Over time, inflation causes a static amount of money to essentially become worth less -- it erodes money's purchasing power. Purchasing power is also eroded when the cost of an item increases at a rate faster than inflation. For the past several years medical costs have been the best example of an expense category rising faster than inflation. The $50 office visit five years ago now costs $100+. Other categories such as housing, especially in some high growth geographic areas, have also risen much faster than inflation.
The solution then is to continue to invest part of your portfolio in stocks. But with stock dividends at such low levels, many retirees don't like that idea because stocks don't generate enough income. The ideal of "not touching the principal" and living off the interest of a portfolio can be difficult to shake. To get over this mental hurdle, we advise retirees to take a "total return" approach to their income needs. Purely from an income standpoint, would you rather own a bond that yields 5% or a combination stock/bond portfolio that yields 2%? The bond at 5% seems like the logical choice: earnings of 5% on $100,000 in bonds is $5,000 a year, while the 2% yield on the $100,000 stock/bond portfolio offers just $2,000 in income. But the amount of current income obtained from a particular investment shouldn't be the only thing considered in this decision.
Generally speaking, in three out of four years the total return (yield plus capital gains) from a stock portfolio will exceed the total return from an all-bond portfolio. What if, thanks to the stock holdings, the $100,000 stock/bond portfolio grew in value by 7% during the year? When you add the income of $2,000 to the appreciation of $7,000, the total return was $9,000 ? considerably more than the return from the bonds. But what if you need the full $5,000 of income to help meet your living expenses? Simply withdraw the difference from the stock/bond portfolio, selling some stock or bond fund shares as needed.
The table below gives two ten-year scenarios. In each case, an annual withdrawal is made that is adjusted upward to keep pace with a 3% rate of inflation (e.g., if income of $5,000 was desired initially, then $5,150 would be needed at the end of Year 1 in order to maintain purchasing power).
The "fixed income" strategy relies exclusively on bonds and CDs. An average rate of return of 5% is assumed. Note that this strategy falls behind almost immediately. The first year's withdrawal, after adjusting for inflation, is more than the amount earned. A small dollar amount of securities must be sold in order to fund the full payout. This leaves less remaining to invest in Year 2, resulting in a slightly greater shortfall that year. More securities must be sold to fund the payout. The cycle continues, slowly eating into the principal. Furthermore, the "ending balance" column in Year 10 doesn't tell the full story. After adjusting for 3% annual inflation, the principal's purchasing power is shown to be reduced to an even greater extent (far right column).
Now let's look at the "total return" portfolio consisting of 60% stock funds and 40% bond funds. Returns vary from year to year, but assume they average 9% per year over the entire decade. The first year all goes well, but stocks take a hit in Year 2, pulling the entire portfolio down. Securities must be sold (in such a way as to maintain the 60%-to-40% balance going into Year 3) in order to fund the payout. Briefly, the portfolio is looking worse than the fixed income strategy. What does the retiree do when his stock-oriented portfolio loses money? The first thing to remember is that you are investing for the long-term. Over the long haul, periods of ten years and longer, stocks have consistently produced positive results. Given life expectancies today, most retirees will live for 20-35 years off their portfolios, so a long-term perspective is appropriate.
