I set my portfolio up? Because there’s a lot of different factors that goes into this. So I’d like to start maybe with maybe the most important, which is your asset allocation. How do you allocate assets across your portfolio?
as you get close to retirement. And we talked about this in an earlier episode when we talked about financial planning. And one of the things that I’d mentioned was that on the first day of your retirement, it’s basically the riskiest day of your life when you’re thinking about your full retirement. And the reason why is you need your money to last for the longest period possible.
because you have your longest life expectancy is that day. Every day you live thereafter, your life expectancy is getting shorter and shorter. On top of that, obviously, so you need your money to last a long period. On top of that, obviously, if the market drops, you could be in a position where you’re having to make that last with a much smaller portfolio. If you think about the alternative, if I’m 92 years old and we go through a market correction, well,
my life expectancy might not be that long. I can kind of weather that storm. But if I’m 65, I might have 30 plus years of having to pull money from a portfolio that has been depleted. So how do you control that? Well, some people might say, well, you should be more dynamic and you should be getting out and be more active around trying to get in and out when the market’s growing up and down, especially around retirement. We think that’s a very, very difficult game to play.
There hasn’t been really much evidence to suggest that you can do it effectively. The best way to control your risk there is through your asset allocation. And one of the things I want to mention that we do with clients that I think is a good exercise to go through and thinking about how to allocate, obviously, I’m going to keep it very high level between stocks and bonds now. So stocks being your kind of growth area, ⁓ bonds being the safe area of your portfolio. When you think about
that decision of how much to put in each. One potential way to think about it is how many years of expenses do you have in bonds? Because if you think about the idea of if you have a 100 % stock portfolio, let’s say, the problem with that is you are matching up very short term liabilities. That would be what I need to spend, let’s say, my first year of retirement. Let’s say I’m 65 and I’m retiring next year.
that first year, I’m gonna have, let’s just say $100,000 of expenses that I’m gonna have to pull from my portfolio. If 100 % of my portfolio is in stocks and the stock market goes down, I have a lot of risk there because now I’m gonna have to liquidate more shares to generate that same $100,000 of income because they have a lower price. So one of the things we like to do is try to think about matching up liabilities, future expenses with the right types of assets in a portfolio.
So if I have expenses that are very short term in nature and they’re certain, I know they’re going to happen. I know they’re going to be fairly quick. I should be matching that up with a safe investment so that I don’t have the risk of having to, you know, kind of recalibrate everything. My expenses that are maybe a little less certain, you know, maybe it’s kind of the more discretionary part of my, my spending and also maybe a little bit further out. I can take a little bit more risk with those and generate hopefully a higher return.
By going through that exercise, you can try to kind of come up with an asset allocation. That’s not the only thing to look at, but that’s one area that we’d like to look at when coming up with an asset allocation. And I would say the more risk averse you are, the more years of expenses you want to have in safe investments. So you might say, you know what? I want to spend a hundred thousand dollars a year. I’m going to simplify it. I need to have about a million dollars in bonds and cash. And that’s going to cover the first
12 years of my retirement. That feels pretty good. Even if the stock market drops, I don’t have to touch my stocks. A lot of investors, that gives them a little bit more peace of mind as it relates to spending. And it also kind of starts to mitigate some of the risks of a big down market right when you retire. So I’d say that’s important. The only other thing that I would say about kind of the riskiest day is the other thing that’s uncertain at that point.
is inflation. And for years and years, we didn’t really worry about inflation. It was very much non-existent for probably the past decade or two. And now we’re kind of back to seeing this really manifests itself through, you know, food prices, gasoline prices, housing prices. And, you know, if you’re a retiree, when you have a long, long time, that’s just more time inflation can erode your purchasing power. So if you think one of the ways I’m going to counteract all the risk,
in my asset allocations go really safe because now I have certainty. Well, the problem is you might have certainty in the dollars that you can spend, but not in what you can actually purchase because you might be losing purchasing power. So these are these kinds of things that you have to think through on your asset allocation.
