120 Waterfront Street, Suite 410, National Harbor, MD 20745 | P: 301.567.0706
211 North Union Street, Suite 100, Alexandria, VA 22314 | P: 703.519.1254

Total Income Approach

The most common method used to generate income from assets is to live off the income and dividends generated from investments. This would include the use of very “safe” investments (e.g., federally insured certificates of deposit, U.S. Treasury bonds) and generally recognized as safe investments (individual high-quality [AAA/AA/A] corporate bonds and municipal bonds and bond funds). This also includes dividends from high-quality dividend-paying stocks, preferred stocks, and alternatives such as real estate investment trusts (REITs) and limited partnerships. This has been a time-honored approach that has been successful for many investors. It is very easy to implement in theory and provides a reasonably steady income stream. This income may also increase with inflation as dividend-paying companies increase their dividends.

In general, interest rate risk is the risk that you accept when you invest in a security that pays a fixed rate of interest over a specified period of time. Interest payments may be made at periodic intervals (i.e., a bond “coupon”) or interest may accumulate over the life of the investment and be paid at the end of the term (e.g., a certificate of deposit). Lastly, the investment may be purchased at a discount and pays out at full value (i.e., at “par”) at the end of the term of the security (as in a zero coupon Treasury bond).

As in all strategies, there are risks with this approach as well. The risk most familiar to current investors is that current interest rates will not support the income that investors need to generate from their investments. Those who have invested in CDs that have matured over the past few years are very familiar with this type of risk. The question is, “Do I invest in a longer term investment to get a higher rate of interest?” The answer to this question involves how much interest rate risk (i.e., the risk that interest rates will rise or fall during the period of time of the investment) that you wish to assume. In an environment of very low interest rates, the interest rate risk is very high. If interest rates rise and you locked in a low rate (for example on a government bond or CD), then your investment would not be worth as much if you needed to sell it (i.e., the price for that security will fall to a point that the corresponding interest rate that a purchaser would earn would be equal to what was available in the current interest rate environment). If you can lock in a rate that is acceptable to you and you know that you will not need to sell that investment before it matures, you do not need to worry if interest rates rise. The only cost that you are accepting is the “opportunity cost” that you would be able to get more interest if you had waited until rates rose. One last point to consider is the purchase of very long-term investments such as 30-year Treasury bonds. If the interest rate that a Treasury bond pays is sufficient to support your income needs, you still have the risk that inflation will accelerate leaving you in a position where the current income that is paid is not allowing the investor to keep their standard of living due to inflationary forces.

Lastly, for those investors who look to dividend-paying stocks to generate the income they need have two risks to consider: individual stock risk and dividend payment risk. Individual stock risk (which is discussed more in the next section) is in essence the risk that the company for which you own stock would go out of business, leaving your investment worthless. While it is acknowledged that this risk is generally accepted as very low when dealing with large, well-known companies, it is nevertheless a risk that must be considered. One only needs to point to the risk in owning Enron or WorldCom stock to understand this type of risk. The second risk is that the company will cut its dividend such that the dividend payment that you receive is less than you expect, or need, to live on. This generally happens during tough economic times and can dramatically impact the amount of income received by the investor. This generally corresponds with periods when the stock market is falling and the value of the dividend paying investment (stock, REIT, etc.) falls as well. If the investor finds herself or himself in the position of needing to raise cash, she or he may need to sell the stock and recognize the risk that they may receive less than they paid for the investment (e.g., stock market risk). 

© 2012

Website Design For Financial Services Professionals | Copyright 2018 AdvisorWebsites.com. All rights reserved