A common question I receive deals with the amount of money needed for retirement.
This amount varies depending to personal situations.
1) Traditional retirement experts focus on income, as opposed to expenses. A common rule of thumb sold by financial professionals is that retirees need to cover roughly 80% of their pre-retirement income. I personally believe that the thing that really matters is expenses. If you save 50% of income throughout your working years, you need to find a way to replace 50% of your salary in retirement. Therefore, if you make $80,000/year after taxes, but you spend $40,000/year, you only need to find a way to cover $40,000/year in expenses. It is nice to see that a higher savings rate results in a lower amount of expenses. Once you figure out what your expenses will be in retirement, then you can proceed to step two.
2) The other important thing to consider is other sources of income in retirement such as social security or a pension. The amount that is left over after that is the amount you need to cover from existing savings and investments. For those who retire early, this step will not be relevant for a few decades. If you spend $40,000/year, but Social Security provides $20,000 in annual income, you only need to find a way to generate $20,000/year.
I can complicate things further by discussing how various streams of income are taxed. Unfortunately, this could take a series of articles in itself, due to the unique nature of tax brackets, personal situations, and nature of income. This is why I am not really going to discuss taxes in this article. For example, Treasury Bond interest and wage income are taxable at ordinary income tax rates and so are REIT distributions that are classified as ordinary income. I am personally expecting that our qualified dividend income will be tax-free below $95,000/year. I am also expecting that my retirement assets would be converted to a Roth by the time I am 70, without paying much tax in that conversion, so those withdrawals will be tax free as well. My HSA withdrawals for healthcare will not be subject to taxes either. If my spouse and I earn less than $34,000 in Social Security income, and have no other source of income, that income will be tax-free. But it is quite possible that some minor change in tax laws in the next 30 - 40 years could wreak havoc on those well laid plans.
3) Once you have figured out how much your expenditures are, you need to determine how to cover them from your investments.
A) Traditional retirement advice calls for retirees to follow the so-called 4% rule from their portfolios. This rule states that retirees will spend 4% of their portfolio balance in the first year of retirement, and then adjust spending for rate of inflation. This means that investors need 25 times their annual expenses saved up. I personally think that this rule should be modified, because interest rates and dividend yields are much lower than they were between 1926 – 1993 when the 4% rule was backtested. After looking at the historical data, I concluded that the success of 4% rule was based on the fact that average dividend yields were surprise surprise 4%. The amount and timing of dividend income and interest income is more stable and dependable than capital gains. This provides an invaluable tool for retirees who would otherwise be dependent on short-term stock market fluctuations if they were to sell assets to live on. In the current environment, it is possible to construct a portfolio with a starting yield of 3%. Therefore, you would likely need a portfolio worth roughly $667,000 in order to obtain $20,000/year.
B) As a dividend investor, I plan on living off the dividend stream from my portfolio. Dividends are more stable than capital gains, and they are always positive. Therefore, this stability makes them a preferred method of generating income to live off in retirement, and avoiding having to sell stocks at depressed prices during the next bear market. When stock prices go nowhere for long periods of time, like they did between 1966 – 1982, the rising dividends provide an inflation proof source of income to live off from. A carefully selected portfolio of stocks that have a long track record of consistent annual dividend increases can provide enough dividend income to live off in retirement. It is important to acquire those assets at an attractive price however. Therefore, the amount of money needed to generate enough dividends will vary, depending on yields available. I think that it is reasonable to construct a dividend portfolio that yields around 3% today. This means that if you have a portfolio worth $667,000 that yields 3% today, you can easily live off it as it generates $20,000 in annual dividends. This translates into 33 times expenses. Perhaps a 3.50% portfolio yield would be possible too, though it will be a stretch. Anything above that is probably asking for trouble at this time. After a few years of prosperity, your income stream will be more expensive to purchase ( high prices lead to lower yields). If you retired when prices were lower, and yields higher in 2010 for example, a 4% yield would have been possible.
All of this includes estimates, since the future is largely unknown. Most of the information behind my idea to live off dividends is based on past data. However, this is the best we can do given the constraints we are given. In order to be a successful retiree however, I believe that one has to be nimble and flexible. Having a margin of safety is very important.
Just because it was possible for an US investor to have lived off dividends for the past 80+ years, doesn’t mean this will be the case for the next 80 years. We also do not know if the stock markets you invest in will generate any returns during the time you need to generate those returns. Perhaps this is why it is important to have fail-safe mechanisms in place, just in case. Maintaining skills could be helpful, as this could provide some income to you and your family if investments do not perform as expected. Working could provide some stimulating environment that results in some extra money. If you are flexible enough to cut costs during lean years, you increase your chances of survival.
Many retirees I have spoken to also own their fully paid for residence, which provides shelter, and reduces the need to generate investment income that would have otherwise paid for housing. It is possible that this money could have made billions in the stock market, rather than being tied to a house. If owning a paid off home this lets you sleep at night, that may be the right thing for you. If stocks go down and stay down for years, you would be in trouble because you may run out of money faster, assuming that your expenses do not fall as quickly. If house prices go down, at least you have a place to sleep in. You cannot move in to live in your stocks if they fall in price.
- Use these tools within your control to get rich
- Financial Independence Is Easier to Model with Dividends
- Margin of Safety in Financial Independence
- Dividend income is more stable than capital gains
- How much money do you really need to achieve financial independence?
The S&P Dividend Aristocrats index is an elite group of companies, members of the S&P 500, which have managed to increase dividends ...
John Bogle is an investing legend. He is the founder of Vanguard Group, a $4 trillion dollar mutual fund powerhouse. Vanguard is credited fo...
The list of dividend champions includes companies which have managed to increase dividends every single year for at least 25 years in a row...
As part of my monitoring process, I review the list of dividend increases every week. I usually focus my attention to companies that have r...
In a previous article I discussed that I am on track to have my dividend income cover my expenses sometime around 2018 . I received a few qu...
Last week, I shared the 2017 list of dividend aristocrats . The most common question I received focused on which companies are attractively ...
I just received notification that low cost broker Loyal3 is shutting down, effective May 22 2017. Loyal3 was a decent commission free alte...
This guest post has been written by Mike McNeil, passionate investor, founder of Dividend Stocks Rock and author of The Dividend Guy Blo...
Successful dividend growth investing relies on finding companies at an attractive price which can grow earnings and dividends over time. A...
Raytheon Company (RTN) develops technologically integrated products, services, and solutions worldwide. It operates through five segments: I...