Incorporating Social Security and Pensions – delaying often means higher withdrawal rates at the beginning but higher probabilities of success in the long run
Marcus Schafer (22:13)
Yeah, and I think you also have to ⁓ incorporate any other potential streams of income that you might have in retirement as well, right? So you have potentially pension payments, those are becoming less common, but at executive levels, we still see them pretty frequently. Social security is another one. So how do we think about incorporating something like social security into this income stream that you’re going to be generating?
Patrick Collins (22:40)
It can be challenging because if you use these traditional rules of thumb of I’m gonna take out 4 % of my portfolio or things like that, well, you may have a stretch in the beginning of your retirement where you’re 65, you decide to wait until 70 for social security. we could talk about that as far as, I think that’s one of the things we wanna really dive into a little bit more is whether that’s a good idea. But if you have…
a stretch where you’re in a low, you you’ve taken less income from maybe fixed sources. Your withdrawal rate might be high out of your portfolio for the first few years, knowing that it’s going to drop once I start collecting social security, I’m going to readjust my portfolio. So it’s really hard to do that in kind of a traditional spreadsheet, just linearly just model it out. I know a lot of clients, know, clients, especially kind of our technical clients that are engineers and like to look at these things on a spreadsheet. It’s a little bit more challenging when you have
multiple sources of income coming in to try to model all of that stuff out. But ultimately, yes, I mean, you’re gonna have income in, you have to model out. can I take a larger withdrawal in the beginning out of my portfolio with the idea that I’m gonna take less later on?
Retirement Income Valley Opportunities – maximizing the low tax brackets between retirement and taking social security + required minimum distributions
Marcus Schafer (23:53)
Yeah, and it builds into this asset location factor as well, right? And this is why it’s important to have a plan, because you say, hey, I need to hit this number. Every year, the market conditions might be a little bit different. So then you can kind of improvise every single year. Hey, you have X amount of taxable income that you can bring into the portfolio before you get kicked into the next bracket. So we’re going to pull this much from this bucket and pull this much from this bucket.
So it’s kind of like asset allocation and then asset location. And then even beyond that, how do we incorporate other streams of income? You can kind of think about that from.
from just your total net worth, right? That should probably be incorporated. And then this withdraw order that a lot of times we talked about it, I think it was episode three, “What is Financial Planning?” This retirement income valley. So that’s kind of what you’re talking about. So maybe talk a little bit about tax projections, how you can think about maximizing those first years of retirement as you think about generating income.
Patrick Collins (24:55)
Yeah, taxes, interestingly enough, you we earn our highest wages when we’re working. And what I think we found is we have the greatest, some of the greatest opportunities for tax planning as we, as we approach and get into retirement. And that’s because our income varies so much in retirement. So let’s maybe go through, run through a traditional client of ours that might retire. So
Marcus Schafer (25:13)
Mhm
Patrick Collins (25:20)
They retire, maybe they have money in an IRA, they have money in a Roth IRA, they have money in a taxable brokerage account. They retire at 65. And what we find out pretty quickly when we do the projections is that they have very little income from 65 till 70, because they decide not to take social security. And then on top of that, required minimum distributions from their IRA, which is basically the IRS mandating distributions. So they have to start paying taxes.
