How The 4% Retirement Rule Converts To Dividend Investing

By: ispeculatornew
Date posted: 03.29.2012 (5:00 am) | Write a Comment  (11 Comments)

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A common rule that has been applied both by individual investors and financial planners/brokers is the 4% rule. What is it? Basically, if you try to plan your retirement, you should expect to be able to retire 4% of your capital in the first year. Then, you can increase the amount that you withdraw every year to account for inflation. If I take someone with a $1,000,000 retirement savings portfolio retiring today that would mean:

$40,000 to spend this year

If inflation is 2.5%, that would mean $41,000 to spend next year and so on

The objective is to set realistic expectations of how much should be spent and how much should be saved in order to avoid outliving your retirement savings. The rule has been a great rule of thumb and one that I personally think is very useful when planning years and even decades ahead. Since retirees generally end up having a very conservative portfolio, the 4% withdrawal does mean selling assets over time and eventually leaving some amount for family but not a whole lot in most cases.

Enters Dividend Investing

One of the main differences between retiring with a traditional savings portfolio and a dividend portfolio one is that the ultimate goal is to be able to live off of the dividends and hopefully avoid selling any of the stocks. In such a way, there is very little to worry about in terms of outliving your expenses but it also means being able to leave a significant amount behind when that moment comes. I think those benefits are very significant.

Ideally, I think someone would look for a dividend portfolio that is similar to the Ultimate Sustainable Dividend Portfolio, a portfolio that yields 3% or so but that can generate dividend growth of 4% very easily. I consider those assumptions to be very conservative.

The one thing that you could say though is that living off of 3% in those initial years makes a major difference right? I mean earning $30,000 or $40,000 is far from the same thing. I agree, so let’s change things a bit. In those earlier years, We will adjust the payout to 3.5% by selling some capital. It’s not ideal but I think it’s a fair compromise. Obviously, this could be adjusted up or down depending on your specific needs but let’s try this out. So basically in:

Scenario #1 – 4% Rule:

John withdraws 4% on year 1 then adjusts this amount for inflation – John gets a 4.5% total return since he must become very conservative

Scenario #2 – 3% Dividend Rule (adjusted 3.5%)

John withdraws dividends, a dividend yield of 3% that increases by 4% per year. In the first 10 years, he actually withdraws 3.5% thus reducing capital but also dividend growth to 3%. I will assume an average total return of 5.5%, very realistic given the portfolio being less risky.

I will also assume that after 20 years, the amount being withdrawn will only increase by the inflation rate (unfortunately, at some point, we become older and less able to travel, etc).

Let’s assume inflation of 2%

First, take a look at my data, which you can download here as well:

4% rule

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Dividend Portfolio

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Now take a look at the amounts that these investors can take out:

And the remaining capital:

Assumptions

Of course, over a 40 year period, changing inflation rates or returns by even a small amount is enough to make a major difference. That is why I tried to be much more conservative. If you asked me what I would really expect, the difference between these two solutions would be much more drastic. That being said, I would love to hear any type of criticism or comments regarding those assumptions or the conclusion.

What Is Your Action Plan?

I don’t think it’s a big surprise to see that an investor that relies on a dividend focused portfolio down the road will end up doing much better than someone that basically switches its portfolio to a low risk, little return portfolio. There are some critical parts to making this work though.

#1-Psychology Switch: If an investor, especially an aging on looks at day-to-day or month-to-month variations in the value of the portfolio, it can certainly become a source of anxiety and in such a case, switching to dividend ETF’s might be a better way to do it. If however a retiree is able to look at the portfolio from the perspective of the annual dividends and focus on making that number grow, I think it’s much easier to remain focused.

#2-Dumping Stocks Before They Decrease Dividends: I’ve discussed this in the past, it’s important to spot the signs early, growing debt, less growth in revenues, earnings and dividends, etc. These should all be warning signs that there might be a better stock out there.

#3-Portfolio Optimization: This is something that I’ve discussed a lot and am now doing with the USDP. Actually if you missed it, seeing last week’s post about the small changes that I made gives you a good idea. Why? I don’t believe in buying a portfolio of great dividend stocks and then just sitting on it. Things changed. Companies evolve and so do their industries/competitors. That means that even a very long term portfolio should have a strong focus on keeping the right names.

What are your thoughts on this? What kind of portfolio do you aspire to own once you retire?

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11 Comments

  1. Comment by Dave — March 29, 2012 @ 6:37 am

    Certainly something that I’ve been thinking of analyzing on my own. It’s nice to see the two scenarios presented in tables. The only drawback I see is that you have less money to spend in the early years when you more likely ready to spend it.
    Might generate another Dividend Portfolio table with a $40,000 initial withdrawal just to see what it looks like. Great information however. Thanks!

  2. Comment by SUSAN — March 29, 2012 @ 7:41 am

    I plan to retire this fall and I believe the 4% rule of retirement is attainable. Dividends play a major role in my portfolio. Thanks for the great articles and common sense thinking.

