I have been retired for more than 22 years. Based on my experience, as well as most literature about the subject, funding retirement is primarily about being able to pay your regular, predictable expenses. To do that, you need income.
Most retirement financial planning comes down to generating enough income without running out of money.
The bottom line is that you need to develop a sensible budget to know your income needs.
2. Where will your retirement money come from?
But here, we will focus on income from your investments. For most investors, this is a significant factor in retirement happiness.
Retirement Income Strategy #1: The 4% Rule
Bengen devised safe withdrawal rates (SWR), meaning how much a retiree can withdraw from assets each year and be confident of not running out of money.
Horrible periods for investors are not uncommon. Bengen’s data included 1973-1974, when the stock market crashed by 37% while inflation rose 22% simultaneously. More recently, retirees who lost 50% in the stock market in 2008-09 were catastrophically affected if they were just about to retire.
Bengen found that, for a 50-50 portfolio (50% stocks, 50% bonds), a 4% initial withdrawal rate, raised 3% for inflation each year, had always been safe for at least 35 years, and most of his historical portfolios actually lasted 50 years.
- The 4% Rule is a withdrawal or decumulation strategy: It depends on selling assets to convert capital into “income.”
- 4% is a benchmark representing a safe withdrawal rate.
- 4% refers to the first year’s withdrawal. Withdrawals in subsequent years are increased for inflation at 3% each year.
The following chart is a typical presentation of the likelihood of 30-year success rates for withdrawing from retirement portfolios without running out of money.
As a retiree, you want to be in a green area, where you can have a high degree of confidence that your withdrawal plan will be safe – that you will not run out of money.
From the table, that puts your maximum safe withdrawal rate in the 3-4% range. Lower withdrawals always improve portfolio safety.
And even short-run bad returns can cause psychological problems. Besides sleepless nights, a bad year or two may cause the investor to panic and move more money into “safer” bonds.
But over the long haul, a higher percentage in “riskier” stocks generally enhances portfolio life. Moving into bonds too early may be self-defeating, even if it provides emotional relief in the moment.
For the rest of this article, I will posit that a 3-4% initial withdrawal rate, augmented 3% each year for inflation, is a decent benchmark for a safe withdrawal rate from most balanced portfolios.
So in one corner, we have the 3-4% Rule.
Living Off Dividends in Retirement
Growing income streams come from stocks with consistently rising dividends, known as Dividend Growth (DG) stocks.
Many dividend investors amass considerable wealth anyway, because they carefully select DG stocks and funds of high-quality companies.
Studies such as the following from Hartford Funds show that dividend growth stocks have the best total returns, and lowest volatility, of all categories of stock when sorted by dividend production.
My wife’s and my DG portfolios have delivered annual income increases every year since 2010, when we completed our switch to DG investing. We are so confident in the approach that our nest egg is about 85% stocks. The rest are liquid assets. We own no bonds.
In other words, if you have saved $1,000,000 for retirement, then withdrawing 3-4% of it in Year 1 delivers the same income as a 3-4% yield: $30,000 to $40,000.
And if your assets are dividend growers, the annual inflation adjustment embedded in the 3-4% Rule will usually happen automatically, often with money left over.
In my wife’s and my portfolios, the past 5-year organic dividend growth rate has been 7% per year. I know this from the summary on Simply Safe Dividends’ Portfolio Tracker, which I use to track our portfolios.
Our overall yield is 3.5%, right in the heart of the 3-4% Rule.
Comparing the Two Retirement Funding Methods
Not needing to sell to generate income can be important.
- You remove Mr. Market’s ADHD behavior from your retirement income.
- The sequence of market returns does not matter much.
- You don’t have to sell more assets each year to cover the annual inflation adjustment. Your income rises automatically.
- You will not get caught as a forced seller when markets are tanking.
That notion is simplistic and false. The fact is, when you sell assets, they are gone. They won’t be around to help you next year or ever.
Obviously, those who state that selling a few shares is the same as receiving a dividend are presuming that the dollar value of the remaining shares will go up enough to recover the dollar value of the shares that were sold.
But that does not describe the real world. Look again at the roller-coaster chart earlier. Share prices do not increase every year.
I have a clear favorite, which is to build stock-heavy portfolios that generate growing income organically.
My comfort with such portfolios comes from (1) caring mostly about the income they provide rather than prices, and (2) appreciating the predictability, reliability, and natural growth of that income.
If you have a portfolio of DG stocks that yields 3-4% and whose income rises 5% or so every year due to dividend increases, you have the 3-4% Rule covered right there.
And you don’t need to sell anything. You will never outlive your savings.
Even if you do not own enough DG stocks to provide all the income that you need or want, every dollar you generate from dividend stocks is one less dollar that you will need to generate by selling assets.
One last thought: Everyone adapts to their financial reality as they approach retirement. Retirement-funding strategies become dynamic and flexible.
Tools in the toolkit include:
- Delay retirement for a year or two, not only to gather more assets, but also to reduce the number of years that your investments must support you.
- Cut back on spending in the last few years before retirement in order to save more.
- Pay off your mortgage and all long-term debt.
- Adjust investments from growth-oriented to income-oriented.
- Maintain an emergency/fun fund of assets not subject to market risk (savings account, money-market fund, certificates of deposit).
- Get a part-time job or gig work in retirement.
- Do not mechanically raise withdrawals each year. Instead, adjust them according to actual inflation, spending, and investment performance.
- Strive for good health to keep medical costs down.
We all end up making things work one way or another. You will too.
Thanks for reading!