that doesn’t start till 73. So you have this period in the beginning of retirement where you may be in a very, very low bracket. It could be zero, could be maybe just slightly above that. And so the question is, how do we take advantage of that? What are the opportunities we can do in the early parts of retirement if this is truly the case for clients? And so there’s things and strategies that you wanna look at, which is if I’m gonna be in a lower bracket today and a higher bracket,
in future years, wouldn’t I wanna potentially bring income into this year and still stay hopefully at a low bracket if I can pay taxes at a lower rate than I will in the future? And that’s really, it’s not as simple as it sounds, there’s actual tax projections you have to do, but a good advisor will look at those things and decide, let’s bring income in now so we don’t have to pay on it later at a higher rate. And how do you bring income into today? Well, probably the,
Most common way we do that is Roth IRA conversions. So we take some of our IRA and we convert it to a Roth IRA. We are basically bringing income in that we would have had to pay out at some point in the future. We’re just doing it sooner. And we’re arbitraging the rates that we’re paying. We pay a low rate today versus a high rate maybe when we have to take it out. So that’s number one. The other way would be that we’ve seen with clients is actually
taking capital gains in their portfolio. Most people never want to pay tax on their investments, but there are opportunities where we could say, well, we bought this stock for a hundred dollars. It’s now worth $250. Why don’t we actually take the gain? Let’s sell it and then repurchase it. And by doing that, yeah, we can take a hundred and fifty dollar gain. But again, if we’re in a very low bracket, we now have reset the cost basis on it. That means our future taxes when we eventually sell it will be lower. And in fact,
at least on the federal side, the IRS has all sorts of rules for when you’re in a very low bracket that you might pay 0 % on capital gains. So these are all strategies that you should work with with a tax advisor, with planner, with your financial advisor to think through. But this is that valley that we’re talking about from 65 to 70. And then it kind of kicks in again at 73 when you have to take required minimum distributions. But we’ve seen situations where clients have just
you know, small amounts of income, $20,000, let’s say, when they retire. But we know when they turn 70 and then 75, it’s going to go up to $250,000. And so you see these just huge differences and we want to take advantage of that because it’s going to be the lowest income that they’re in in their entire life, which is counterintuitive. People think my income is going to keep going down. In fact, it actually goes down for a period of time and then spikes up in retirement.
Marcus Schafer (28:38)
Yeah, this is a great example of kind of financial planning is not just one specific criteria. It’s not, hey, just build a plan one time, revisit it every five or 10 years. It’s not build an investment portfolio, fill the products, and hopefully those products will achieve what you need. It’s not just tax in isolation. Hey, do really good taxes this year, minimize my taxes in this year. It’s considering all of those things.
forward looking. And then maybe one thing that always should not be missed, but a lot of the things we talk about, assume you’re in a super diversified portfolio filled of index funds or index type level diversification. And I think some things that might be missed sometimes is if you have a more concentrated portfolio, you’re naturally going to have more dispersion, more range of outcomes around your returns.
that gives you less certainty to do tactics like this because, hey, your returns could be 30 % one year or negative 30 % or even wider than that. So, I also think manager selection, how do you build the actual pieces that go into your portfolio? Although it’s gotten, I think, easier if you can go in all index or index level diversification type solutions. It’s gotten easier to do that, but
people still aren’t doing it. And if you’re not getting that thing as your starting basis point, a lot of the things we talk about, you just have less knowledge about whether or not you can actually do them in the future.
Patrick Collins (30:13)
Yeah. And the one thing on the, kind of going back to the tax piece, I just want to mention that I think will be helpful for listeners to think about is, you know, we talk about diversification, obviously quite a bit on this podcast about how important it is and how valuable it can be. And we’re obviously talking about asset diversification. There’s also some tax diversification that I would encourage people as you are in the accumulation phase to consider.
Tax Diversification is Key for Retirement Income – unknown future tax rates means a tax optimal decision in the accumulation phase might not be optimal when you reach your withdrawal phase
And so when I talk about that, there’s really several buckets of how you can save your money for retirement. When you’re thinking about generating this income, you have obviously just a brokerage type of account, an after tax account, which just means you put money in, you buy stocks, you buy bonds, you buy mutual funds, and you’re going to be paying the tax on the dividends and interest every year. When you take it out, if you sell, if you have a gain, you’re going to pay capital gains on it.
