When payroll checks are rolling in month to month supplemented by restricted stock vesting and option exercises, only a small number of individuals are concerned about where their next dollar is coming from. The regular, reliable cashflow makes most of us feel comfortable and we go about our lives, until something begins to dawn on us…Perhaps it won’t always be this way.
What happens when the paycheck stops?
Anecdotally, age 50-55 appears to be the age in an executive’s life when this thought bubbles to the surface (sometimes more in the mind of a spouse). The pre-retirement jitters set in about 5-10 years beforehand and occupy the mind, taking place of more important life events such as children graduating, family vacations and holidays, and spending time with aging parents. We see this most often with the spouse who controls the checkbook. These pre-retirement years become extremely important to button up financial plans and make sure the right investments are in place to meet all financial needs and wants after the working years.
This blog will focus on where we see paycheck gaps in the lives of our executive clients and how we fill those gaps. In a future post, we will talk about how we communicate this differently between spouses. In our experience, the executive client is rarely the one running the household checkbook. Their involvement in family finances is typically high level and investment focused. Their spouse is lasered in on the cash flow of the family. Because the spouses have different needs, we meet with them differently and frequently hold meetings with the “checkbook spouse” to walk through our cash flow modeling and show them exactly how the paycheck will be replaced. More to come in the future.
A financial management firm based in Texas refers to Freedom Day as the goal of this type of financial planning. Freedom Day is a day we work toward and plan for with every single client. In their words, “Freedom Day occurs when multiple streams of income exceed all expenses (needs and wants) and can last until the age of 100.” We would add one important objective: keeping the totality of those streams of income on pace with inflation.
The Paycheck Gap
Our Senior Leaders generally must reach a specific age to retire with 100% vesting of stock options as well as portable ownership of restricted stock awards. Some companies define this tipping point as Normal Retirement which, for example, can be defined as age 55 and 10 consecutive years of service. Achieving Normal Retirement gives the Senior Leader an opportunity to walk away with vested equity awards in the event of voluntary termination of service (aka: retirement). While some award designs do not vest their option holders in the full 10-year life of their options at Normal Retirement, they generally have 5 years. Therefore, the typical income flow transition into retirement might look something like this:
- Age 54: standard salary + Restricted Stock Units (RSUs) and/or Non-Qualified Stock Options (NQSOs), if exercised
- Age 55: Retirement – salary ceases
- Age 55-60: Exercise remaining Stock Options and enjoy normal vesting of Restricted Stock (RSUs)
- Age 60 – Age 70/72: The Paycheck Gap
- This period requires comprehensive financial planning as Stock Options and Restricted Stock are exhausted and many clients have not taken Social Security income yet.
After RSUs and stock options have been exhausted, some clients will still have Deferred Compensation plans that can help fill the income gap before Required Minimum Distributions (RMDs) kick in. In the gap, some clients may withdraw from their qualified accounts prior to RMDs since there is no longer a penalty to do so. However, this usually involves selling principal.
Most of our executive clients at this stage have a dividend growth portfolio in which they have been reinvesting dividends for years to build up principal and boost income. This paycheck gap stage is typically when we make a change within our client portfolios from dividend reinvestment (accumulation phase) to turning on dividend income (withdrawal stage).
More on Creating Qualified Dividend Income
Qualified Dividend Income is tax-advantaged at a top federal rate of 20%. Creating significant, inflation-adjusted, tax-advantaged streams of dividend income ought to be a major focus in retirement portfolio construction. New investors at The Bahnsen Group generally begin their dividend growth portfolio with a yield of about 4% on invested capital. Contrast that with the index investing that is so popular today. One can hardly live on the 1.3% passive dividend yield of an S&P 500 index strategy. Long-time investors, who have held their dividend growth positions at The Bahnsen Group over a longer period, can have yields on their original investment which exceed 10% in many positions! These longer-term investors have made use of the most important ingredients in this type of dividend growth investing: focused active management and time.
Moreover, regardless of what the market is doing, even in a negative market year, dividend income continues to grow in well-constructed and actively managed dividend growth portfolios. In other words, you are likely to receive a dividend raise every year in retirement. If your advisor doesn’t show you growing dividend income on your annual portfolio reviews, perhaps a fresh perspective is in order.
Income flexibility mitigates portfolio and emotional risk in retirement.
If a client does not need income during the accumulation stage of portfolio construction, the dividends are reinvested and compounded. At the flip of a switch, we can send all or a portion of this income to our clients’ checking accounts just like the paychecks of pre-retirement days. Our goal is for this tax-advantaged, inflation-adjusted dividend income to replace most of the former salary from the working years without having to invade principle within their portfolio… ever.
In addition, living from dividend income, instead of touching principal, takes tremendous stress off one’s portfolio (and one’s mind). Dividend income allows for greater portfolio appreciation over time with less market risk. How is this possible? Not because of a promise of better performance of the underlying securities but because of the reduced risk that principal will need to be liquidated to meet income needs. We believe it is unwise to depend upon systematic liquidation of a securities portfolio at some pre-determined rate, like 4-6%, to free the necessary cash flow on which to live. Portfolio liquidation in a persistently down market is devastating to one’s financial and emotional security and so, ample dividend income is what negates or mitigates this risk.
This is both exciting for the investment minded spouse and massively reassuring for the cashflow minded spouse – truly a win-win on a portfolio and emotional level.