The Best Income Generator in Retirement
Now that my wife and I have been vaccinated for COVID-19, we are beginning to reconnect with old friends. Last weekend, we enjoyed an evening with another couple about our age that has spent the past year thinking hard about retirement. They asked if we could get together and talk about it.
They came to the right place. Earlier in my career, I was a retirement planning specialist. I spent nine years advising employees of a Fortune 500 company that were eligible for a voluntary reduction in force (VRIF).
As a result of that experience, I have a very good idea of what matters most in retirement. And when it comes to money, what matters most in retirement to most people is cash flow.
A generation ago, many companies provided pension plans to ensure that there would be enough income in retirement to make ends meet. However, pension plans for private-sector employees have become a thing of the past.
These days, you need to create your own pension plan in retirement. That’s especially true if your Social Security benefit will not be sufficient to fully support your annual living expenses.
Unfortunately, most people do not have enough money in savings to generate meaningful income from stock dividends and bond interest. Relying on stock market appreciation for income is a dangerous game to play in retirement. It only takes one major stock market correction to put you in harm’s way.
Major corrections occur about once every decade. That means that there is a good chance my friends will experience at least one major stock market correction during their retirement. How can they generate enough income to make ends meet while avoiding the risk of running out of money?
Lack of Interest
The fundamental problem with traditional sources of income is that interest rates are historically low. Despite doubling over the past six months, the yield on the 10-year Treasury note is still only 1.7%. Good luck living on that!
Even junk bonds are not paying much these days. The yield on the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) is 4.9%. That means you’d need to invest more than $1.2 million in this fund to generate $5,000 per month in dividend income.
Most people don’t have that much money to invest. Plus, junk bonds are far from safe. They tend to perform well while the economy is humming along but quickly lose value when a recession hits.
Since 1950, the U.S. economy has gone through 10 recessions. That averages out to one recession every seven years. According to the U.S. Census Bureau, the average length of retirement in the United States is 18 years.
That means the average retiree in this country could experience at least two recessions and one major stock market correction. If you live at least 21 years in retirement, you may witness three recessions and two corrections.
That’s why I do not advocate relying on stock market appreciation to generate cash flow in retirement. That strategy works fine as long as stock prices keep going up. But it’s a recipe for disaster when they take a big dive.
That is also why I do not advise owning junk bonds in retirement. A prolonged recession could result in a wave of bond defaults that end up wiping you out.
That’s the bad news. The good news is there is a much better way to generate more income in retirement that is considerably less risky than either of those two strategies.
Got You Covered
It is a technique known as covered call writing. Here’s how it works.
First, you buy the common stock of companies with solid balance sheets and robust cash flows. For the purposes of this example, I’ll use International Business Machines (NYSE: IBM).
Next, you sell a call option against your shares. Whoever buys that option has the right to buy your shares of IBM at a specified price within a certain period of time.
A few days ago while IBM was trading near $135, the call option that expires on July 16 at the $135 strike price could be sold for $5. You get that money now and it is yours to keep no matter what happens next.
Now, let’s do the math. The $5 option premium you receive for selling the covered call option works out to an options yield of 3.7% over the next three months. On an annualized basis, that equates to 14.8%.
You also get to keep any dividends paid on those shares while you still own them. IBM pays a forward annual dividend yield of 4.8%. Its next quarterly cash dividend payment will be made in June before this option expires.
In this example, the combined annualized options and dividend yield on IBM adds up to 19.6%. That amount is four times greater than the dividend yield on the junk bond fund.
At that rate, you would need a little over $300,000 in equity to generate $60,000 in total annual cash flow instead of $1.2 million. For some investors, covered call writing may be the only way to make ends meet in retirement.
An expert in the covered call strategy is my colleague Robert Rapier. Keep an eye out for an exciting offer from Investing Daily. It’s a new premium trading service, with Robert at the helm. His trades generate steady income like a machine. Watch for details, soon.