Those are really, really important accounts because they give you a lot of flexibility. If you decide to retire early, you don’t have to pay penalties. You’re not going to, it’s not all ordinary income when you withdraw it. So having a chunk, it was one of the problems I see sometimes with retirees is they’ve done all their savings in their retirement accounts. And when they need to have a large chunk come out for some reason, you know, we’re buying a new house, we’re doing this or that.
It is just, it’s a massive tax hit to them because all of its ordinary income, pushes them into higher brackets. So having a chunk of money in a taxable brokerage account, in my opinion, makes a lot of sense. Obviously you get advantages by investing in IRAs and 401ks. So you still want to contribute to those. But then the last thing I would say is Roth 401ks or Roth IRAs are also valuable assets to have. And you can make the argument obviously that
Hey, if I’m in a high bracket, I want to get tax deductions. I shouldn’t invest in the Roth. But the one thing I would say is that I still think I have even my highest income earners that we advise are often making Roth contributions to their 401k. One, because they might still be in the highest bracket. They don’t know when they retire. If they are very successful in what they do, they may just have a ton of income in retirement. So they may not go into a lower bracket, which is kind of the thesis of
why I would invest in an IRA or 401k is I get a tax deduction now I’ll pay tax later when I take it out and I’ll be at a lower bracket. The other part is we don’t know where the taxes are going to be. We don’t know what the tax law is going to look like. So I think all those things are really valuable when you’re thinking about generating income from a portfolio is having some diversification of the taxes and the types of accounts that you have to give yourself some flexibility each year of where to pull from. And I think that’s
You know, one of the things that we want to talk about, and so maybe that’s, a good lead into thinking about, okay, I do have, maybe you’ve done this, you have a bunch of accounts that, that you’ve built up and now you’re getting ready to retire. A big question we get all the time is where should I pull from? What’s the, where should I pull first from? And I would say this is, often tough to say in a podcast and just say blanket advice because.
Account Withdrawal Order – Taxable first, tax-deferred second, tax-free third?
everybody’s a little bit different. You have, everybody has different circumstances. There’s definitely not a right answer to this, but I will say on average, what we tend to see is that it usually makes sense to defer taxes as long as possible. Again, caveat that if you’re in a low bracket, you may want to pay them early, but let’s just say, you know, that on average that we want to defer taxes. Well, if that’s the case, basically what you would say is you want to start to deplete
more of your taxable investment account first. We keep the IRAs going. We don’t have to pay tax on ordinary income tax rates on that. And then we get, once we kind of, I don’t want to say we deplete it because you usually don’t want to take it down to zero, but we use that first primarily. Then we move into our tax deferred assets. And I would say the last asset that we want to use is our Roth IRA assets, because those are the most valuable assets that we hold. Every dollar of growth that we can
you know, continue to grow it at is tax free. So we want to make sure that we’re growing this thing as long and as fast as possible. So we don’t want to deplete those assets because of their nature. So that’s kind of a that’s a broad scheme. But I would say you really need to work with an advisor to come up with a plan, because there are reasons why you’d want to accelerate tax if you’re on low brackets. But in general, if you’re trying to kind of defer as long as possible, taxable first, tax deferred second,
Tax-free last.
Marcus Schafer (34:46)
Yeah, I think that’s a great thorough explanation of why cookie cutter advice kind of doesn’t apply. you’re speaking to me when I started my career, everybody says, hey, max out your 401k. They didn’t actually mean me, you know, because I wanted to buy a house seven years later and I can’t do that for my 401k. They meant the average person that’s in their peak earning years. Hey, defer into your 401k, max that out.
Incorporating Social Security – despite future potential changes, delaying often makes the most sense on paper for those in good health with one spouse that earned more
When Warren Buffett says, just buy the S&P 500, I think he says that because him saying buy a globally diversified market cap, weighted portfolio and cheap index funds is too wordy. It doesn’t stick. It doesn’t cut through the noise. So I think that’s a great explanation. One of the other, it’s kind of less related to portfolio income, but is income in retirement. How would you think about social security? There’s a lot of questions about this for somebody
more my age? Hey, if you’re retiring and we’re seeing this happen right now, there’s more certainty there than there is for somebody my age. What advice would you give somebody my age knowing that the ultimate answer is save more, invest more?
