As I’m about 2/3rds of the way to having theoretically enough money to cover our living expenses, I wanted to take a closer look at the actual mechanics of living off of my investment portfolio.
I’m using a 3% withdrawal rate, which means that for each $100,000 I have, I’m expecting it to grow such that I can withdraw $3,000 a year, adjusted for inflation, for 40+ years (essentially forever). A conservative way to take withdrawals from an investment portfolio is to spend only the dividends and interest while leaving the principal untouched. This is assuming you don’t go reaching for yield by buying things like troubled, high-dividend stocks and high-yield junk bonds. As a baseline, I wanted to see how much income my passive portfolio would create with my current target asset allocation:
There are many different yield definitions to choose from, but I decided to go with trailing 12 month (TTM) yield as it’s based on a year of past distributions. Specifically, the Morningstar yield is found by dividing the sum of the fund’s income distributions for the past 12 months by the previous month’s NAV (net asset value). Only interest distributions from bond funds and dividends from stock funds are included.
Model Portfolio Yield Breakdown:
| Fund (Ticker) | TTM Yield |
| Vanguard Total Stock Market Index Fund (VTSMX) | 1.76% |
| Vanguard Small Cap Value Index Fund (VISVX) | 1.80% |
| Vanguard REIT Index Fund (VGSIX) | 3.23% |
| Vanguard Total International Stock Index Fund (VGTSX) | 2.4%* |
| Vanguard Emerging Mkts Stock Index Fund (VEIEX) | 1.7%* |
| Vanguard Total Bond Market Index Fund (VBMFX) | 2.66% |
| Vanguard Inflation-Protected Secs Fund (VIPSX) | 2.27% |
| Weighted Distribution Yield (70% Stocks, 30% Bonds) | 2.4% |
3% above inflation may be a lot lower than some people hope/want/need their portfolios to earn, but I think that it remains reasonable number for aspiring early retirees that need their money to last a long time. Right now, investors looking for income are facing both historically-low dividend yields and historically-low bond yields:
image credit: Reuters
At a 2.4% TTM yield, my current portfolio would come up a little short. Now, I could make a few moves to increase yield without sacrificing too much quality. For stocks, I could invest in a US or International Large Value index and get a higher yield without screening specifically for dividends. This isn’t unreasonable, as value stocks have historically outperformed growth stocks over long periods of time. For bonds, you could invest in investment-grade corporate bonds or investment-grade tax-free municipal bonds without venturing into junk bond territory.
As another comparison, the Vanguard Wellington Fund (VWELX) is a balanced fund that’s been around since 1929 and has 2/3rd stocks and 1/3rd bonds, with a Morningstar TTM yield of 2.78%.
(* For the case of VGTSX, the stated Morningstar yield of 4.50% is misleading because it is adding up the trailing 12-months of dividends from December 2011 and also September 2010, even though that appears to include all 2011 dividends and three quarters of 2012 dividends. I decided to pro-rate the dividends for an actual estimated 12-month yield of about 2.4%. I did the same for VEIEX.)
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Focusing solely on dividends is a bit arbitrary. Home-made dividends, produced through realizing Capital gains, can produce just as real of returns as dividends. Capital gains occur when companies appreciate, and is especially evident when firms distribute profits in the form of share repurchases.
The industries dividend fettish has never made sense to me. Payout yield, consisting of both dividends and share repurchases, is a much more informative measure of a firm’s payout policy.
I, too, am a fan of homemade dividends, insofar as I believe it is more accurate to consider both dividends and cap gains from the point of view of portfolio returns.
Regarding your 3% IWR, Jonathan, may I ask how you arrived at this figure, and what data or calculations lead you to believe it will last 40+ years? In addition, when you say “essentially forever,” am I to understand that you believe that a constant 3%/year withdrawal rate would last, say, 100 year? Would a 4% rate fail to do so? Would a 2% be unnecessarily low under all probable conditions for a 100 year time horizon?
