What's Wrong with Living Off Capital Gains?

[headingout]

Conventional wisdom is that those approaching retirement should move their asset allocation toward fixed income. Older generations in my own family have the motto "never touch principal," leading them to a primarily fixed income portofolio, which is at risk from inflation. Discussions on this forum seem to favor a "bucket" approach where 1-5 years cash is generated and kept on hand.

My question is this: What's so bad about just regularly selling stocks (in an up market) to live on? Capital gains are usually taxed less than interest/dividends, right? And, assuming you are well diversified, you can sell bonds if needed during the down markets. Seems like being too focused on "income" can lead to diminished overall returns and less safety than a well-diversified portfolio of stocks and bonds.

I'm interested in other opinions, especially from those actually living off their portofolios. Thanks.

 

[xynny]

I don't think there is anything wrong with living off capital gains, but I think the taxes on them will be raised pretty soon. I don't want this to turn into a political thread, but it might happen if we start talking about Obama's plan to raise capital gains taxes. I think if the capital gains taxes incur as much of a tax bite as fixed income investments like money markets then I would rather take the lower risk and put my money in the fixed income investments. In retirement capital preservation is very important, so if stocks carry a higher risk and higher taxes then maybe it's just not worth it anymore. Anyway, I'm not living off capital gains yet, but I worry when I get to the point of cashing out my portfolio the taxes on them will be pretty high anyway.

 

[haha]

Conventional wisdom is that those approaching retirement should move their asset allocation toward fixed income. Older generations in my own family have the motto "never touch principal," leading them to a primarily fixed income portofolio, which is at risk from inflation. Discussions on this forum seem to favor a "bucket" approach where 1-5 years cash is generated and kept on hand.

My question is this: What's so bad about just regularly selling stocks (in an up market) to live on? Capital gains are usually taxed less than interest/dividends, right? And, assuming you are well diversified, you can sell bonds if needed during the down markets. Seems like being too focused on "income" can lead to diminished overall returns and less safety than a well-diversified portfolio of stocks and bonds.

I'm interested in other opinions, especially from those actually living off their portofolios. Thanks.

This is no longer conventional wisdom. Conventional wisdom is what you are proposing- total return investing.

What's wrong with it? Maybe nothing, maybe something. Let us know 40 years down the road.

Ha

 

[FIREd]

I agree with Ha, total return investing seems to have become the standard nowadays and we will see how it performs overtime.

I am personally right in line with the older folks in your family and the Norwegian widow. Never touch the principal and live on the dividends will be my number 1 rule when I retire. It doesn't mean however that my portfolio will be 100% fixed income. It still will be a mixture of dividend paying stocks (with some non-dividend paying stocks thrown in for diversification), bonds and REITs. My target yield would be right around 3.5% for my entire portfolio (right now a 50% stock/ 50% bond AA would get me close to that 3.5% yield). It should allow me to keep up with inflation overtime while providing me with enough annual income to pay the bills. At least that's the plan...

 

[haha]

I agree with Ha, total return investing seems to have become the standard nowadays and we will see how it performs overtime.

I am personally right in line with the older folks in your family and the Norwegian widow. Never touch the principal and live on the dividends will be my number 1 rule when I retire. It doesn't mean however that my portfolio will be 100% fixed income. It still will be a mixture of dividend paying stocks (with some non-dividend paying stocks thrown in for diversification), bonds and REITs. My target yield would be right around 3.5% for my entire portfolio (right now a 50% stock/ 50% bond AA would get me close to that 3.5% yield). It should allow me to keep up with inflation overtime while providing me with enough annual income to pay the bills. At least that's the plan...

I also use the inviolate principle plan- with the exception that I will sometimes buy a relatively small amount of a non-dividend paying stock as a spec. But even in this case, my income needs are covered by other cash payments from my investee companies.

I hope to increase my real income over time, but we shall see. I believe it was primarily the Ford Foundation and the endowments of Yale and Harvard and maybe some other Ivy schools that several decades ago made total return investing respectable for portfolios burdened by income needs. Now this strategy is commonplace, and recommended by most academics and retirement pundits, as well as the FAs in the trenches. It is also the dominant strategy touted on this board, although that might not apply to the majority who have no pension from corporation or government, and who no longer have any working family members. Something about actually confronting the bear in the alders rather than reading about how to dispatch him that makes him look more formidable.

I think that a retired individual is a very different animal than a multi-$billion endowment. Maybe Yale is supposed to allow 5% or so withdrawal pa ( I have a vague memory that Robert McNamera at the Ford Foundation might have popularized that number), but unlike you or me much of that demand could be postponed, spread out, etc. It is more an administrative and organizational problem than a problem of survival.

