Over the weekend, I was reading Barron’s, and there were numerous articles about obtaining enough income in retirement. The recommendations vary from buying dividend stocks, annuities, and/or bonds. All of these strategies offer various challenges and risks.
Buying dividend stocks offers income and the potential for capital appreciation. The problem is that many of these stocks trade at elevated valuations, such as utilities and consumer staples stocks, which have historically been reliable for dividend payouts. Other higher yielding stocks can carry quite a bit of risk and can be subject to dividend cuts, so you don’t want to be suckered into a high yield, without a careful examination of the underlying risks. Equities tend to be more volatile, so if you are relying on dividend stocks to fund your retirement income, you must be willing to accept larger swings in your portfolio. Not panicking when you endure these swings is of paramount importance.
Annuities are theoretically an answer to longevity risk, in that they can generate income if you live longer than expected. They come with an insurance company guarantee, but that guarantee comes with a litany of negative aspects. Costs tend to be quite high and the return potential is usually considerably lower than what can be earned in a traditional investment portfolio. If the market tanks, you will likely feel better temporarily sitting in a fixed annuity with less market risk, but if you have a longer-term time horizon, there are usually better options. There are many types of annuities with different features, but in my opinion, there are more efficient and cost-effective ways to structure a portfolio with superior characteristics. Annuities also have terrible liquidity problems and can be very costly to terminate early if you come to a change of heart on them.
Traditionally bonds were ideal to generate income upon retirement. They offer fixed interest payments, and in aggregate tend to offer less market volatility than equities do. A bond-ladder, where you are staggering the duration of your bonds, can help hedge interest rate risk. As we’ve discussed, many times before, interest rates across the globe have never been lower. With over $13 trillion in negative yielding bonds, it is very hard to build a bond portfolio with solid credit characteristics and attractive yields. The higher yielding bonds tend to have greater default risk. Currently, most high yield stocks are in the distressed energy sector, where low natural gas and oil prices are pressuring profits for the shale drillers’ especially. Rising interest rates have the potential to decimate a bond portfolio’s returns, so bonds at current prices should not be considered a low risk option. Annuities also carry that risk, in that buying a fixed annuity right now, virtually ensures historically low returns, regardless of whatever higher yields are available in the future.
Fortunately, there are better solutions to generate income, with a better risk and cost profile than these strategies. At T&T Capital Management (TTCM), our focus is on deep value investing, and intertwining income-generating strategies, which also reduce risk. Once we identify an undervalued stock, we often like to sell put options on them. Usually, we are targeting annualized returns between 10-18% when we do this, which is about 5-10 times what 10-year Treasury bonds are paying. If the market drops, taking our stock down with it, we will take mark to market losses similar to stocks in the short-term. However, as the option’s time value elapses and gets closer to expiration, the protection from the option will shine through. Generally if we sell a put at the money (where the stock trades at currently), and collect a 10% premium, and the stock declines 20%, we will only be down 10% at expiration. This is 50% less than we would be down owning the stock outright. Upon being exercised on the option, we would have all of the upside and dividends that the stock can provide. Many of our best returns historically have come from being exercised on stocks and riding the recovery higher.
For example, if a stock we like is trading at $50 per share, we might sell a $50 put for $5 for premium, with the option expiring in a year. Each option is based on 100 shares, so we are collecting $500, on $4,500 of risk ($5,000-$500 premium). Our break-even is $45 per share and let’s say we value the stock at $65. If the stock tanks due to some short-term issues and goes to $40, we will be down 11% at expiration, instead of the 20% had we bought the stock outright at $50. Now we own the stock we believe is worth $65 and can ride the recovery. If the stock trades above $50 when the option expires, we make a very solid 11% return. To me this is a much better risk/reward opportunity than paying too much for stocks, buying an annuity, or purchasing bonds at record-low rates. Naturally, we are able to find opportunities in fixed income, REIT’S, and MLP’s from time to time, but the option tools are a major competitive advantage.
While the strategy has worked wonderfully, the true value of it will exhibit itself when times are toughest. When this bull market ends and the market sees lower equity returns, these strategies could mean the difference between generating enough income in retirement or not. That isn’t meant to be a bombastic statement at all. It is hard to get enough income owning bonds yielding 2%, before inflation, where real returns are basically zero. Stock returns have been the bailout, but bull markets don’t last forever.
In summary, there are many different ways to reach your retirement objectives. We are at a point in time where the market has had a historic run and interest rates are exceptionally low. Future returns on both stocks and bonds are almost assuredly going to be far lower than what they have been in the past. If you are limiting yourself to simply owning stocks, bonds, or annuities, you are taking a knife to a gunfight. Implementing options on value stocks is not easy to do and it takes a lot of research, which is what we are here for. I feel like we are well-protected with quite a few hedges via covered calls and cash-secured puts. Sometimes we will see volatility from having some concentration in our top names, but those stocks have tended to provide our best returns over the years.