Retirement Lab: Growing Income From CEFs And ETFs

Written by Nick Ackerman, co-produced by Stanford Chemist

During retirement, the last thing you want to worry about is your cash flow and potential disruptions. However, these are key things that need to be addressed. Addressing these issues with a plan can keep one from re-entering the workforce. After all, this is time that should be spent with family or doing whatever else you love.

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I believe one of the biggest risks here is the erosion of buying power due to inflation if you aren’t able to grow your income stream – at least grow it modestly to outpace inflation. Another key benefit of growing your income stream when you can is to reduce the risk of what a future market collapse can do to your income. Growing income now can help negate some or all of the damage that might be done to your income. The best time to be planning this is before a crash happens. Unfortunately, we are in the midst of a crash year due to COVID-19. The full extent of the damage is not known yet. We can use this as a lesson though to future proof one’s incoming cash flow.

There are at least two primary ways that an investor can take to grow that income stream too. The first, for most CEF investors we realize that we have to reinvest at least a portion of our distributions. Additionally, there are ETFs that can focus on growing income too. Generally, these aren’t starting out at as high of a yield; but, with these, we can also use a more of a hands-off approach and use the passive nature of growth do the work.

Reduce The Risk Of Inflation Eroding Buying Power

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Evil number one to an investor, inflation. This can be a thorn in the side of any investor at any age. It becomes more of an issue for a retiree as it can do double damage; reducing buying power and not participating in wage increases. Since most of these folks aren’t in the workforce, they don’t receive the corresponding wage increases to help offset that workers can generally feel as paychecks increase from an employer.

Chart

Data by YCharts

Generally, inflation doesn’t come up in sudden bursts, at least historically in the U.S., we have been relatively sheltered. You may notice or recall though, in the 1970s the spikes in inflation that did happen. Interest rates took off dramatically, “raising interest rates to some 20%, a number once considered usurious.”

Generally, inflation is a slow, creeping monster that slowly sucks the life out of your portfolio. It isn’t much of an impact until you leave the workforce and you don’t receive annual pay increases from an employer. You certainly will feel the strain when you are on a fixed-income though, as I’m sure many of our readers would attest to.

In fact, the U.S. Fed can be a source of sore discussion on this topic. As inflation is looked at monitored as “core inflation.” Core inflation takes out those pesky volatile items such as food and energy. You know, the items that consumers use every single day to live. Yeah, those don’t count.

A growing income can help potentially head off the worst impacts that inflation can have on your income.

Reduce The Negative Impact Of Dividend Cuts During Tough Economic Times

Another factor that one might consider a big risk, the falls that we see in the typical market cycle. Everyone knows that booms and busts happen in the economic cycle, this then generally carries over to the markets. The markets then experience peaks and troughs as we enter into and out of recessions. A glaringly obvious reality as we are in the midst of one currently.

In looking back, the U.S. has entered many periods of recessions. Of course, like any other nation in the world. Consider this, as nations around the world become more and more intertwined, this increases the risk of global economic catastrophe. This isn’t to be a scaremonger, it is just a fact that as we get closer ties we will experience hiccups at the same time. What this means is that there will be fewer places to hide out during these times. As a side note, I am a huge believer in diversification. However, we are still limited in where we can shelter assets in a global manner.

The chart below is all the recessions we have experienced and the performance of the S&P 500.

Chart

Data by YCharts

The overall trend of the market is biased to increase over time, that we know. Inflation does play a role in asset prices increases as well. Companies increase their earnings as they increase prices for products and services – this in turn raises EPS. Share buybacks here play a role as well to increase EPS and lower P/E ratios, but that is another whole topic.

What is really interesting is the table below. It shows the annual amount of dividends per share from the S&P 500.

(Source)

We also see this tends to increase over time as expected. Two important keys to take away is the fact of how the market has absolutely exploded higher over the last ten years. Dividends have followed suit too. What you can also take away is the drops in dividends per share for the index as periods of uncertainty hit. It is yet to be determined what the final outcome for 2020 will be, as this table is for the prior 12-month period ending June 30th, 2020. That means we still have some of last year’s data leaking over.

We may be lucky and the worst is over; this would put us on firmer ground as dividend cuts should be relatively minimal. With that being said, we could revisit lows as coronaviruses tick up in the U.S. and that would put significant pressure on dividends once again. Either way, another prime example of a risk that we face as investors to our income stream.

Reinvesting Portions Of Incoming Cash

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Now, on to the important subjects. How to offset the risks that inflation and market crashes can have on your portfolio.