Patrick Collins (36:00)
Well, yeah, somebody that’s young, that’s still accumulating, obviously, I would say one is social security going to be around? That’s a kind of a hot button topic, obviously. And I think there’s a very good chance there could be changes to social security over the coming years and decades. Do I think it’s going to go away completely? No, I think that’s unlikely. I think
any politician that really heavily leans into that is going to struggle to get reelected because it is a very well, you know, liked, loved part of our financial system, as well as when you think about who votes in this country, it tends to be older people. They do not want to see their social security taken away. But could there be means testing? Could there be higher taxes to cover it? Yes, that’s all possible. But
I think when we’re talking about it from in this podcast view of how do we use it to think about income and you how does it play with our portfolio as far as you know, things work? I would say in general, well, first backing up, social security is an asset or an income stream that you cannot purchase anything like that anywhere that I know of because what it’s generating basically is a set level of income that adjusts every year to the actual inflation rate.
I can buy an adjusted annuity that goes up at let’s say two or 3 % every year, my income stream, but that doesn’t match inflation. If inflation goes up 10%, I’m losing out in that. So social security is a really, really valuable asset in that sense, and that it is matching it directly with what we’re gonna experience from an inflation standpoint. So moving backwards, I think the decision around social security
One thing to note is you can start taking it as early as 62. You can wait till 70. Every year that you wait, you get an 8 % increase in your income benefit. And there is a break even age that you can kind of think about. The longer that you wait, the shorter the time period that you’re going to collect, but the larger dollar amount. And social security, the people that work there, they’re not dumb. There are actuaries that work there.
They figured out that the break even age is right around life expectancy. It tends to be early-ish 80s, early to mid 80s. And so if you’re in very good health, our belief is that it makes sense usually to wait till 70 to take social security. And there’s a few reasons for that. One is, especially the highest earning spouse. The main reason there is that it protects you more from the thing that people are scared about the most, which is running out of money.
because I get more income, think about it from age 67 to 70 if I wait, I’m gonna get about 25 % more income by waiting that long. So if I live a long time, if I live to 100, I’m really happy that I waited because I’m getting 25 % more every month by waiting till 70. Now what’s the risk of waiting? The biggest risk is I wait till 70 and I die at 72. That’s the risk is I will not collect.
all of that I paid in over the years. My response to that may seem cold-hearted is, yeah, but you’re dead at that point. So does it really matter? That’s not the risk that we’re worried about, of dying early. We’re really worried about living a long time. And so that’s number one. The last thing I would say too is if you’re two spouses,
When someone passes away, the surviving spouse gets the greater of the two benefits. So we want to have one benefit that is paying at the highest rate possible. there’s a few things to consider. Again, this is one component of an overall income strategy in retirement. If you do wait till 70, the thing that you have to consider is how is my portfolio going to make up for maybe the 65 to 70, you know, kind of age gap when I don’t have that social security income coming in.
Evaluating “Boomer Candy” 6, 7, 8, 9, 10, 11, 12 – annuities, high yield, derivative income, buffer strategies and more…
Marcus Schafer (39:52)
Yeah, yeah, and I think that lays out really well everything we think through just to recap, instead of focusing on a very small subset of high income producing assets or products, how we think about it builds a super diversified portfolio, match your risk tolerance between your growth assets, your stocks, your conservative assets to
like you were talking about with your liability driven investing approach, which is your bonds. Make sure you can draw those down if equity markets fall to support your lifestyle. Build a super diversified portfolio and then just sell as opposed to letting the portfolio sell for you. You there’s two approaches to income. You can do it yourself or you can have somebody force it upon you. And if you’re relying on dividends or coupon payments,
You’re letting somebody else determine how much you can spend. And sometimes that’s great. Sometimes that’s bad, but it’s better in our opinion to have a lot more control and a lot more diversification. And I think one of the key themes there too is any like individual asset class, this fundamental pillar of finance, any individual asset class, I can essentially replicate it by a mixture of stocks and bonds.
