Total Return Investing Versus Income Investing in Retirement

There are two main approaches to generating an income. The first is called income investing; this is implemented by focusing on the yield of the underlying investments to generate your desired income (specifically dividend and interest income). The second approach is called total return investing; this is where you consider the dividends, interest and capital gains of the underlying investments when generating your desired income.

Total Return Investing

It is not that we do not like dividend paying securities. We have many dividend paying securities in our portfolios. And when you generate an income, we do incorporate the dividends in your desired income.

The marketing behind dividend investing is quite attractive. You will often hear “you are being paid to wait” or “it is less risky as you’re getting a portion of your investment returned every year,” but in a study by Dimensional Fund Advisors they found that a global portfolio of dividend payers and non-payers have had similar average total returns – (Global Dividend-Paying Stocks: A Recent History – Black, 2012).

The main drawback to income investing during retirement is that the income you generate is based upon the underlying yield of the investments and not based upon your specific needs and wants. We believe that you should design your portfolio to generate your desired income rather than take whatever income the investment may or may not generate.

For example, a very popular and effective way of accumulating funds is investing in real estate. It is effective because the income generated from the property allows the rent earned (income) to help pay the mortgage. Over time, the mortgage is paid down, and you can start to use some of the rent as income. But it is not as effective for a retirement income strategy.

For example, you buy an investment property for $1 million and “rent” it out for $2,500 a month. Your yield (or income earned) is $30,000 a year, representing a 3.0% yield (this example ignores any costs associated with owning the real estate). The problem with real estate is not that it is not a good accumulation asset (it can be) but that it does not allow you to generate a cash flow higher than the rent, as you cannot sell 1/20 of the real estate if you need or desire a higher income.

This brings up another issue that we commonly see in the marketplace: the search for yield to maintain income in retirement has forced many investors to invest their funds in more volatile and higher risk investments in search of a higher yield to maintain their income. We believe this is a dangerous strategy. In a total return income strategy, you do not need to continually chase yield to maintain your income. It is important to invest based on your goals and objectives and appetite for risk (volatility).

Typically, the higher the yield the higher the volatility and significant downside risk. Many investors assume that if I just invest for yield, I will not be touching the capital and therefore I am preserving my capital.

For many Canadians, a significant portion of their retirement income is going to be generated by registered funds (RRSP, LIRAs and defined contribution pension plans). The government policies behind these types of funds require that you dig into capital over time. They are designed to provide an income for you and your spouse, but the government increases the percentage amount you must withdraw every year. These types of funds are not conducive to income investing. You need to have a strategy that systematically allows you to dig into the capital over your lifetime, which involves a total return investment strategy.

Conclusion

Most Canadians will need to dig into their capital over their retirement years. Either by government policy (RRIFs) or to maintain their lifestyle (inflation) throughout retirement. A total return investing strategy is much more conducive to digging into capital and generating your desired after-tax income rather than an income investing income strategy.

We believe focusing solely on the yield generated on your investments reduces your diversification possibilities and may force you to take greater risk in generating your desired income.