Ha

 

[socca]

When the stock market is booming, everyone tells me that I'm stupid not to climb on board and enjoy the ride. When the stock market is crashing, everyone still tells me that I'm stupid, but there's an undercurrent of bitterness and jealousy as they watch their own fortunes dwindle. In the meantime, my portfolio just plods along, maximizing safety of principal but not returning a heckuva lot over my own personal rate of inflation. This is just the way I like it.

It's going to be fascinating to watch what happens when all of the baby boomers begin retiring en masse and start selling stock to maintain their own standards of living. Who's buying?

 

[Jay_Gatsby]

When the stock market is booming, everyone tells me that I'm stupid not to climb on board and enjoy the ride. When the stock market is crashing, everyone still tells me that I'm stupid, but there's an undercurrent of bitterness and jealousy as they watch their own fortunes dwindle. In the meantime, my portfolio just plods along, maximizing safety of principal but not returning a heckuva lot over my own personal rate of inflation. This is just the way I like it.

It's going to be fascinating to watch what happens when all of the baby boomers begin retiring en masse and start selling stock to maintain their own standards of living. Who's buying?

Ironically, they'll be selling companies from which other Baby Boomers will be retiring, thereby rendering such companies poor investments.

 

[Kronk]

It's going to be fascinating to watch what happens when all of the baby boomers begin retiring en masse and start selling stock to maintain their own standards of living. Who's buying?

Well, see, I thought boomers didn't have anything saved up anyhow, so they don't really have much to sell!

 

[REWahoo]

Well, see, I thought boomers didn't have anything saved up anyhow, so they don't really have much to sell!

Yep. That's one of the fallacies in the boomer sell-off doomsday theory.

 

[al_bundy]

When the stock market is booming, everyone tells me that I'm stupid not to climb on board and enjoy the ride. When the stock market is crashing, everyone still tells me that I'm stupid, but there's an undercurrent of bitterness and jealousy as they watch their own fortunes dwindle. In the meantime, my portfolio just plods along, maximizing safety of principal but not returning a heckuva lot over my own personal rate of inflation. This is just the way I like it.

It's going to be fascinating to watch what happens when all of the baby boomers begin retiring en masse and start selling stock to maintain their own standards of living. Who's buying?

i thought all the boomers sold off their stock long ago and put their money in bonds for retirement income?

 

[haha]

i thought all the boomers sold off their stock long ago and put their money in bonds for retirement income?

Great one-liner. But I am not so sure that boomer equity liquidation is can be dismissed so easily. Many of boomer era pension funds may also be selling stock to meet their obligations, and since many of them have been frozen there is no offsetting inflow.

Ha

 

[Animorph]

It never made sense to me to exchange equites for FI just to generate "income" that would be taxed at a higher rate than just selling off excess stock. I don't plan to have a cash/bond allocation that stays fixed. When possible, I'll try to sell some shares when the market is above my retirement assumptions. I have about 13% in cash now from doing that last year. Hopefully the market will recover before that goes to zero or I'll have to sell at a lower price than I would want. If the market really goes down, I'll probably reinvest some or all of that cash and sell shares as needed after that. If bonds looked likely to rise in the short term, or provided a good interest rate, I'd buy some bonds with the cash. I've already returned about 40% of my original cash when the market was down close to 20%. Pretty much automatic rather than predicting the market.

 

[Abreutime]

It's going to be fascinating to watch what happens when all of the baby boomers begin retiring en masse and start selling stock to maintain their own standards of living. Who's buying?

People buy shares of companies because the companies make money. If the price goes down low enough, people will buy. Besides, baby boomers will not be selling their stocks en masse. Most boomers don't have significant assets, and the ones that do will not be selling them off quickly.

13 retirement myths - Boomers will crash the market (5) - Money Magazine

 

[megacorp-firee]

Agreed.
BBs will not emasse sell off their $250K portfolios on day 1 of retirement. They will be drawing it down gradually, if at all. Although, we think we are the exceptions, IMO many will have some plan (good or bad) to systematically draw down their funds.
Additionally, BB 'retirement' are spread over a good number of years. While the trend MAY be a gradual selling of assets, it won't be a spike and run on the market as some are implying.

 

[clifp]

I think what Ha Ha said here is key.

I believe it was primarily the Ford Foundation and the endowments of Yale and Harvard and maybe some other Ivy schools that several decades ago made total return investing respectable for portfolios burdened by income needs. Now this strategy is commonplace, and recommended by most academics and retirement pundits, as well as the FAs in the trenches. It is also the dominant strategy touted on this board, although that might not apply to the majority who have no pension from corporation or government, and who no longer have any working family members. Something about actually confronting the bear in the alders rather than reading about how to dispatch him that makes him look more formidable.

I become an equity income fan during the 2000-2002 bear market which unhappily coincided with start of my early retirement. (of course the great internet bubble made my ER possible so I won't complain)

In theory it is all very simple, take your $1+ million portfolio with a 60-80% in stock index funds, and 20-40% in bonds, with a cash cushion. Once a year move $40K (4%) to a money market at the end of year rebalance, increase for inflation, rinse and repeat until you die.