I could say, that’s what you’re looking to achieve? Let me go do so with a mixture of stocks and bonds in a more diversified, lower cost, more tax efficient methodology. And maybe next, what I would love to get into is, so this is our approach. What are some other things? You just mentioned social security is like, you can’t buy this investment anywhere else. Well, what are the other products that people are selling that you could buy to try and generate income in a portfolio?
And when we evaluate these, like we evaluate all the other investments, they’re the same as what I just said. These are more expensive, less diversified, more concentrated, less efficient ways of doing what we’re doing. So maybe let’s just talk about a few different things. We kind of, think, already hit on dividend yield or high-yielding strategies. Is there anything else you want to talk about on that, Pat?
Patrick Collins (42:09)
I don’t think so. I think the dividend high yield strategies, I think we talked about some of the downsides of just entirely focusing on those types of strategies. One product that’s out there is annuities. That’s another product that can be used. there are good annuities and there’s bad annuities. And we probably have a whole other episode on annuity products.
But that is a potential strategy you can use, which is essentially you give some portion of your money to an insurance company and they promise to pay you for the rest of your life. Similar to like a social security type of income. So that’s a possibility. We think that sometimes those can be good. I would say the vast majority of those that we see tend to be, to your point, high cost, complex, not great for actual retirement income. But there’s now, I’d say, a few more that seem to be popping up.
that there’s an article in the Wall Street Journal that called them “boomer candy” which is basically this idea that as older people start to retire, they love to hear about income strategies. kind of already to some degree debunked some of the concerns, or least raised some concerns around these dividend high yield, but there’s others. Maybe you want to talk about some of these things that are in the article that we read about that as we dig into, we realize, wow, this isn’t really that much different than anything we’re doing other than
they’re adding layers of fees and complexity to that that probably is not necessary.
Marcus Schafer (43:31)
Yeah, think the “boomer candy” kind of says it all right. These are things that are highly appealing in the short term. And then you think about the long term and they just don’t shake out that well. So generally, boomer candy is kind of classified into two different types of categories. These are derivative income or defined outcome. And I’ll kind of explain what those are. But one of the reasons why
We’re talking about this is because in 2020, the SEC changed some rules that enable these strategies to be repackaged into ETFs a little more efficiently. So the launch of new products, the AUM of new products has kind of exploded. It’s about $230 billion. I think as of March, maybe my number is. So definitely a massive increase. I think the largest active ETF
is a derivative income solution. So it’s super appealing. And the question is, does it shake up? Let me just break down derivative income first, and then we’ll get into the the buffered defined outcome. So derivative income is essentially saying, we’re going to buy an equity portfolio, but then you overlay some option strategies on top of it to produce income.
Now, when you overlay option strategies, you’re essentially changing the payoff structure. And I have to tell you, Wall Street is very good at this game. And they’re very good at making it look like the dividend yields you’re receiving are super high. But that comes at a cost. There are no free lunches in finance. So if you’re getting a 10 % dividend, it might be a return of capital, not a return on capital.
The tax efficiency of these, definitely should not be in taxable accounts because they are super tax inefficient. And then when we replicate it with very simplistic stock bond portfolios, it gets exactly what we talked about earlier. Hey, a stock bond portfolio, 60 % stocks, 40 % bonds, 60 % stocks, 40 % T-bills, they tend to do a little better. So that’s kind of just derivative income in a nutshell.
And I think that some of these, code words you should be on the look for, premium income, income, when you see high yields, you have to think what are the costs of those? And the thing that always goes through the back of my mind is, let me just compare it to a 60-40 portfolio that anybody can build, and let me just see if I can replicate it in a cheaper way.
