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Income Replacement

The capital markets have consistently demonstrated the ability to grow assets over time but in my opinion the best use is for income replacement. Whether working or retired, we all need a steady stream of income. During the paycheck years our income comes from employment. I have spent nearly a quarter of a century helping people transition from the employment phase into the “own-your-time” phase (although widely used, I never preferred the term “retirement” because of the lackadaisical connotation that history has imposed upon it). The challenge of replacing the employment paycheck is greater when long term planning is not involved. If we think about it, there is currently a perfect storm for retirees. First, interest rates are low therefore income from time deposits are low. Second, inflation may impose a higher cost of living as we age and third; living longer places us in danger of outliving our savings.

The first level of resistance to using stocks and bonds as the income replacement investment medium is typically derived from a misunderstanding of volatility. “If I invest my savings in stocks, I can lose my money!”. I will begin by pointing out that there is not a single example of a permanent decline in the history of the stock market1. Each past decline has experienced a full recovery. Second, I can argue quite effectively that volatility is a key element to a premium rate of return. Any efforts to dampen volatility in an asset class will lead to a reduction in the expected return. Dare I say that volatility is our friend? Yes, many people have lost money in stocks over the years and many will going forward. In most cases due to a lack of diversification or selling prematurely during a decline when emotions can affect judgement. If taken case-by-case we could determine the reason behind the losses and likely provide a solution that would have altered the outcome.

How does an income replacement plan work? Let’s assume a couple is retiring and need to replace the $70,000 in household income (pre-tax) that they earned while working. It’s likely that all will not need to be replaced with assets because other income resources (like social security, pension income, etc.) will cover a portion. In this example, we will assume that the couple’s social security payments will replace half of their former paycheck and they would like for their investments to provide the other half. If they begin planning years in advance and built a nest egg of $840,000 (one rule of thumb is 12x pre-retirement household income), they should be in good shape. Our team uses simulation software to project outcomes and when we apply the following assumptions:

  • A balanced allocation strategy (approximately 60% stocks, 35% fixed income and 5% cash).
  • 25 year joint life expectancy.
  • 2.20% annual inflation.
  • $33,000 first year distribution with cost of living increases (COLA) annually.
  • Total distributions of $858,000 throughout life expectancy.

We conclude that this couple has an 80% probability of success. What this means is that we can advise a high level of confidence that this goal will be met without significant adjustments to the plan.

Let’s return to the point made earlier about volatility and premium returns. If we took the $840,000 in savings that the couple had saved and placed it into a fixed and guaranteed savings instrument that paid 1%, the couple still would have met the income replacement objective. Because of the low rate of return, the couple would face certain depletion if they lived longer than normal life expectancy and at the end of the 25 year period would have little or no assets left to leave behind. If not for the volatility of the stock and bond portfolio, the potential for a premium rate of return and high probability of having a significant amount left in the investment portfolio at the end if life expectancy would not exist.

Why do capital market investments make sense as an income replacement strategy? Because while the fixed income components of the portfolio produce a steady income stream, corporate earnings have led the way to higher stock prices and many stocks have demonstrated a history of increasing dividend payments. According to FACTSET, Aggregate dividend (income) payments for stocks amounted to $105 billion at the end of the second quarter (July), which was a 10-year high for the S&P 500. This was the ninth consecutive quarter that dividends increased, and the fifth consecutive quarter that dividend payments hit a new high. On a trailing twelve-month (TTM) basis, the aggregate amount of dividends paid out was $399.3 billion. This was the sixth consecutive quarter that the index hit a 10-year high. At the end of Q2, dividend payments were nearly 45% greater than the 10-year TTM average of $274.5 billion.

Income replacement is a challenge that most of us will face sooner or later. Proper planning along with a disciplined savings regiment and prudent investment decisions can lead to a successful transition from paying your dues to owning your time!

-Rick O’Dell

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