How to Create Safe Income from Mutual Funds

by Neal Frankle, CFP ®

There are many ways to create income from mutual funds. But there are only a few that are really safe over the long-run (which we’ll get to). Many people think that they can buy mutual funds that buy bonds or preferred stocks and that by so doing they’ll safely get the income they want.

It’s true that such funds generate income but they expose investors to risks they may not be aware of. I say this because people who pile into bonds give up the potential to grow their money. They also make the mistake of locking in to today’s ridiculously low rates. That means that when interest rates rise, the value of that bond mutual fund is going to sink faster than the Titanic. That’s because as interest rates rise bond values drop. That’s just what  bonds do.

So if you are interested in creating safe income from mutual funds – especially growth mutual funds – there is a far better way. Let’s look at such an alternative.

Let’s assume you have $100,000 and want to take an income check every year from your account. You’ve decided that bonds aren’t for you. You like the idea of investing in the S&P 500 because you like the long-term potential for growth.

You also realize that you need that income for a very long time. So buying long-term investments seems like the right thing to do. Your only problem is that you want to get an income check every year and don’t know how to do it. Let me solve that problem for you right here and now. Look the graph below:

mutual fund income

 

This shows what happened to an investment of $100,000 made in the S&P 500 over many many years. (You can’t invest directly in the S&P 500 but you could have purchased any number of index funds or ETFs that do and your returns would probably be pretty darn close to the numbers you see above.  The only problem is that the past is no indication of the future.  Darn it.)

Look at column “C” and see what theoretically happens to the value of your $100,000 investment – after the market does it’s thing and after you withdraw 4% of the value of the account value at year end. (We’re going to see how this value impacts your income in just a minute or two. Patience.)

Can you see that the balance of your initial $100,000 is worth almost $170,000 (hypothetically) by 1991? Feels good…right? Now, if you set up your account to withdraw 4% of the balance, your income increased from $4000 a year in 1988 to more than $6700 in 1991. Sweet. That’s an increase of over 50%.

And by 1999 the value of your original investment grew to more than $540,000. That means your income grew from $4000 to over $21,000. If that’s not fantastic, I don’t know what is.

Sadly, the direction isn’t only up. By 2002, your account value dropped to $292,000 – enough to ruin anyone’s barbeque. And to make things worse, your income dropped from $21,000 in 1999 to $11,703 in 2002. That’s more than a 50% drop. Terrible. Of course, it’s still almost 3 times greater than the $4000 income you started getting 11 years ago but most people forget about that. They focus on the “loss” rather than the relative gain.

As you can see, your income rises and falls pretty dramatically. That can be hard to stomach for anyone. I understand this but it’s a mistake to let those issues stand in the way of using equity to create income. There are two reasons for this:

1. Bottom Line

Which would you prefer? A fixed income of $4,000 a year or one that went from $4000 to as high as $21,000 and then back “down” to $14,000? While the emotional roller coaster was greater with option 2, so was the income.

2. Volatile Capital Doesn’t Matter

While it’s nice to see your principal rise every single year – it’s not important. You aren’t spending your capital (hopefully). The income is what’s important. Am I right?

It’s important to grow your capital if you want to grow your income. There is no other way to do that. And if you want to grow your capital you must accept short-term risks.

Summary:

If you want to create “safe” income from mutual funds you must first define “safe”. Is it more important that your income is fixed? If that’s how you define “safe” you will struggle with inflation down the line and ultimately this decision may jeopardize your financial future. I can make the case that this route is anything but “safe” over the long run.

If you define “safe” as having sufficient income over the long-run you’ll turn to equity growth. The downside will be short-term fluctuation of your capital and your income.

How do you define “safe” income?

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