I will outline those disadvantages first, so that I then can show you how to prepare to handle them and minimize any potential risks. With some planning and a little steady maintenance management, you can set up and manage a portfolio and make sure that the advantages outweigh the disadvantages.
1. There is no research or published information on this approach.
As I indicated in a previous article, the investment industry uses the traditional Total Return approach to providing retirement income almost universally. Therefore, it can be difficult to find information about the alternative method of retirement income investing. You will have to learn everything on your own or from some stranger like me.
2. Companies change their dividend policies.
Dividend payouts are not guaranteed and for C-Corporations are purely elective. Even companies that have rising dividend policies outlined and codified in their business plans may change their policies depending on the company’s financial performance or changing conditions in the overall markets. Therefore, companies can, and often will, slow dividend growth, reduce dividend distributions or even eliminate their dividend payouts completely.
3. This approach requires a substantial amount of work
Even once you set up your portfolio, you will have to dedicate time and effort regularly to screen, analyze and select suitable income securities for your portfolio. Income security selection is not passive.
4. Purchasing power (inflation)
Potential reduction of purchasing power is a substantial risk to long-term fixed income as provided through long maturity bonds or preferred stock. While you can select securities that pay rising dividends and mitigate some of the inflation concerns, you still must monitor the contents of your portfolio to ensure annual portfolio income is increasing at least with the rate of inflation so that your household will maintain purchasing power.
5. Dividend transactions
Depending on the number of securities in your portfolio that distribute dividends quarterly, you probably will have 20 to 30 transactions per month that you must track and record. Securities that pay monthly dividends will increase the number of transactions even higher.
6. This approach has its quirks that you must accept and, more importantly, you must teach yourself to go of the old total return paradigm.
The inability to make this mental shift could lead you to take actions that will be detrimental to your Income portfolio. You could end up selling into market troughs or, worse, “taking profits’ at market peaks, with a resulting decrease in portfolio income and no easy way to replace it without reaching for higher yield and higher income risk. Therefore, this will be the show-stopper for most who try this method but end up in the years ahead with reduced portfolio income due to actions that seemed to make sense at the time they did them.
7. The pure income investor must be able to accept that the established investment community will denigrate this approach.
The pure income investing approach creates no income to middlemen. Broker-dealers, mutual fund managers, insurance companies or any other investing professionals will not receive any money from you. You will receive every penny from your income securities. Middlemen do not like being dealt out of the retirement portfolio management business as this is their livelihood.
I can think of no reason why a Registered Investment Advisor (RIA) could not provide advice about pure income investing that I am sharing in this series of articles and in my book “Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends.” For some retirees who do not wish to manage their own true income approach, it might make sense to hire such an RIA to manage their income portfolios on the behalf of the retiree for a small fee or a percent of the income. However, among the many RIAs I have met, such an RIA will be exceedingly rare.
8. Tax preparation for retirees using taxable accounts can be onerous
Taxes for a pure income portfolio will be more complex to prepare and might result in increased cost of tax preparation. Most of the large brokerages today will consolidate all securities 1099 data into a single 1099 that can be electronically downloaded to tax preparation software. However, even with this consolidation feature you will still have a lot of transactions to manage and track. For a portfolio that holds 50 income securities paying quarterly dividends, you will have to monitor 200 distribution transactions per year. That is equivalent to about 17 transactions per month that you must monitor.
9. Ignoring peer pressure.
At cocktail parties and other social events, your friends and acquaintances will undoubtedly brag about their double-digit and triple-digit asset value gains when the market is in an uptrend. When it is your turn, you must be able to say that you received all dividends on time with a 3.4% annualized dividend increase here or a 6% annualized dividend increase there and that you have no idea what the valuation of your portfolio has done. You must be perfectly content with this when you get condescending stares, comments and eye-rolls of disbelief from others.
10. Tax issues surrounding Master Limited Partnerships
In your pursuit of high-yield investment vehicles, you will have to invest in a few Master Limited Partnerships (MLPs). The price you will pay for these high-yield returns is that you will have to deal with some tax issues that are specific to MLPs and which can be daunting. This is a complex issue and I will provide more information in a future article.
If reading about the advantages of this approach in my previous article got you interested or even excited about pure income retirement investing and if the disadvantages listed above did not dampen your excitement too much, you are ready to move on to the next step. In my next article, I will start discussing few risks before I continue outlining some basic terminology and individual steps you must take to create your pure income retirement portfolio.
Bruce Miller is a certified financial planner (CFP) who also is the author of Retirement Investing for INCOME ONLY: How to invest for reliable income in Retirement ONLY from Dividends and IRA Quick Reference Guide.