Patrick Collins (46:14)
Yeah, it’s having kind of started my career at a big, big brokerage firm and seeing these products. And this was 25 years ago. The products have evolved, but seem very much the same flavor whenever, you know, one of the things that you tended to see when they would build products to have the salespeople go sell them to clients, high income was a big one because they knew as people retired, this would be attractive to them. But when you got under the covers and you looked at.
you know, what are they at? What’s under the hood of this thing? It tended to be you were getting your actual capital back a lot of times. So it looked like, well, I got this great 8 % yield. Well, half of it was your own money getting returned to you. The other part is it tended to be leveraged. So they would go borrow a bunch of money to generate this high yield. I think the, you know, kind of the thing to take away is when you have, when you hear a yield,
that is more than what I would consider the risk-free yield, which is right now somewhere around four-ish percent. And someone’s saying that they’re offering six or seven or 10. There is risk associated with that. There is no way to offer a extremely high yield without taking some level of risk. And that’s important for you to, if you don’t understand where that risk is coming from.
then you should be very, very wary of whatever strategy that is. You really need to understand. It doesn’t mean that risk is bad, just means that you have to understand what that risk is and are you willing to accept it.
Marcus Schafer (47:38)
Yeah.
Yeah. And do you fully understand the strategy that you’re investing in? Because nowadays, just because something’s an ETF, it doesn’t mean that it’s an index. And that could be good, but it could be bad. So a lot of these options overlay strategies, they’re actually actively managed strategies within some actively managed options overlay. So you’re kind of compounding things that the evidence is showing us doesn’t make sense. And I would just say, anytime you see
yield and that’s what you’re focused on. Zoom out, look at total performance. This is price change plus dividends and just see what that performance is because when you look at the behavioral finance research, there’s a thing called mental accounting and you kind of bucket different categories in. And although financial theory, we talked about this earlier, says we as investors shouldn’t care what form return comes from, whether it’s dividends or price appreciation.
It seems that individual investors do tend to anchor over one or the other. And so anytime you are thinking about one, it is helpful to, hey, let me go compare to the other to make sure I’m not missing something. Let me jump to defined outcome, which is you’ll see this, the nomenclature is buffer strategies. And these are essentially what we talked about in our episode. I think it was episode seven on annuities.
which is, there’s these different clauses, right? There’s floors and there are ceilings and say, hey, you won’t lose more than 10 % of your money, but that means that you can’t make more than 12 % of your money. And then you look at, how do returns actually happen? And it turns out that returns very rarely happen continuously within that range. And one of the real tricks, I think, for investors when it comes to these strategies is sometimes it’s
Like you have to be in for the whole holding period for them to apply. So you could be thinking, Hey, let me, let me buy this. This looks good. It’s going to protect my downside. And I’m nervous about my downside right now. Well, you might not even get that, get that protection. So do think it’s really, really important to peel back the layers and it’s called boomer candy because it’s sweet and it seems like it’s great, but it’s probably not great for your health.
Summary – we break down the 4 key steps to making a retirement income plan
Patrick Collins (50:08)
Yeah. So maybe, maybe I’ll kind of summarize some of the things that we believe and maybe it’s a good way to wrap up the podcast. So I think going back to, if you’re at a point where you are approaching retirement, you’re thinking about generating income from a portfolio, there’s a few steps that we think that you should be thinking about. So first, what’s the most important decision is your asset allocation. How much should you have in stocks and bonds that should be dictated by how much risk you’re willing to take?
how much return you actually need, and then also how much protection do you want or certainty do you want from income, at least for the first several years of retirement when you think about matching up assets and liabilities. So that, number one, that’s the first part. The second part is thinking about distribution. I’m sorry, the distributions where they’re gonna come from. which accounts should I pull them from? Should I pull from my taxable account, from my IRAs, from my Roth IRA?