We have discussed the topic of reinvesting all or a portion of income cash has on an investor’s portfolio. This was explored in one of our Income Lab Ideas series. In that, we arrived at the fact that an investor could potentially grow their income at around 8.3% at full reinvestment. This assumed an 8% portfolio yield at the time, paid monthly in an even amount.

Though, if you are in retirement already reinvesting 100% of incoming cash isn’t really a realistic goal. We then followed this calculation up again by calculating out the partial investments.

Reinvesting 25% of your income we found out the annual increase could be potentially as high as 2.075% annually. This also means that if you are fortunate enough to reinvest half or 50% of what your portfolio is pulling in you would potentially achieve a 4.15% annual raise.

Again in this scenario, we assumed an 8% portfolio yield reinvested monthly. We did assume a level payment throughout the year as well. The starting values of the portfolios were both $500,000. However, dollar amounts weren’t really a factor as percentages are percentages. Ultimately, the difference between 25% reinvestment and 50% reinvestment after 20 years was substantial as one would imagine.

The ending value for reinvesting 25% was $753,974,.78. The income an investor could have potentially been pulling in went from $40,830 the first year to $60,317.98. A total increase of almost 48% after 20 years.

For the 50% reinvestment, we arrive at a final value of $1,127,596.22. Income had grown from that potential first-year pulling in $41,659.99 to $90,207.70. That works out to almost a 117% increase over that time period. That is massive.

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Unfortunately, we aren’t all in the same boat in life. We go into retirement with varying accounts and varying needs. There isn’t a one size fits all. The bottom line: reinvest what you can, it pays off significantly.

ETFs With Growing Income Streams

Utilizing an ETF strategy and one can be a bit more hands-off. With the reinvestment strategy taking a more active role. Additionally, reinvesting a portion of an ETF portfolio can also be massively beneficial. The downside here is that you generally start at a lower yielding portfolio initially already. That leaves less on the bone to work with.

With that being said, one might be interested in checking out our new ETF Income Portfolio. A portfolio with a last reported yield of 6.83%. That is above average what you can expect from an ETF portfolio. Even as the portfolio is constructed as more of a passive and well-diversified source of income via ETFs.

Traditionally, what we see with many ETFs is that they track an index. Therefore, they also pass through the dividend income to shareholders. This can happen naturally as underlying positions in an index increase dividends. Then, there are those with a specific focus on increasing and growing income as well.

Just taking a look at the most popular; we have SPDR S&P 500 Trust ETF (SPY). As we highlighted above, the index has experienced growth over the years in dividend income. Some years coming down as we go through recessions. Now, we can see how this played out in an investible ETF.

(Source – Seeking Alpha)

What we can see is that last year SPY paid out $5.6184 for 2019. Now consider this, from 2008 to 2009 we saw a 19.96% cut to dividends. Remember, this was in a deep and prolonged recession. This current one will potentially be shorter-lived with less damage. For the sake of what we have to go on though, let’s assume another 20% cut in dividends this year.

Based on last year’s $5.6184 a 20% cut means we would fall back to around $4.495 in dividends. Going back through the years again, in 2014 SPY paid out $4.2059 and in 2015 it paid out $4.539. Ultimately, we are set back about 5 years from current levels. Devastating, but still mitigate some of the worst if you just assumed we were at a flat amount from the beginning. That is just one scenario and it doesn’t necessarily mean it will work that way again.

Consider some ETFs that have an investment objective to achieve growing income. Something like the Vanguard Dividend Appreciation ETF (VIG). They “provide a convenient way to track the performance of stocks of companies with a record of growing their dividends year over year.” In this case, the fund has only come out in 2006. So, they appear to have been able to achieve this. Most of these dividend grower ETFs have a relatively shorter life span. ETFs in general have just begun to pick up popularity.

One thing we do see though with VIG is that they were able to achieve this. With most ETFs, we do see a varying rate but generally, the trend is upward.

(Source – Seeking Alpha)

Our Model Portfolio As An Example Of Full Reinvestment

Income Generator

We have also experienced income growth by more than just reinvesting dividends too. Utilizing our swap strategy, we have also grown income over the years. This is another example of 100% reinvestment. This is as the portfolio takes distributions in the form of cash, Stanford Chemist will then put that cash to work in opportunities.

(Source – Stanford Chemist’s Income Generator Portfolio)

Above is the 3-month average income collected in the model portfolio. Using a 3-month time period reduces the variances that we see from quarterly payers. It is also important to realize that this isn’t a completely passive portfolio, it does take trading as we swap between investments. Overall, trading is less frequent than our Tactical Income- 100 Portfolio where we look to take advantage of special situations.