  3. Comment by Zavi — March 29, 2012 @ 9:26 am

    That’s really interesting!! I’m visual, so the graphs speak for itself 🙂

    I have a scenario #3 though, don’t you think that at the retirement age, having 100% dividend portfolio is way too risky. I guess assumptions would be to be 50% bonds-cash and 50% dividend portfolio make more sense? (I guess it would represent a middle line between scenario 1 and 2?). But i can understand your point.

  4. Comment by John — March 29, 2012 @ 9:35 am

    The 80 year average for inflation is 3% and you used 2%? The dollar is crashing and debt is staggering into a non-recoverable situation and you use 2%? What will your dividends buy when inflation is 12-15%?

    Future inflation is the real issue. What about a portion of the portfolio being used in laddering immediate annuities with an inflation component?
    All serious retirement studies show this to be a VERY effective strategy.

    A dividend portfolio is not the ultimate stand-alone strategy. It should be used as a piece along with laddered inflation-protected annuities, bonds and a growth component. This “set-it-and-forget-it” plan will ultimately lead to failure just as the 4% rule will.

  5. Comment by Peter — March 29, 2012 @ 9:46 am

    As the market tanks over s number of years in a protracted bear market, what will you do? All of your capital is in equities. The market drops 50% and flatlines for years. Companies start cutting their dividends right and left. What will you do? Bail out and try to replace those stocks with other “high’payers”? So you will sell at a 50% loss to get your 3% back in a potential period of high inflation where you have a negative real return?

    Not a strategy I would be interested in. Equities can go down and stay down for a very long time. What will you do when most of your stocks have cut their dividends, the equities are not appreciating, inflation is 8% and your portfolio is down 50%?

  6. Comment by Geo — March 29, 2012 @ 12:34 pm

    The two scenarios presented are anything but real.
    1. People do not pay bills on a yearly basis.
    2. Inflation at 2% is not real.
    3. Real markets do not move as you indicate.

    Take the last 40 years by month and input the data and lets see what you get!

  7. Comment by Droubal — March 29, 2012 @ 3:46 pm

    The 3% rule will likely provide more remaining capital, so for those that want to leave wealth to their heirs, this is a reasonable idea.
    Looking ahead decades at a time is difficult. However, my guess is that we will see low returns and high inflation. Incomes are not growing for most of the public. This is not a good future indicator. Also, the gov’t. is borrowing so much money that we are likely to see high inflation in the future; probably double digits for at least several years.
    So, people with a million dollars invested will be fortunate, but I suspect everyone is going to suffer in some way.
    I like dividend stock the most. You are not likely to get stuck with an Enron if a company has been paying dividends for a number of years.

  8. Comment by Dom Brunone — March 29, 2012 @ 5:35 pm

    Having retired in 2007, I just went through this exercise for real. Some comments:

    1- Don’t retire unless you can do 3-3.5%.
    2- Being retired is a different gig than raising kids. If income goes down, or an unexpected bill pops up, you can curtail spending more easily…e.g., one vacation every two years instead of every year, or one less pair of shoes. Outflow has more elasticity to it.
    3- I keep ~ 20% of my portfolio in income producing mortgage bonds and other short term instruments. That way I have some dry powder if the market dips.
    4- Don’t buy into the market all at once. Sell puts on stocks you wish to buy if they drop to a lower price.
    5- Emphasize dividend coverage along with growth.
    6- After buying, don’t watch the stock price, watch dividend coverage. E.g., XOM only pays out ~25% of its earnings in dividends. It’s not huge, but it grows every year. There’s no way that dividend gets cut.
    7- If you use the inflationary 1970’s as a proxy, inflation can be handled by slowly shifting your asset mix to emphasize real assets that pay dividends. Actually, a good mix of stocks and bonds did well then. Now it is a bit different because our government is broke and refuses to show any restraint, so inflation is a bigger threat. Best thing you can do to help yourself is join with other like-minded folks to throw out all free-spending politicians starting with Obama.

  9. Comment by Ed — March 30, 2012 @ 12:09 pm

    I would also be interested in looking back at the last 40 years and see how this would turn out.

    My plan would be similar to the dividend portfolio with the exception of having 3-4 years living expenses in cash to cover any ‘down’ years or times I might have to switch out some dividend cutters. The dividend portfolio’s payouts would be used to ‘refill’ the living expenses account.

    Two things I would like to add, DOM is right, when the market tanks, even though you have been conditioned to keep taking out the next yearly amount in monies, psycology kicks in and the majority of retirees’ cut back and don’t take out the alotted amount.
    Second thing, I am not specifically leaving an ‘estate’ for my kids. If there is anything left good for them, but my goal is to die with $0. So it won’t hurt my feelings if I need to dip into prinicple/capital if needed in year 35.

  10. […] couple of weeks ago I wrote what turned out to be a very popular and very controversial post about how the 4% retirement rule applies to dividend investing. I received a lot of interesting feedback that I will certainly be looking into in the next few […]

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