You should have a tax strategy in place to be able to plan for that, plan for that retirement income valley that we talked about. third part I would say is other fixed income sources, work that into your income plan, social security, pensions. When are you going to start those? If you’re going to start those later, make sure you have distribution plans for, ⁓ for the beginning part of your retirement that might, it might need to take out a little bit more than the end. And then.
You know, the last thing would be just, we talked about a little bit, but the tax piece of it, there’s opportunities to do tax planning. You may think about Roth conversions. You might think about taking gains earlier than expected from your, from your, capital gains standpoint. So all these things should be built into an income plan. and at the, at the end of the day though, you can do that with a low cost diversified portfolio. You don’t need to have really complex, expensive products.
In fact, if you do bring those into the fold, it’s probably going to hurt your overall retirement income prospects, whether it relates to longevity of the portfolio or just how much you can withdraw from the portfolio.
Marcus Schafer (52:12)
Yeah, very well said. I think I mentioned at the beginning, but this is one of the most challenging behavioral changes that occurs. I find it myself when I have to go purchase things that are expensive. Like, no, I’m used to saving more money than I spend. And now we’re saying, hey, maybe think about, you know, obviously you’re not saving money, so you will be spending more money.
The analogy that I think a lot of investors envision their portfolio is kind of a tree. And they think about income in terms of, I’m just going to pick the fruit off of this tree. And I would say the juxtaposition for how we think about it, yes, we have a tree and yes, there’s some fruit, but we’re also focused on making our tree bigger at the same time. And it’s not just about picking the fruit off the tree. So that’s maybe what I would have us close out on.
Patrick Collins (53:07)
Great. Well, was fun conversation. Really appreciate it.
Marcus Schafer (53:10)
Thanks, Pat.
Sources:
1 What Can We Learn From Elite Endowments | Greenstream #4: https://www.youtube.com/watch?v=2wXKgVGUmyo&t=1463s 1
2 How Much Money Do I Need to Retire | Greenstream #10: https://www.youtube.com/watch?v=PPGYWsn7FFQ&t=1s
3 Global Dividend Paying Stocks: A Recent History (Dimensional 2013): https://my.dimensional.com/asset/35082/global-dividend-paying-stocks-a-recent-history
4 Dividends in the Time of COVID (Dimensional 2020): https://www.dimensional.com/us-en/insights/dividends-in-the-time-of-covid-19
5 A Slice of Dividend Accounting (Dimensional 2024): https://www.dimensional.com/us-en/insights/a-slice-of-dividend-accounting
6 The Truth About Annuities: Why Their Bad Rap is (Mostly) Deserved | Greenstream #7: https://youtu.be/2gGq4lX2yP4?si=fduhVER5a2KoT_AX
7 Why Investors Are Piling Into Funds That Promise Not to Beat the Stock Market (WSJ, 2023): https://www.wsj.com/articles/covered-call-etf-option-income-jpmorgan-global-x-ff5591f7?mod=article_inline
8 These Hot New Funds Are ‘Boomer Candy’ for Retirees (WSJ, 2024): https://www.wsj.com/finance/investing/retirees-boomer-candy-investing-fund-62454210?mod=article_inline
9 These Funds Are Like Candy for Boomers. The Taxes Aren’t (WSJ, 2024): https://www.wsj.com/personal-finance/taxes/boomer-candy-funds-are-hot-the-taxes-are-not-280c41a3
10 ‘Boomer Candy’ Funds: Sweet Treats or Investment Toothache? (Morningstar, 2024): https://www.morningstar.com/columns/rekenthaler-report/boomer-candy-sweet-treats-or-investment-toothache
11 Rebuffed: A Closer Look at Options-Based Strategies (AQR, 2025): https://www.aqr.com/Insights/Perspectives/Rebuffed-A-Closer-Look-at-Options-Based-Strategies
12 Buffer Madness (AQR, 2025): https://www.aqr.com/Insights/Perspectives/Buffer-Madness
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