You would think that terms like income, earnings and cashflow would be simple. In a certain sense, they are “simple” because each has a relatively short definition which is easy to understand. In practice, however, these terms are often confusing because they are treated as if they are the same. This small mistake has torpedoed many a retirement plan.
Let’s start with the definitions.
Income is defined as “a benefit, usually measured in money, that comes from your labor”. The most common synonyms include salary, pay, and wages. Some people also correctly include interest and dividends. Certainly that is how we think of it on our tax return; we look at our salary, the interest or dividends we receive, along with any social security or pension payments. For most people, that’s “income”.
Earnings is a more expansive term. It includes income, and that’s where many people stop, but there’s more to it than just income. To properly understand earnings, we do need to include capital gains. And we need to include both the capital gains we get when we sell an asset or investment (called “realized” capital gains) as well as the capital gains which occurs when an investment isn’t sold but still increases in value (called “unrealized” capital gains). Even when we don’t sell that investment, if the value has gone up, we have “earned” that increase.
Properly understood in the context of investments and retirement, earnings equals your salary, social security and pension payments, interest and dividends, and both types capital gains (realized and unrealized).
Cashflow is an entirely different animal, and it is one of the most important pieces of your financial plan. Simply put, cashflow is the net amount of cash that comes into your account or leaves your account. It includes earnings, but it also includes anything we sell or buy. When you sell something, cash comes in; when you buy something, cash goes out.
Why is this so important? We all have to live off of our cashflow. We don’t live off of “income” or “earnings”. We can’t pay for groceries by giving the grocer a “piece” of our 401k or IRA, even though they both earn money. We can’t pay the electric or heating bill by tearing off a corner of a stock certificate we own and giving it to the utility company. Everyone who supplies our daily needs wants to be paid with cash.
When you receive an interest payment in your checking account, it is part of cashflow. When you receive an interest payment in your IRA, 401k or annuity, it is not part of cashflow. You have to make a withdrawal from your IRA, 401k or annuity in order for it to be part of cashflow.
If you’re too young to withdraw money from the IRA or 401k without a substantial penalty, then the “earnings” there will not help you. Likewise, if there are still surrender charges in your annuity, you will likely not withdraw money from there, so it won’t help you either.
In order for your income or earnings to actually help you live the life you want, you must be at the stage where you can reasonably withdraw from these accounts. But let’s assume you are at that stage. Here again, you need to properly understand the differences in these terms to enjoy your retirement.
The average stock portfolio will generate about 2% to 3% in “income”. That’s the current average rate for stock dividends, and history doesn’t offer much hope for substantially better rates.
- Between 1970 and 1990, the average dividend yield was barely 4%.
- Between 1991 and 2007, it declined to 1.95%.
- In 2008, it briefly rose to 3.11%.
- Between 2009 and 2018 it averaged about 2.1%
Too many retirees make the mistake of looking at just the “income” in their retirement account and not cashflow. They look at the interest and the dividends they receive in those accounts and sometimes conclude that they cannot possibly retire they way they want because the “income” is too small. This is a very common – and painful – mistake.
A similar mistake is made at the other end of the spectrum. Many retirees look at the “payout rate” from an annuity and conclude that they are making a killing in their annuity. For example, if you have a $100,000 annuity from which you can receive $7,000 per year, it is tempting to do a simple calculation ($7,000/$100,000) and conclude you’re “earning” 7%. Unfortunately, you’re not.
The annuity company is willing to pay you the $7,000/yr in this illustration because you’re willing to agree that if you die (or sometimes if you and your spouse both die), all annuity payments will stop. The annuity company is actually paying you earnings and some amount of principal each year. Each $7,000 annuity payment contains a return of your original principal along with your earnings. Your real “earnings” are less than the payout amount.
The only way to properly determine whether your financial plan is good, bad or neutral is to determine what you need to withdraw (cashflow) in order to meet your expenses and then compare it to the total return you could earn from your retirement portfolio.
To go to extremes to make the point, if your portfolio has a total return of 7%, and you’re withdrawing 15% per year, you’ve got a problem. Common sense tells you, correctly, that you are going to outlive your money and then have to move in with the kids or become dependent on the government. On the other hand, if you’re withdrawing only 4% per year, while earning 7%, odds are very strong that you’ll have a long and prosperous retirement.
Total return 7% and withdrawing 15% – Trouble is a brewing
Total return 7% and withdrawing 4% – Smooth sailing ahead
Total return is the average annual return you earn on your investment. It includes all forms of earnings – interest, dividends, realized and unrealized appreciation. You should not restrict yourself to just trying to live on interest and dividends any more than you should rely on principal withdrawals as a long-term source of cashflow. Principal withdrawals can easily run out some day.
If your retirement portfolio is structured properly, your total return should generate the cashflow you need and simultaneously keep your portfolio growing throughout the remainder of your life.
Investment terms don’t need to be complicated. With a little clarification, you should be able to focus on the keys to a successful retirement – make sure that on average your total return is greater than your cash withdrawals.