Motley Fool Answers’ September Mailbag: How Should Retirees Extract Cash From Their Portfolios?

Ah, the traditional pleasures of September. Summer's heat starts to recede. Pumpkin spice–flavored everything starts to appear on menus. People get in their first complaints of the year at seeing retailers roll out the Christmas marketing before they've even picked out their Halloween costumes. And, of course, here at Fool HQ, the month would not be complete without a mailbag show from Motley Fool Answers podcast hosts Alison Southwick and Robert Brokamp. To help them address all your autumnal financial conundrums, Sean Gates, a financial planner with Motley Fool Wealth Management (a sister company of The Motley Fool), returns to the studio. 

In this segment, they look ahead to that time when you stop focusing on growing your portfolio and pivot to living off of it. But what, asks listener Alastair, is the more Foolish approach: Just keep your assets in growth stocks, selling shares when you need money, or reallocate into dividend-generating stocks and bonds that throw off regular income, even if that means their value grows more slowly? Ah, say the Fools. It's a trick question...

A full transcript follows the video.

This video was recorded on Sept 25, 2018.

Alison Southwick: The next question comes from Alistair. "Assume for a moment that we all arrive at retirement dewy-eyed and with an emergency fund, several years of spending money in low-risk assets, and a pile of stocks to last us through 30-plus years of retirement. There appear to be two general strategies for converting stocks into cold, hard cash. One, grow the basic value of the assets and then just sell the assets when we need cash; two, convert the assets into dividend-generating stocks and bonds to provide income, maybe accepting the lower rate of return, but preserving the assets. Which one is more Foolish?"

Robert Brokamp: The quick answer is both. I'll take the one with the dividends. I personally like the idea of dividends for retirement income for lots of reasons. First of all, there are many studies that have shown that a diversified portfolio of dividend-paying stocks is less volatile than the overall market.

Dividends, again as a group, tend to be paid each and every year and go up every year, at least at the rate of inflation and sometimes higher. There have been a handful of years, over the last 50 years, when dividends have been cut by the overall market, but for the most part, if you're getting, say, $5,000 this year from your dividend-paying stocks, you can be pretty sure you're going to get at least $5,000 next year. So from a planning perspective, I like that if I'm a retiree. Whereas if I'm going to rely just on capital gains, I don't know what my portfolio is going to be worth.

There are many people who think that relying on capital gains is a better way to generate retirement income, and one of those people is none other than Warren Buffett. In his 2012 annual message, he explained what he called his "sell-off method." He said that you have a company that gets cash every year, and you can pay that as a dividend. But if you have managers who can reinvest in the company and grow the stock price even more, that's a better way to do it.

Plus, with a dividend you have to take it every year whether you need it or not. If it's outside a retirement account you have to pay taxes whether you need it or not. But Buffett points out that if you're going to use capital gains, you only sell stock when you need it. If you don't need it, you can just hold onto the stock. His other point was that with a dividend, it's completely taxable. With a capital gain, only part of it is taxable, because the part that comes back as basis is tax-free.

I think that argument is compelling, as well, so I would generally say a diversified portfolio of both is a good idea. One way to differentiate it is to say, "I have a certain number of expenses that I have to cover in retirement." You make sure that's covered with Social Security [a pension if you get it], and maybe some solid dividend payers so you know you have that income coming in, and then you can take a little more risk with the rest of your portfolio. Maybe invest in some of these stocks that don't pay dividends like Amazon and Netflix. They've been great stocks to own, even for retirees, even though they don't pay a dividend.

Sean Gates: And a report from the field. Generally when I take calls from folks, almost the default thought is, "I have a pot of money." Let's say it's $1 million. "I want to live off of that $1 million, so how do I get you to keep the $1 million at $1 million and just pay me my desired income of $70,000? Tell me what dividend portfolio you have that can give me a 7% yield."

The reality is that a 7% yield, because you need $70,000 a year off your $1 million portfolio, doesn't exist. Or it does exist, but it's an extremely risky version of dividend stocks. So there are high dividend payers who are stretching their business sheets to reward their shareholders with cash and risking some of the business needs to pay that high dividend, and then there are more stable dividends like Bro was referring to; dividend growers and things like that.

The reality is you need a combination of both and ultimately you want the highest total return and how you mix it up doesn't matter. You just need that overall return profile.