Generating monthly income after early retirement is a logical as well as an emotional exercise.
There are 2 primary ways to generate monthly income after early retirement from your retirement corpus.
The first method is so called Total Portfolio Approach.
The second method is the Income Approach.
The total portfolio approach is the rational and logical way to generate retirement income.
This is what your brain would tell you to do.
The income approach is the emotional way to generate retirement income.
This is what your heart will tell you to do.
Let us look at each of these 2 approaches in some more detail.
We will dig into the pros and cons of each of these retirement income generation models.
Total Portfolio Approach to Generate Retirement Income
The total portfolio approach involves making withdrawals from your early retirement corpus from time to time.
Each withdrawal means you sell down a part of your portfolio principal as well as some of the capital gains in your portfolio.
At the same time the rest of your portfolio continues to compound and grow.
This is like the portfolio compounding you experienced while getting to the point of financial independence.
This is exactly what a systematic withdrawal plan (SWP) from your mutual fund is supposed to do.
It is dollar cost averaging in reverse.
There are some clear benefits of following this approach as outlined below:
In the total portfolio approach you take out income in the form of capital gains.
You can choose which assets to sell and when. This lets you take taxes into consideration much better.
It lets you to largely control your tax bill.
You also pay a relatively lower tax rate since capital gains are typically taxed lower than regular income.
Greater Control Over Cash Flows
By being in control of your cash flows you can balance your income and your expenses in retirement.
You can dial your income up or down depending on your specific cash needs during a specific period.
This lets you better manage your portfolio and keep your desired asset allocation in place.
Greater Inflation Protection
Since you only take what you need, the rest of the portfolio can continue to grow and compound over the years.
You could follow the 4% rule to make portfolio withdrawals under this model.
This helps to maintain the purchasing power of your retirement corpus for a long time to come.
So, as it stands everything looks good about this total portfolio approach.
What exactly is the problem then?
Well, there are some obvious emotional cons about this model which in turn are the pros of the second retirement income model.
We now look at the second model for generating income after early retirement.
Income Approach to Generate Retirement Income
The second approach for generating retirement income after early retirement is the income approach.
This method is an emotional approach to generating retirement income.
This is what your heart tells you to do irrespective of what your logical brain in telling you.
It addresses the deepest fear for any early retiree – Running Out of Money during your lifetime.
The fear of eating into your retirement corpus.
Peace of Mind
There is nothing like the peace of mind of having regular passive income every month come rain or shine.
The comfort of getting a monthly salary in the form of dividends / rent / interest from your portfolio is the true joy of achieving financial independence.
Getting an income each month without having to work at a job is bliss.
It can do wonders for your sense of financial security.
Add to that the icing on the cake.
By not touching your principal, you can be assured that you are not going to face the greatest fear of any retiree.
That fear is the fear of running out of money during your lifetime.
You don’t need to monitor your portfolio or make decisions about what to sell every time you want to get some income.
With your portfolio generating regular income that hits your bank account, you can focus on your other priorities in life after early retirement.
Easier to Spend
Research on retirement income has shown that retirees find it much easier to spend money that come in the form of regular income.
Generating income by selling a part of your portfolio is much emotionally harder to spend.
The idea that you can go from being a saver to a spender overnight in early retirement is one of the most common early retirement myths.
The point of getting to an early retirement is to enjoy the fruits of your hard work.
If getting a regular retirement income lets you spend more freely in retirement, then that is a huge pro in its favour.
Having looked at all the pros of the income approach it is time to look at its flip side.
Higher Tax Outgo
Getting regular income from your portfolio is like a having a salaried job.
The government will tax this as regular income using incrementally higher tax slabs.
The tax slabs for regular income are typically much higher than capital gains tax rates applicable in a total portfolio approach.
Therefore, you have much lower post-tax returns in the income approach versus the total portfolio approach.
Less Control Over Cash Flows
You have very little control on the timing and value of the cash flows you will be getting with the exception of any bonds you hold.
How much you get as dividends and when you get them depends on the whims of the market or the fund manager.
Moreover, income in the form of rent or dividends may be subject to volatility depending on the market conditions.
It may require you to exercise greater flexibility in your lifestyle expenses.
Principal Loses to Inflation
When you start taking out all income as regular distribution your principal has no ability to grow in line with inflation.
Your retirement nest egg will keep getting smaller as the value of money erodes over the years.
The real value of a 3-crore portfolio may drop to less than 2.7 crores in just a couple of years due to inflation.
There is a real risk that over the years your original portfolio value may shrink.
It may be unable to generate sufficient income to fund your retirement expenses.
You may be forced to dig into your principal at this stage to generate sufficient income.
This is ironic since the attraction of the regular distribution approach was to avoid touching your principal amount.
Effective Strategy for Generating Retirement Income
Now that you understand both these approaches to generate retirement income after early retirement, which one do you go for?
Both approaches have their pros and cons.
A good compromise is to structure your retirement income generation in a manner that combines elements of both these approaches.
This will let you benefit from each of these approaches while limiting the downside from picking 100% one way or the other.
You can let half your portfolio generate a regular cashflow following the regular income approach.
This will leave you in much better mental place knowing that you have some regular streams of income that will deliver cash each month.
The other half can remain invested in a total portfolio approach.
This will allow your retirement nest egg to continue growing even after you have entered retirement.
Your portfolio can be used from time to time to generate additional income.
This is when your regular income falls short, or if you have an unexpected cash requirement.
A hybrid approach like this will go away to capture most of the pros of both approaches.
At the same time, it will limit the cons of going 100% one way or the other.
Dushyant Choudhary is the founder of dushyantnomics, an early retirement blog for professionals. Dushyant retired early from his 9-5 corporate life after a successful international career. He brings his knowledge and experience to his current role where he’s dedicated to helping professionals achieve a fulfilling retirement.