In reality I have yet to meet an early retiree who follows the book, but I have met plenty of folks planning for ER who think that is what they are going to do. Perhaps with a government pension or two you can. But when Mr Bear is in full force, all the books, FIRECALC runs etc don't provide a great deal of comfort. (And this is from one of the least risk adverse guys on the board, i.e. angel investor, option writer, high yield chaser, and WSOP poker player.)

The old way has a big advantage; you have good idea what you can spend based on your projected income. For example say your $1 Mil portfolio looks like this
400K stock index funds @2% dividend yield = $8,000
300K bonds/cash @ 5% interest = $15,000
300K dividend stocks/funds/managed payout @5% = $15,000
Total income = $38,000

That is what you spend, with 70% of your money invested in assets with history of income growth a relatively modest annual dividend/managed payout increases of 4-6% keeps up with inflation.

If you run into a bad market like this year where some firms slash or eliminate the dividend and the fixed income interest rate drops to 4%. Your income may drop to say 35K, to keep up with inflation you need to spend 42K. You have a shortfall of 7K and need to dip into your emergency fund/cash cushion. This isn't financially much different than annual rebalancing with a total return approach, but pyschological drawing down 7K from your say 50K emergency fund is much easier to stomach than watching your portfolio drop from 1,000K to 930K (due to a 10% drop in your equity holdings) and withdrawing 42K. Next year if Mr. Bear continues you start to look at ways to bring your spending in line with your income, much the same way you would if your spouse lost his or her job. When Mr. Bull returns you replenish your emergency fund, and go take the vacation and maybe buy the new car.

 

[headingout]

I appreciate the replies from folks actually living off their assets. No question that real world experience trumps theory. Having invested through the dot-com bust, 9/11, and now the credit crisis I'm confident in my behavior during the accumulation phase. But I don't know how these "crises" would look to me from the retirement side. One inviolable rule, in my opinion, whichever path you take, is not to sell assets at a loss.

 

[Finance Dave]

My question is this: What's so bad about just regularly selling stocks (in an up market) to live on? Capital gains are usually taxed less than interest/dividends, right? And, assuming you are well diversified, you can sell bonds if needed during the down markets. Seems like being too focused on "income" can lead to diminished overall returns and less safety than a well-diversified portfolio of stocks and bonds.

I'm interested in other opinions, especially from those actually living off their portofolios. Thanks.

Capital gains tax rates vary based on Congress and tax laws. Most current research says they will increase in 2010 after expiration. McCain would want them to increase a smaller amount than would Obama, although Obama is discussing a "donut hole" approach that may not affect low to moderate income families.

But there are a couple other issues:
1) When I look at the long term (20-30 years), I can see no logical way we can continue to have tax rates as low as we do. Our budget deficits, national debt, and funding shortages with both SS and more importantly Medicare seem to indicate to me that tax rates are headed up (perhaps it won't be cap gains taxes...who knows).

2) Asset allocation. If you continue to leave all principle in equities, and the market keeps going up, you'll exceed your risk tolerance, especially as you age. Then when the market declines (as it does from time to time) you'll contemplate jumping out a window...not something I advise with concrete streets.

Dave

 

[jIMOh]

A person should factor in different taxes (maybe) depending on where the dividends come from.

Consider:
$ 1 M all tax deferred. 4% SWR=40k. Married filing jointly suggests taxes owed on this are $5197. Does not matter if the 40k was from dividends, bond interest or any other type of asset- all taxed as ordinary income.

40k-5.2k=34.8k total spendable income.

Consider the suggestion above of

400K stock index funds @2% dividend yield = $8,000
300K bonds/cash @ 5% interest = $15,000
300K dividend stocks/funds/managed payout @5% = $15,000
Total income = $38,000

if the dividends are in a taxable account and bonds/managed payout tax deferred, the 38k income is taxed as follows:

8k yield taxed at 5%=$400
$30,000 managed payout taxed at $3698.

38k-4.1k=$33.9k income
Total tax bill is $4100. There is 2k less income coming in, yet only $900 less in spendable cash.

If a person puts all income into a taxable dividend account

$1 M in a dividend fund which yields 3.5% and is taxed at 5%
$35,000 income taxed at 5% ($1750)= $33.3k income

I would argue the third scenario is the one least likely to run out of money and it has only 1.4k less than the second situation.

 

[Kronk]

That's not quite accurate. Married Filing Jointly taxes on $40,000 would be $2,513 at the current rates. Standard deduction of $10,900 and personal exemptions of $7,000 lead to taxable income of $22,100.

Quick federal tax estimator: Federal Income Tax Estimator - Financial Calculators from CalcXML