How about a basket of dividend growth stocks?
“How about a basket of dividend growth stocks?”
Lack of diversification.
I assume that since your talking about early retirement, this is outside of a tax deferred account such as a 401k?
For such a focused planner you make what I think is a fundamental mistake and place an unnecessary limitation on your ultimate success. You seem to be totally US-Centric in your thinking. Your investments may be mildly diversified but until you have real dollars in other currencies generating income in appreciating foreign currency and as long as you remain stuck in the mir of living your whole life in an uneconomically unviable United States you are never going to have the security and breathing room you are seeking no matter how many “what if” scenario spreadsheets you run. I’ve been there, done that.
what would you consider “investment-grade corporate bonds”? something like vanguard’s VWEHX, or what exactly?
@Jonathan – Would this be for your overall portfolio, including all tax-deferred and taxable accounts? If so, how do you take taxes into effect when performing these calculations?
I think you are grossly under estimating the amount of spending you will do in retirement particularly if you plan to retire early. Currently you are working so figure 8 hours a day, plus maybe another hour in commuting, your numbers might vary slightly of course this is just estimating purposes sake. So 52 weeks x 5 days = 260 days and lets figure between paid time off and holidays you get 30 days off a year, so your work 230 days x 9 hours a day = 2070 extra hours a year of free time. Now of course you will probably sleep a bit more and many activities have little or no cost but in all likelihood you will spend money on travel, hobbies, and any other recreational activities you use to fill your time. Ask anyone you know who is retired if anything they spend more in retirement then they did while working, all of that work has been done to enjoy the golden years. The earlier you retire the more active you are likely to be between 30 and 50 versus at 65+. The last thing you would want to be is to retire early and then have to rejoin the workforce 10 or 15 years later with a very out of date skillset. Oh and you became a parent recently the running estimate from birth to college graduation is about $1 million per kid in real terms, of course there are ways to spend less on your kids, but who wants to so that?
I also think you are overestimating the ability of your portfolio to provide the amount of income you are expecting, for starters you are using a 70% stock and 30% bonds portfolio which is way too risky when you are drawing off a percentage as income to live on, look at the volatility over the last few years, had you retired in 2007 and continued to draw from your portfolio at your estimated rate, to do that you would have to sell assets as your dividends would fall short of your cash needs, then on the recovery your asset base is smaller so you either have to take on more risk to make up for your losses or move forward with a smaller portfolio. Either way the likelihood of you being able to survive for 40 years is almost non-existent. Run some Monte Carlo tests against the average return and standard deviations of your asset classes and you will find in a lot more scenarios then you think you will wind up broke.
If you don’t know how to run Monte Carlo’s I have a very easy to use excel spreadsheet I can send you (I didn’t create it, I have tweaked it though).
You are also not taking into consideration taxes or inflation based on your draw, you have done so well in building up your financial security I would hate to see you wind up not being able to support your lifestyle after all your hard work and how much you have helped others with this blog.
@Baughman – I agree that it is a bit arbitrary, but there is only a difference between total return and income return if the total return exceeds the income return (again if you don’t stretch for income).
@Andrew – 3% is a rough number based on various SWR papers and Monte Carlo simulations, as well as a little buffer for what looks to be a lower-return future based on rules like the Gordon Equation and Bogle’s own predictions:
https://www.mymoneyblog.com/jack-bogle-makes-market-prediction-for-next-decade.html
Here’a popular Monte Carlo simulator, 3% withdrawal has 0% failure rate over 50 years when I played with it:
http://www.firecalc.com
@aa – I’m personally no opposed to a basket of dividend stocks under certain conditions. You’ll need decent number of high-quality stocks (perhaps greater than 70?) from different industries and you’ll need them to have good numbers where they aren’t paying out all their free cash flow into dividends and still have growth prospects. And you’ll need some bonds to balance things out. Right now it seems like too much work for me to juggle as an entire portfolio. But basically take a look at the holdings of Wellington Fund. It’s been around since 1929 with nice return numbers but hasn’t done all that much better than the very simple Vanguard Balanced Fund over certain stretches.
