Tax-implications of yield vs. total return approaches to drawing income

On September 30, 1981, income-seeking investors had it easy. The Bloomberg Aggregate Bond Index offered a yield of 16.5%. The Russell 1000^® Index complemented that with a yield of 5.5% (which would climb nine months later to a peak of 6.2%). At the time, a balanced investor could have earned a 10% yield from a hypothetical 60% equity, 40% bond portfolio simply by rolling out of bed in the morning. Fast forward 36 years, and the picture for today’s income-seeking investors is very different. As of September 30, 2017, the Bloomberg Aggregate Bond Index offered a 2.6% yield and the Russell 1000 Index’s yield stood at 2.1%. Source: FactSet as of September 30, 2017. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly. This has driven many investors to stretch for yield in historically riskier asset classes, like MLPs, emerging market debt and global high yield, which are yielding 7.4%, 4.5% and 5.5% as of September 2017, respectively, according to the Alerian MLP Index, Bloomberg Emerging Markets Debt Index, and the Bloomberg Global High Yield Index. Wondering how much riskier these asset classes have been in the past? The chart below illustrates it well. These higher yields have been counterbalanced by some of the worst 12-month returns dating back to January 1994: -39.7%, -29.9% and -37.1%, respectively, for MLPs, emerging market debt and global high yield. Cash: Citigroup 1-3 Month T-Bill Index; U.S. Treasuries: Bloomberg U.S. Treasury Index; U.S. Aggregate Bond Index; Credit: Bloomberg U.S. Credit Index; Long Treasuries: Bloomberg Long U.S. Treasuries Index; Global Infrastructure: S&P Global Infrastructure Index; Bonds: Bloomberg U.S. Aggregate Global REITs: FTSE EPRA/NAREIT Index; Emerging Market Debt: Bloomberg Emerging Markets Debt Index; U.S High Yield: Bloomberg U.S. High Yield Index; Global High Yield: Bloomberg Global High Yield Index; MLPs: Alerian MLP Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. However, as my colleague, Sam Pittman, Head of Retail Solutions, has pointed out: yield isn’t the only way to generate income from a portfolio—and in many cases, it may not be the most efficient, especially when taxable accounts are involved.

Looking beyond yield for income

Depending on the investor’s circumstances and preferences, consider generating income by taking systematic withdrawals from a total return portfolio. For example, investors who:

• prefer greater control over their cashflow pattern
• don’t mind spending portfolio principal
• are attempting to generate a cashflow stream from a taxable account

may find a total return portfolio helps them reach their goals in a more tax efficient manner while also reflecting their circumstances and preferences.

Let’s look at an example

Assume a $1 million nest egg from which an investor wants to withdraw $40,000 per year—a 4% withdrawal rate. Let’s consider two portfolio options for achieving this goal:

1. Portfolio option #1: A Yield-oriented Portfolio targeting a 4% yield To achieve the yield target, this hypothetical portfolio would be allocated 50% to U.S. stocks and 50% to bonds. The portfolio would derive a 2% yield from dividends and 6% from bonds (mostly U.S. and global high yield bonds).
2. Portfolio option #2: A Total Return-oriented Portfolio from which the investor will take systematic withdrawals equivalent to the $40,000 income requirement Let’s assume that this portfolio is allocated 60% to stocks and 40% to bonds to help it continue to grow over the long term despite the withdrawals. The stock portion of the portfolio would generate approximately 1.5% in dividend yield (assume a diversified portfolio of U.S. and non-U.S. stocks, large cap and small cap exposure); the bond portion approximately 2% (assume an aggregate bond-type portfolio). The total yield of the portfolio would be approximately 1.7%. The investor would make up the remainder of the desired income by systematically selling shares from the portfolio.

For illustrative purposes only. What does the cashflow stream look like for these two portfolio options—especially once taxes are considered? In both approaches, the pre-tax cashflow is the desired $40,000. However, the after-tax cashflow looks very different for both portfolios:

• The Yield Portfolio leaves the investor with $24,600 after taxes;
• The Total Return Portfolio leaves the investor with $33,129 after taxes.

This is a hypothetical illustration and not meant to represent an actual investment strategy. That 35% difference in the amount of after-tax spending is due to the higher tax rate applied to interest and dividends—from which 100% of the Yield Portfolio’s cashflow is generated—than to capital gains—particularly long-term capital gains. The Total Return Portfolio generated $17,000 of the desired $40,000 cashflow from dividends and interest and the remaining $23,000 through systematic selling of shares, thereby reducing the tax liability of the portfolio. Of course, this doesn’t mean that a total return approach is best for all investors. In fact, a yield-oriented approach is typically a better fit for investors who have a preference to not invade principal, do not mind some variability in their cashflow, and are drawing income only from non-taxable assets. In contrast, for clients who are considering drawing income from taxable assets, want to control their cashflow pattern and don’t mind spending principal, the potential tax advantages of a total return approach may be better suited.