Retired clients often wonder how they will generate income in retirement. Beyond Social Security, pension payments, and other forms of guaranteed income how does their investment portfolio actually produce the money they will need to keep up with inflation and pay the bills?
Two ways in which your investments can support you in retirement are “yield” and “total return”. In this post I will share how they are different and what role they play in your long-term retirement income plan.
Yield vs. Total Return
The term “yield” refers to how much interest or dividend income your investments pay.
“Total return” refers to how much you made (or lost) on your investment over the time you owned it.
Yield is part of your total return. In fact, Yield +/- Appreciation (Depreciation) = Total Return.
An S&P 500 index for example, currently has an annual yield of about 1.74%. That means the dividend payments of the stocks the index owns average out to about 1.74% over the course of a year. During that time, however, the market will fluctuate and the value of the index will be more (or less) than what you paid for it. In other words, your total return will be something other than 1.74%.
Maybe some numbers would help make the point. Imagine a $100,000 investment into an S&P index fund. The yield is 1.74% so you can expect to receive $1,740 of income over the next 12 months. A year from now the S&P will be up or down from where it is today, but you still would have received about $1,740 in dividend payments.
In this example, if we assume the market went up by 6%, then the total return would be 7.74%. Here, a 1.74% yield + 6% appreciation = 7.74% total return.
Keep in mind it goes the other way when prices go down:
1.74% yield – 6% loss = -4.26% total return. (I know. The concept of a negative “return” is contradictory, but that’s the language of money).
Bonds are a little different. In a very literal sense, when you own a bond you are loaning money to someone else, usually a company or government entity. Like any loan, bonds pay interest to the owner of the bond. Bonds are also set for a fixed period of time: 1 year, 10, years, 30 years, etc.
When that time period ends, the bond is said to have matured and the investor gets his original principal back. Along the way, the bond has been paying a fixed interest payment each month or year. This interest payment is your “yield”. If you hold a bond to maturity, yield and total return would be the same.
As with other investments the value of a bond can go up or down in value between the time you purchased it and maturity. However, if you keep the bond until maturity you get your initial investment back. This makes bond investing a little different than stocks or mutual funds. With bonds there is a promise to pay back your principal. In stocks or mutual funds there are no promises.
In some cases, of course, a bond issuer may default on their promise to pay back the principal at maturity. This worst case scenario is unlikely, but it can happen.
Lower risk bonds that come from issuers with strong credit ratings often pay less interest. The 10-Year Treasury Note currently pays 2.95%. Bonds that pay high interest are likely to come from issuers with weaker or questionable credit.
Retirement income: total return or yield? Clients often want to know which is more important, total return or yield. The truth is you need some of both. You will need consistent, reliable and rising income from your investments if you are to live off them during retirement and keep up with inflation. However, a negative total return (i.e. you are losing money) is obviously unsustainable.
A bad quarter or year, even a bad few years, can be tolerated as long as you aren’t forced to liquidate your investments to pay the bills. Eventually, markets will improve. However, selling investments to pay the bills when those investments are down in value is a sure way to experience permanent losses on those investments.
This blog post is a super simple description of the differences between two investment concepts: yield and total return. Before making any investment decisions do your homework. If necessary, consult with a financial advisor or other investment professional to create a retirement income plan that meets your income needs, stays within your risk comfort zone and is appropriate for your goals and time horizon.