@Jay – For most people saving for early retirement, you’re going to need to save outside of 401k and IRAs. If you need to tap them before 59.5, you can use the 72(t) rule to avoid early withdrawal penalties
https://www.mymoneyblog.com/early-retirement-planning-taking-early-withdrawals-without-penalty-from-your-401k-or-ira.html
Or you can just sell more out of taxable as needed. I’m still looking into the best way of juggling that as well.
@Rob – You may be right, but I’m not sure insuring against what I view as a tiny risk is worth the cost. I do think holding some hard assets like real estate is good.
@Frank – I was thinking more like VFICX? – Vanguard Interm-Term Invmt-Grade with a TTM yield of 3.65%.
VWEHX? – Vanguard High-Yield Corporate is basically junk bonds, albeit the higher-quality portion of junk bonds. TTM yield 6.35% but higher expected default rate. I could see owning a little of this I suppose, but it’s also closed to new investors.
@Pete – I’m ignoring taxes, but with a withdrawal rate under $50k, I’m hoping taxes aren’t much of an issue if I’m fully retired:
https://www.mymoneyblog.com/pay-zero-income-taxes-in-retirement.html
@Jay – Let’s see if I can break this down.
(1) My estimate for future expenses is not just taking my current expenses. The estimate is higher than my current expenses (minus mortgage as the house will be paid off beforehand) and includes things like kid expenses, self-bought health insurance. Other expense are based on many years of spending so I think I’m comfortable with that. I’m keeping it ratios as I’m no longer revealing full net worth numbers.
(2) Withdrawing 3% in 2007 would have been fine. Dividends and income would have nearly covered it all as interest rates were higher. If you find a Monte Carlo simulation with 3% withdrawal rate and my portfolio at 70/30 and get anything but a 100% success rate over 50+ years, please let me know.
(3) Dividends of the broad stock market rise faster than inflation. Interest on intermediate bond used to be a little higher than inflation, but not right now. I’m basically shooting for a 3% real return.
Jonathan,
Vanguard’s Monte Carlo retirement calculator gives a 92-93% success rate for 3% annual withdrawal at 50 years:
https://retirementplans.vanguard.com/VGApp/pe/pubeducation/calculators/RetirementNestEggCalc.jsf?cbdForceDomain=false
I have, for this reason among others, personally chosen to aim for a 2% withdrawal rate.
I’m very much interested in hearing your thoughts on this.
@jonathan,
i see VFICX as exactly what you suggested. i’m not sure i would go for something like this, but then again perhaps to diversify a bit…?
i’ve been watching VWEHX since 2006 and i’m happy with the performance, not sure how it’s possible but i have never seen a single default. Not even ONE since 2006! a bit more risque but i haven’t seen the bad yet.
@jay,
i think a 3% withdrawal is safe and doable, as long as a strict budget is followed. many simulations show that being the case, and i have yet to see one that doesn’t.
@Andrew – 92% is definitely lower than I would like. A 60/40 portfolio is around 94%, which is probably closer to what I want going forward.
2% is definitely a good recipe for a rock-solid safe withdrawal rate, but I just think it’s too conservative for my tastes. 2% would probably cover my “critical, high-priority” list of expenses like health care, property taxes, and grocery food, but there is enough fat in my spending that I like 3% for the whole picture (travel, dining out, beer).
@frank – High-yield is doing well, and has done well for a while. Spreads are tighter now, but future as always unknown. I think VWEHX would probably be the only high-yield fund I would own, if I did own high-yield. Good active management at very low cost, with focus on quality over yield.
