The number one question Financial Advisors around the country ask me is “How do I restructure a client portfolio to provide them more income?”
There are four ways, and I will explain them in turn.
- Income-only plan
- Systematic/Partial Withdrawal Plans (SWP)
- Combination of SWP and annuitization
An income-only plan requires a slow shift of equities into a portfolio of income assets. One of the key issues you need to know before embarking on this transition is the health environment of your client. Obviously, a client who is eighty-five and suffering from poor health will require a different plan than a sixty-eight-year-old in good health.
The goal you want to achieve in an income-only plan is to create an income-focused portfolio comprised of different asset classes. This combination will both mitigate risk and create a blended rate of return. Hence, if the income from one asset class is reduced, the impact on the blended rate won’t have an outsized negative impact on the income stream.
The following financial instruments can be used to create an income only plan. You don’t have to use all of these, but you will need to use enough of them to provide needed income and diversification.
Long-term bond interest
I recommend buying long-term bonds to achieve the diversification you need. As tempting as it can be, now is not the time in a client’s life cycle when you want to reach for yield by reducing quality. So, I suggest either US Government bonds or municipal bonds.
Laddered certificates of deposit interest
I recommend you take the funds you are going to place in certificates of deposit, divide that sum into 5ths, and invest equal amounts in 1,2,3,4 & 5 year CDs. If rates suddenly go up, then a 5th of your capital will be available each year to reinvest.
Common vs. Preferred
Every portfolio should have a common stock component although the size of this component is reduced in an income-only plan. This is the sole way to ensure capital growth. At the same time, you want the common stock portion to contribute to the blended income stream. Therefore, you want to have the common be value-oriented stocks which traditionally pay dividends.
The stocks with the highest dividends are preferred stocks. Since corporations are allowed to exempt 70% of income from preferred stocks from taxation, most preferreds are purchased by corporations. If you deal only with individuals, you may not have as much familiarity with preferreds as you do with common stocks.
There are various types of preferred stocks, but I am going to focus on regular preferreds and convertible preferreds. You purchase a regular preferred stock solely for income and not capital appreciation. Unless there are rapid changes in interest rates, the price of the stock will trade in a narrow band.
A convertible preferred gives you the best of both worlds. Namely, they have greater surety of income and less volatility than common stocks. Because you can convert the preferred into the common stock of the issuing corporation, a convertible preferred will give you an opportunity for capital appreciation and have the potential to keep pace with the inflation rate.
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Contributing Writer: Subject Matter Expert Charles McCain