Wall Street has discovered something investors find almost irresistible: a double-digit yield.
Twelve percent. Twenty percent. Some investment funds advertise distribution rates of 50% or more.
For retirees looking to generate income, those numbers can be awfully tempting. Why settle for a traditional portfolio yielding 3% or 4% when another investment appears to offer three, four, or even ten times as much?
There's just one problem.
A fund distributing 12% a year isn't necessarily earning 12%. In fact, it might not be earning anything at all.
And the distinction between those two numbers is something the investment industry doesn't always make particularly obvious.
The $100,000 Illusion
Imagine investing $100,000 in an exchange-traded fund advertising a 12% annual distribution rate.
Over the next year, the fund pays you $1,000 every month. By December, you've received $12,000 in cash.
Sounds like a pretty successful investment, doesn't it?
But there's another number you need to examine: the value of your remaining shares.
Suppose those shares are now worth just $88,000.
You've received $12,000 in distributions, but your investment has declined by $12,000. Add the two together, and your total return is approximately zero, before taxes.
You collected a 12% distribution without actually making any money.
Now imagine your fund's value declined to $80,000 instead. You still received your $12,000, but your overall investment lost $8,000.
The distributions were real. So were the losses.
This doesn't mean every high-distribution fund loses value. Some generate excellent returns. But the amount of cash a fund distributes tells you surprisingly little about how well your investment actually performed.
How Wall Street Creates Those Eye-Catching Numbers
Here's where the marketing gets interesting.
Many funds emphasize something called a distribution rate. Unlike total return, which measures investment performance, a distribution rate measures cash paid to shareholders relative to the investment's value.
And sometimes, that advertised percentage isn't even based on a full year's payments.
A fund might take its most recent monthly distribution, multiply it by twelve, and divide the result by its current share price.
That's an annualized distribution rate, not a guarantee of what investors will receive over the next twelve months.
Where does the money come from?
Depending on the fund, distributions may include dividends, interest, realized investment gains, or proceeds from options strategies. Some distributions may also be classified as return of capital for tax purposes.
Option-income ETFs have become particularly popular because they can generate substantial cash through options contracts. But those strategies involve tradeoffs, including potentially sacrificing investment upside in exchange for current cash flow.
And return of capital isn't automatically a warning sign. Tax classifications can be complicated, particularly with options strategies. But the broader point remains:
A cash distribution is not proof that an investment earned that amount.
The fund may be generating genuine profits, distributing a portion of its assets, or some combination of the two.
The distribution rate alone won't tell you which.
The Danger for Retirees
For someone accumulating wealth, confusing distributions with returns can lead to disappointing investment decisions.
For someone living off their portfolio, the consequences can be considerably more serious.
Imagine planning your retirement around a fund's advertised 12% distribution rate. You anticipate $12,000 in annual cash flow from every $100,000 invested.
But if the fund's value steadily declines, your remaining capital shrinks. Future payments may fall, and maintaining your desired income could become increasingly difficult.
You might spend years believing your portfolio is generating substantial income while gradually consuming the assets you depend on.
There's nothing inherently wrong with spending investment principal during retirement. In fact, a well-designed retirement plan often anticipates doing exactly that.
The problem is doing it without realizing it.
Look Beyond the Yield
High-distribution investments aren't necessarily bad investments. Certain strategies can serve legitimate purposes for investors who prioritize current cash flow and understand the accompanying risks.
But an impressive distribution rate shouldn't substitute for understanding what an investment actually accomplishes.
At Hanover Advisors, we believe retirement income should begin with a financial plan, not a product promising an eye-catching payout. A thoughtful strategy considers your spending needs, investment returns, taxes, liquidity, and the long-term sustainability of your portfolio.
Sometimes that means generating income from dividends or interest. Sometimes it means strategically selling appreciated investments. And sometimes a specialized income strategy may have a place.
Our job is to help you identify the most efficient way to meet your financial goals—not simply chase the highest advertised yield.
Because when it comes to your retirement, the question isn't just how much money your investments pay you.
It's how much money your investments actually make you.