I have a problem with the fundamentals of comparing yield to withdrawal rates, for example if you have a $1,000,000 portfolio and you want to draw 3% annually that means you want $30,000 a year in income, well in the following year if the market drops and your portfolio is worth $900,000 a modest 10% market correction a 3% withdrawal rate is now only $27,000 which is less then you needed the prior year and inflation never lets that happen. If the market is up and your portfolio is $1,100,000 a 3% draw is $33,000 more then you needed. This methodology is all backwards, you need to start with the dollar amount you need then derive the draw rate based on expected returns. If you are lucky and have several good years in a row early on you can draw less than 3% and as your portfolio grows to make the $30k a year you need requires smaller draws. However the opposite is true, if you need $30k and you are hit by a few bad years early on then you will have to sell assets to get your $30k, which in turn reduces your portfolio size and continually requires higher draw rates and eventually will zero out your account balance long before you zero out.
The reason it is suggested that you reduce your stock holdings and increase your bond holdings as you approach retirement is to reduce volatility in your portfolio so you can keep a more consistent portfolio size and your yield is due to bond interest, by maintaining a 70/30 stock bond portfolio when you begin drawing off it will surely drain your funds in a lot less time then 30 or 40 years.
Monte Carlo simulations are based on Total returns and standard deviations; total returns include capital appreciation and dividend yield, there is no central repository of standard deviations for dividend yields, you would have to calculate that yourself and if you were it would be best to use your cost basis not the current price as that is relevant number to gage your returns based on income, your income is based on your price not the current price, current price is only useful when you want to sell your assets. Even if you were to derive your dividend yields and the standard deviations of those yields it would be useless as yield can increase while actual income decreases due to price movements which still drain your accounts, you can’t base retirement spending on dividend yields as there are too many unpredictable variables needed to get real income numbers from them. Monte Carlo simulation are useful as the look at total return and don’t isolate appreciation from dividends as the whole picture is what matters.
I really like DoubleLine Total Return Bond (DBLTX) which cherry picks the best MBS out there. Yield of 6.7%. Return of more than 8% a year. Minimum purchase $100,000. With the US buying mortgage bonds for a long time a la QE forever there is a reason why Jeff Gundlach’s fund is attracting lots of capital these days. Good place to bag super solid safe yields.
@jay,
having an expected salary for retirement is dangerous, and simply not feasible for the reasons that you stated. a frugal mentality and a constant watch on finances is the only way i see to make sure you don’t draw more than 3% of expected returns. some years you can afford to splurge, others you have to buckle down… one of the downside to retiring early, i suppose.
the simulations that i’m familiar with don’t matter the investment vehicle, only the projected returns to calculate what a safe withdrawal rate can be. i always assume the safest returns anyway since i’m tired of the stock market volatility… i like to sleep at night.
if you want a specific guaranteed income than you will probably need more savings for retirement, and a withdrawal rate a little lower than 3%.
I totally agree with Jay. Having complete control and flexibility in managing your expenses is much more important than trying to manage your cash flow, which in your case, at least in my mind, is unpredictable. So you are in essence at the mercy of any black swan event or bankruptcy busting health care crises. And these, not to belabor the point, are the fallacy of trying to accomplish your goals in the typical US-Centric myopic manner.
You step into Thailand, Malaysia, Panama and a host of other countries your expenses drop 25%-40%. Healthcare becomes affordable and your returns on Time Deposits jump from nothing in the US to as high as 5% in New Zealand, 3.5% in Thailand and 4% or more in China.
Rob, what are you suggesting for a US citizen, regarding international diversification? I assume you are not saying that anyone should actually move out of the US or give up their US citizenship, since that would not be feasible for many people. Jonathan already has nearly half of his equity portfolio in non-US stocks. But I take it this is problematic, in your view, because it’s all held in US funds and US accounts. Fair enough. Are you saying he should open deposit and brokerage accounts in other countries and hold cash and assets in those accounts? Personally, I find that appealing, as a way to diversify geo-political risk, but there are many costs associated with a strategy like that. Not only is the US cracking down hard on offshore accounts, but financial institutions in other countries are refusing to accept US customers. What to do?
