Are you living off income or cash flow?

Ask a group of retirees what they want from their investments and they’re likely to give the same answer: income. If you’re relying on your portfolio to meet monthly expenses, that makes sense. But in most cases, what retirees really want is cash flow. We’re not just splitting hairs here: when investors don’t appreciate the difference between income and cash flow, they’re prone to make poor decisions.

Income, in the truest sense, refers to interest from bonds or dividends from stocks (if you own an investment property, it also includes monthly rent). The key idea is that income does not deplete your original capital. Cash flow, on the other hand, includes all distributions from your investments, including capital gains and return of capital.

Retirees often say they want to live off the income from their investments while leaving their capital untouched. But that goal is out of reach for most Canadians. At current rates, a broadly diversified portfolio of bonds and stocks might yield 3% or so, meaning you’d need a $1 million portfolio to generate just $30,000 in annual pre-tax income.

The fact is, most retirees will need to draw down some of their principal to meet monthly spending needs. In other words, they should plan to live off cash flow, not income.

When monthly income isn’t really income

Many investment products produce steady cash flow using some mix of interest, dividends, capital gains and return of capital. Unfortunately, they’re often called “monthly income funds,” a name that can be misleading. If you’re spending all the cash flow from these funds, you are definitely not living off income: you’re spending capital, too. In some cases, a lot of it.

A dramatic example is the BMO Monthly Income Fund, which pays a monthly distribution of $0.06 per unit, or $0.72 annually. Here’s how those distributions were characterized during the last four years (periods ending September 30):

The BMO website explains that “this fund’s objective is to provide a fixed monthly distribution while preserving the value of your investment.” However, its $0.72 distribution currently works out to an annual payout of close to 10%. As a result, the fund’s unit price has been declining steadily for years: it was $9.64 at the start of 2004 and was $7.25 in early March of this year, a drop of about 25% over a decade.

Another option

Now let’s look at the RBC Monthly Income Fund, which has per-unit distribution of $0.0425 per month ($0.51 annually), down from its earlier target of $0.0475 ($0.57 annually). Here are the details from the last four calendar years:

With this fund, capital gains and return of capital are occasionally used to keep the monthly distribution consistent, but these make up a small portion of the overall payout. The annual distribution works out to less than 4% of the fund’s current price.

The point is not necessarily that one of these funds is better than the other. It’s just a matter of understanding what you’re buying. Traditional planning models suggest that if you spend about 4% of a balanced portfolio each year (adjusted annually for inflation), it’s likely to last throughout your retirement. By contrast, spending 10% of your portfolio annually is sustainable only in the rosiest of scenarios. If your “monthly income” in retirement consists mainly of return of capital, you’re at risk of outliving your money.