When meeting with financial advisors, we’re consistently hearing concerns that retirees may feel challenged to generate sufficient income to meet everyday expenses in this low-interest-rate environment. As a result, they may be tempted to pursue certain high-yielding investments, without fully understanding their associated risks. But yield, of course, is only one form of income, and it should not be the sole focus of a retirement income strategy.
We found that investors looking for income may benefit by implementing an entirely different approach. As I share in a recent article in
Financial Advisor Magazine, the behavioral tendency of “mental accounting” may help advisors shift client conversations from yield to income.
Nobel Prize-winning economist Richard Thaler, credited with illuminating the concept of mental accounting, has observed that people treat money differently depending upon where the money comes from and its intended use. While advisors are in the business of constructing efficient portfolios that maximize return per unit of risk, most individuals view their wealth in buckets or pots.
Recognizing this tendency, we created a framework that breaks income into three distinct tiers:
Anchor, Cushion and Yield.
Anchor Income includes employer pensions and Social Security payments and may also include other predictable, periodic income streams like annuity payments. Ideally, anchor income should cover essential expenses, such as housing, utilities, food and insurance premiums. If anchor income falls short of covering essential expenses, it may be prudent to convert a portion of a portfolio into a vehicle that generates guaranteed income.
The second tier of retirement income is
Cushion Income. These funds can be used to pay discretionary expenses and unexpected expenses, or to cover a gap in paying for essential expenses. Examples of cushion income include low-risk, short-duration investments such as savings accounts, money market funds and short-duration bonds.
After the first two tiers of income are addressed, any remaining cash can then be allocated to investments with the potential to provide additional
yield to the portfolio, generating income and offering diversification from the stock portion of the portfolio. Yield is one calculation that can be used to help select these investments.
The Three Tiers of Retirement Income is a simple, yet powerful, tool to help your clients allocate money to generate the cash flow they need. Learn more about the program
here.
There is no assurance that the investment process will consistently lead to successful investing. There is no assurance the stated objective(s) will be met.
Diversification neither assures a profit nor eliminates the risk of experiencing investment losses.