Financial queue (Photo by Dominic Lipinski)
To live off a portfolio, you need yield. But you can get into terrible trouble reaching for it.
These days the average payout on stocks and bonds is a meager 2%, and it’s hard for a retiree to survive on that. I’ll show you a good way to boost that yield. But first I’ll show you how yield chasing can be very bad.
The problem is not that going for more yield is risky. There’s nothing wrong with risk, if you get paid to take it. Junk bonds have a high risk, because some will default, but their high yield compensates for the default losses. Stocks are risky, but they compensate with high returns over time.
The problem with high yield is something else. It’s that Wall Street has concocted products that use yield as a bait and then smother the buyer with fees.
You can see this in a closed-end fund called John Hancock Tax Advantaged Global Shareholder Yield. When it opened for business 12 years ago, yield-hungry investors bought it because it promised to make big percentage payouts. Which it did, and still does. The current dividend checks amount to a lavish 8% of the portfolio annually.
But a large fraction of the payout has come from “return of capital.” When earnings on the portfolio are inadequate, Hancock cashes in principal and mails it out.
Imagine that in a time of 2% yields on CDs a bank promises to pay out 5%—and then notes in the fine print that it will be crediting 2% interest while debiting your balance by 3%. What customers would be foolish enough to think that they’re earning more money this way?
But naive investors did buy the Hancock fund, paying $20 a share. Those shares are now worth $7.
Total return on this fund over the past decade has been 4.6% a year, Morningstar calculates. Contrast it with the Vanguard Total World Stock exchange-traded fund, which is in the same line of work—that is, it owns a diversified portfolio of U.S. and foreign stocks. The Vanguard fund’s annual return over the decade has been 8.9%.
The difference in fees is stunning. Vanguard’s fund has an expense ratio of 0.09%, or $9 a year per $10,000 invested. Hancock’s fee is 15 times as high at 1.34%.
Let’s suppose your income need comes to 4% and you want some exposure to international stocks. Buy the Vanguard fund, pocket the dividend of 2.2%, then do your own cashing in by selling 1.8% of your shares every year.
The next decade probably won’t be as bounteous as the last one, but there’s a good chance the total return on global stocks will average at least 4%. If it does, then a 4% withdrawal will leave your principal intact.
If you want to be in safer investments you could buy 2% certificates of deposit and cash in 2% of the principal every year. You’d be collecting 4%. But you wouldn’t kid yourself that you’re earning 4%.
That sorry Hancock fund is just one example of a vast array of income-oriented products manufactured on Wall Street and sold by stockbrokers and insurance agents. Sometimes you can find the fees if you know which page of the prospectus to turn to. Often, especially with anything that has the words “variable annuity” in it, you’d need a dozen mathematicians to figure out what’s going on.
The right way to invest for retirement, or in retirement, is to own index funds with the lowest fees you can find, then create your own custom yield with a withdrawal plan. It’s easy to set up an automatic withdrawal schedule with open-end, a.k.a. mutual, funds. Mutual funds can be found at Vanguard with low fees and at Fidelity with zero fees.
For holdings in taxable accounts (not IRAs, that is), exchange-traded funds are better. Cheap ETFs are offered by BlackRock, Fidelity, Schwab, State Street and Vanguard; find them in the Forbes Best ETFs for Investors survey.
Tomorrow’s installment: The Long-Term Care End Run. Find it by bookmarking this page.