In this case, for the first 3-months, the portfolio existed in February, March and April of 2017 the portfolio collected $2,242.56. For the same period in 2018, this worked out to $2,394.86 or a 6.8% increase. In 2019, this amount increased to $2,581.72. That is good for an increase of 7.8%. For 2020, we arrive at a grand total paid out for the same February, March and April periods of $3,106.91. That is good for a massive increase of 20.34%!

Being that this year was quite a bit larger, it does skew the data in our favor. From the first three months of inception to 2020, we arrive at an increase of 35.54%. That works out to an annualized increase of 12.85%. That is rather high and quite frankly, very lucky. I would temper forward expectations. Something like a 10% increase would even be fantastic. Of course, again, this is assuming a 100% reinvestment of all cash distributions coming in. It also was under the assumption every trade was taken at every exact price a trade alert went out.

This is especially true that we should temper expectations as we could see an overall downtrend this year due to the COVID-19 sell-off. We are already seeing the impact of companies cutting dividends. These dividend cuts are and will translate into CEFs and ETFs cutting their distributions as well.

Ultimately, that is what I am wanting to highlight though. If you give yourself flexibility now to increase income, then when the risks do hit you aren’t completely at their mercy. You have built-in a sort of “buffer” for your income if you are able to grow the income stream.

Tactical Income- 100

Our Tactical Income- 100 Portfolio also had some income growth. With this portfolio though we are more focused on making tactical moves to generate potential alpha.

(Source – Stanford Chemist’s Tactical Income- 100 Portfolio)

Note: The ‘spikes’ in income at the end of the year and the beginning of the years are due to special distributions being paid out. This is when many CEFs pay out their required amount of capital gains/income to stay within compliance of the RIC status.

The model portfolio launched in January of 2017. In the first quarter after that portfolios launch income came in at $2,022.98. For 2018, income rose a bit to $2,076.46. A small rise of 2.64%. For 2019’s equivalent January, February and March’s income we have quite a significant rise of $2,617.44 or a massive climb of 26.05% off the prior 2018’s income. Finally, for 2020 income came in at $2,602.32. This was a slight dip off of 2019 of -0.58%.

Overall, from Q1 2017 to Q1 2020, we arrive at an increase in income generation of 28.64%. This works out to annualized growth of 9.55%.

Conclusion

The ultimate risk to one’s reliable income stream is inflation and market crashes. Utilizing two strategies of to increase dividends can ultimately fend off the worst of the situations. Using a strategy of reinvesting we discovered that an investor could negate the negative effects. Not every investor is fortunate to be able to reinvest 25-50% of their income. However, something is always better than nothing.

At current levels, 25% is more than enough to mitigate the impact of “core inflation.” Although with core inflation we are taking out the volatile impacts that food and energy have on the everyday consumer. Going back to 1913, the U.S. has averaged an annual inflation rate of 3.22%. With that being said, we haven’t seen inflation over 3% in the past 10 year period. This is according to the U.S> Labor Departments data from July 14th, 2020. (Source)

If we continue that historical average, one would struggle to keep pace with inflation on only a 25% reinvestment. If we see inflation levels as we have recently, then we do have a very real possibility to outpace inflation. We haven’t even averaged 1.82% over the last 10-years.

The other strategy to mitigate potential disruptions in dividend income is to offset those with ETFs that grow payouts over time. This can be a function of just their underlying positions appreciating in payouts or their direct target of dividend growth itself. Both result in an added benefit to a shareholder of mitigating the negative impacts of inflation and market sell-offs.

Finally, using our swap strategy at the Income Lab can have a huge positive on our final results as well. “Compounding income on steroids” has been been a boon for our portfolios. Though this can work in any shareholder’s portfolio as well. As we end up with “free shares” that compound our already high portfolio yields in the first place! We have certainly been able to blow income growth out of the water – though expectations going forward should be more subdued.

Using the free shares method is the most hands-on route. Ultimately, investors have been the most rewarded. Reinvesting all or a portion of one’s incoming cash flow does also take some more hands-on work, but isn’t too strenuous. Then, allowing dividend growth to happen naturally from a portfolio of ETFs can be a completely hands-off approach, though is the most inconsistent. One could also find CEFs that increase over time as well. In that case, there just happens to only be a select handful that has survived without cuts, while being around before the GFC in 2008.

Profitable CEF and ETF income and arbitrage ideas

https://static.seekingalpha.com/uploads/2019/5/2/27546953-15567808556447084.pngAt the CEF/ETF Income Laboratory, we manage ~8%-yielding closed-end fund (CEF) and exchange-traded fund (ETF) portfolios to make income investing easy for you. Check out what our members have to say about our service.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article was originally published to members of the CEF/ETF Income Laboratory on July 19th, 2020.

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