What’s the best way to generate cash from your investments in retirement?

What's the best way to turn your investments into a steady source of cash?. Getty Images

For most of your adult life, one of the challenges of managing money is slicing off a piece of your paycheque and adding that to investments that will, hopefully, grow your nest egg over time.

But a growing number of people in or near retirement are facing the opposite problem: how do you slice off something similar to a regular paycheque from your investment portfolio?

One popular strategy is to invest in assets that produce a regular cash flow. Once upon a time, for most people, that used to be guaranteed investment certificates (GICs). You’d lend money to a financial institution for a set number of months or years and would be guaranteed your money back plus a certain amount of interest.

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Until the 1990s, “you could just take your whole portfolio, turn it into GICs, and get eight per cent, which was a thing,” said Julia Chung, a certified financial planner and partner at Spring Financial Planning.

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But as the general level of interest rates in the economy started trending lower, dragging down GIC rates as well, other cash-generating investments became more popular. These include real estate investment trusts (REITs) and high paying bonds. But arguably the most such asset is stocks that carry a dividend, a portion of earnings that a company distributes to its shareholders.

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Dividend investing

A dividend stock works a bit like a rental property, Chung usually explains to clients. The dividend is similar to the monthly rent: a regular source of cash. But you also own the stock, which, like the rental itself, will hopefully increase in value over time.

One of the main arguments for that strategy is that retirees can draw on dividends for their cash-flow needs and never have to worry about the volatility of the underlying stock, said Rona Birenbaum, a certified financial planner and founder of Caring for Clients.

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And if the companies you choose to invest in increase their dividend over time, you’re all keeping up with inflation, she added.

“There are a very vocal few number of people that say dividend equities is the only smart way to invest,” she said.

But where that strategy starts to break down is when you have an investor who needs to draw down on the capital over 10 or 20 years,” which would be the case for most people, she said.

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One of the issues is that, if you have to sell some of your dividend stocks, you’re not only reducing your underlying investments but your dividend income as well, Birenbaum said.

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And while there are several large and well-established Canadian companies with dividend stocks that have a very solid track record, limiting yourself to those investment increases your exposure to just a few corporations and a few sectors of the economy, Birenbaum added. In Canada that would mean having many of your eggs tied up in, say, utilities and bank stocks, she added.

However, dividend investing doesn’t necessarily mean you have mean cherry-picking individual stocks. You can also easily invest in dividend funds, including exchange-traded funds (ETFs), Birenbaum said.

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Another thing to consider taxes. Dividends from Canadian corporations receive a better tax treatment than interest payments, which are taxed just like regular income.

But the complex tax math for Canadian dividends involves a calculation that will increase the income you declare on your tax return.

“First all of the income is grossed-up, then you get the dividend deduction,” Chung said.

The problem is that the gross-up can lead to a clawback of government benefits like Old Age Security, Chung said.

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Selling your investments

But retirees who need a steady income stream from their portfolio don’t have to necessarily shift to investments that automatically generate cash. Another approach is to happily accept that you’ll just periodically sell some of your investments to generate the money you need.

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If your portfolio grows at least at the same rate at which you’re drawing down the money, your initial capital investment remains intact. The problem, of course, is that won’t always be the case.

Stock markets downturns “can be capital destroying if you have to sell investments at an inopportune time,” Birenbaum said.

The way to manage that risk is to have both stocks and fixed-income investments in your portfolio and withdraw from the latter when the stock market is down, she added.

Fixed income is a type of investment that pays a fixed payment over time until maturity. As you probably guessed, GICs are an example of that. But the most common types of fixed income are bonds, an interest-bearing loan from investors to governments or corporations. Bonds are generally less volatile than stocks, meaning they can soften the overall impact of stock losses on your portfolio.

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But Birenbaum argues fixed income should also include cash stored in a high-interest savings account (these says, she noted, you can easily get a better interest rate on a simple savings account than on a short-term GIC).

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Chung calls this the “cash wedge,” which says should be equivalent to one to two years of living expenses.

Overall, Birenbaum recommends having four to five years worth of living expenses invested in fixed income. The idea is that it would likely be enough to ride out even a recession as severe as the financial crisis — it took five years for the S&P 500 to recover from its October 2007 peak — without having to touch the stocks in your portfolio.

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Year after year, investors should draw from either their fixed-income or their stocks bucket — depending on how the market is doing — to maintain the same balance between the two over time, Birenbaum said. This means that when the stock market is down — and the overall value of that bucket decreases — investors should sell some of their fixed income not just to pay for living costs but also to buy more stocks. Vice versa, when stocks are up, it’s time to skim some of the cream off the top to beef up your fixed-income holdings.

This approach allows investors to be broadly diversified, spreading risks across companies, industries, countries and types of investment.

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A potential drawback, though, is that there’s a lot to keep track of. In addition to managing flows to and from the various investment buckets, you’d also likely be dealing with several accounts, including registered retirement income funds (RRIFs), which come with mandatory yearly withdrawals. That’s not to mention keeping track of taxes.

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That’s work you can outsource to a financial planner, who can design the overall setup, and an investment advisor, who will take care of the investments.

Another option is to use a robo advisor. At Wealthsimple, for example, anyone with a portfolio worth at least $100,000 gets a financial plan, which includes advice on things like when you should be taking your Canada Pension Plan (CPP) if you’re about to retire, said portfolio manager Michael Allen.

The company will look at factors like longevity, whether you have a pension, your cashflow needs and your risk tolerance to build an investment mix that fits your needs. It then takes care of any automatic withdrawals and of rebalancing your portfolio.

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All that’s covered by a management fee of 0.4 per cent plus the low fees you’d pay for the ETFs Wealthsimple uses to invest. (Mutual fund fees, by comparison, easily reach 2 per cent of the value of your investments.)

And while you won’t get to meet with a financial planner in person, “we have video conferences,” said Allen.

The bottom line

Both dividend investing and staying focused on the total return of your portfolio are “very viable approaches,” Birenbaum said.

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“The best strategy for the investors is the one that they’re going to stay disciplined to.”

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