Sometimes as advisors we fall short in addressing the most basic questions clients have for us. Not because they’re not important, but because we as the advisor often fixate on the most technical and nuanced questions. A question that fits neatly into this basic yet crucially important category is how exactly advisors turn your retirement savings into retirement paychecks. It’s at the foundation of what we do, but all too often it gets overshadowed or neglected in client conversations.
We Start with a Portfolio
One of the initial steps in working with any advisor is determining the appropriate investment strategy for your portfolio. Essentially, you’re looking to strike a balance between your personal risk tolerance and how much retirement income you want / need from the portfolio. The less risk you’re willing to stomach the less lifetime retirement income you should expect from the portfolio, and vice versa.
When calibrating risk in the context of investing the most basic question is what portion of your portfolio should be allocated towards stocks, which are more volatile but higher performing investments. Then, simultaneously, what portion should be allocated towards bonds, which are more stable but lower performing investments. It’s the responsibility of the advisor to guide you through this conversation and ultimately help you strike the optimal balance between risk and reward throughout your retirement.
Creating Cash Within A Portfolio
Once you and your advisor have chosen and invested your money in the optimal mix of stocks and bonds, the advisor has a number of different ways to “create cash” within your investment accounts. Creating cash is the process of utilizing your existing investments to generate liquidity (more cash), which can then be paid out to you in the form of monthly withdrawals.
More than likely your advisor uses a combination of investments to create the liquidity you need. One of the most common sources of cash generation in a retirement portfolio are bonds. Bonds make interest payments to the bond holders on a recurring basis, and depending on the portion of bonds in your portfolio those interest payments can be quite significant. Oftentimes bond interest can generate enough cash throughout the year to cover several months of withdrawals for a retiree.
With bond interest often covering anywhere from three to six months worth of a retiree’s cash needs, advisors then look to stocks for more cash generation. It’s fairly common for US companies to offer a dividend, or recurring cash payment, to its shareholders as a way of enticing investors. Once again, depending on the portion of stocks within your portfolio, dividend paying stocks can generate another few months worth of liquidity needs.
Selling High To Top Up Cash
It’s not uncommon for bond interest and stock dividends to fall short in covering a full year’s worth of withdrawals. So, in order to create the additional cash needed to fund the rest of the year’s withdrawals, advisors will sell stocks within your portfolio. Ideally advisors will sell stocks that have risen in value, which cashes in on that particular stock’s strong performance. Additionally, trimming those particular stock positions keeps the portfolio from becoming top heavy, where a few concentrated stock holdings grow to represent an uncomfortably large portion of the overall portfolio over time.
This practice of rebalancing the portfolio not only avoids concentration risk within the portfolio, but also acts as another form of cash generation. It serves as an additional way to top-up cash needs that dividends and bond interest weren’t able to cover. Then, being that dividend payments and bond interest recur annually, the entire cycle of creating cash starts again.
Creating cash within a client’s portfolio is one of the more basic responsibilities we have as advisors, which is why we tend to skate over it as a talking point. As basic as it may be, it’s important for any investor to know what’s going on behind the scenes within their portfolio. Therefore, the next time you’re wondering how your retirement savings turns into your retirement living, you have your answer.