Andrew…. There is no problem opening up accounts in a large number of countries where you can benefit from higher interest rates and at least over the last few years favorable exchange rates. My net worth has increased over $60,000 in the last 5 years on exchange rates alone. I hedge my investments by only investing in countries where I want to spend time. If the Chinese Yuan, $NZ $AU or $CAD go significantly in the wrong direction, I get a vacation rental and spend 2 or 3 months living in the country and spend my money there. So I’m always 1 to 1 or better. All the misinformation aside, when I first bought 5.65% 5 year time deposits in China, the exchange rate was about $US1 to 7.6 RMB its now $US1 to 6.25 RMB.
Brokerage accounts can be more difficult but are still easy to do in Canada or New Zealand. As far as the US government goes. You pay your taxes, you fill out two additional forms and that’s all there is to it. If you are Mitt Romney with $100 million in the Cayman Islands it is probably more complex, but that’s not me.
Finally, black swan events happen suddenly and randomly. And I for one neither have the confidence nor the appetite for risk that it takes to believe that the US financial situation or the people controlling are competent, rational and acting on anything other than their interests, not mine.
@frank/ @rob
My goal is to have $140k a year after taxes; I plan on earning it by having a laddered portfolio of muni’s of about $7 million, I will never touch the principal. I would also like another probably $2 million that I can leave in the market for nice growth opportunities and to have some fun with.
I take risk now to build up my nest egg while I am earning and not living off my investments, when I have enough assets I plan taking as much risk off the table as possible and simple earn triple tax free income.
While Jay is right that yield and withdrawal rates aren’t really comparable for the aforementioned reasons, by striking a middle ground between these two approaches a “spend the dividends” (or a multiple of the dividends) strategy in many ways allows one to eliminate the worst disadvantages of both such as the risk of “zeroing out your account” as well as the unpredictability/volatility of basing spending on dividend yield…
If you care to look it up, you’ll find that the annual cash dividend paid in nominal dollars by the S&P500 has actually been incredibly stable and consistent over the years so that the vast majority of unpredictability/volatility of dividend yield is actually caused by price fluctuations in the denominator. This shouldn’t be surprising because the value of a stock is traditionally equal to the net present value of all future cash flows so that price volatility is simply the result of compounding the unpredictability of all future dividends which the laws of reason itself tell us must always be far far more unpredictable than the unpredictability of the cash dividend paid in any single year.
For the same reason, the optimal dividend investment strategy is not to reach for high yielding securities, but to simply buy the cap weighted market index because that is the portfolio which is most likely to provide the most consistent and fastest growing cash dividend over the long run and to implement it you don’t need to try to outsmart other traders with Monte Carlo simulations (which are surely downright primitive compared to the methods employed by the professionals with the biggest bankrolls).
Only thing that makes me hesitate is that Jonathan’s OP has revealed that I’m obviously not the only early retiree thinking along these lines and, when it comes to investing, thinking like the crowd is rarely rewarded.
@Rob – I like your unique perspective about not being US-centric. I’d like to extend an invitation for you to contribute guest post on MyMoneyBlog.com about hedging your exposure. I’m sure many readers would be interested in the actual mechanics and rules regarding opening a brokerage or bank account in a foreign country that is not subject to US law, and so on. Would you be interested?
Hi Jonathan….I just sent you an email
@jay,
i would say that an early retirement income of 140k is very comfortable, and with that kind of savings easy to accomplish. i’m on the other side of the spectrum but with the same early retirement goal. my approach is more urgent, risk tolerant, and lifestyle opposite. i hope to be done before 40, willing to do minimal part-time or seasonal work to replenish depletion of savings (not too often, hopefully), and will always stick to a budget and save when possible. this recipe will allow me to retire early with much less savings (~300k), but also with a little bit of passive income (rents). overall, i should generate about 25k per year to live on. not going to fiji on that kind of income… i can accept that. i’ll be the guy with the rv hitting all the state parks. it may not seem as very much, but my needs (not including wants) are low, last year they came to 13.5k.