How much money will you need before retiring? This obviously is very important question, but also a very difficult question to answer. There are many factors and assumptions that go into estimating the income that will be needed in retirement. With so many estimates and assumptions, there is a high probability the estimated number will be incorrect.
In the summer of 2009, BusinessWeek week ran an article in which Brett Hammond, TIAA-CREF's chief investment strategist, shared an easy way for people to check on their retirement readiness. Here are some of the major points from the article:
Hammond's calculations start with one of the basic tenets of retirement planning-that people need at least 70% of their pre-retirement income during post-working years.
If you're 35 and plan to retire at 65, you need 2.1 times your salary to be on track.
By 45, you had better have 3.6 times.
At 55, the multiple rises to 5.4 times.
And by the time you retire, you'll want it to be 7.7 times.
He assumes a 10% contribution rate, 4% salary growth, a bit ahead of inflation; a 6% return on investments; and a 25-year retirement period to finance.
If your investments are growing at 6% every year and you are withdrawing 4% each year, then you will not run out of money, even with 2% inflation. The problem that I have with such estimates is that market does not move in a straight line. What happens when the market tanks for several years?
Sometimes Bad Things Happen
Consider 2008 when the S&P 500 lost a third of its value. A retiree will still have bills and thus need to withdraw a certain amount of dollars. This dollar amount is likely fixed, which means it will be more than the 4% estimated. For example, if your living expenses are $40,000/year, you would need a one million dollar portfolio to support it if you limited your withdrawals to 4%. Assuming your portfolio lost 33% in 2008, that would leave you with $667,000 dollars. Taking a flat $40,000 from it would result in a 6% spend rate, more than the 4% maximum many experts cite. Another alternative would be to limit yourself to 4% which would be only $26,680, well below the $40,000 needed.
Once you get behind it is hard to catch up. Let's say you spend the full $40,000 needed to meet your expenses, this leaves you with $627,000. To get back to the one million needed to generate the needed income of $40,000 at 6%, your portfolio would have to grow by 59% in 2009.
Dividends Provide A Safety Net
To mitigate the risk associated with relying solely on capital appreciation, consider introducing an income component to the equation. In addition to bonds, some high-quality lower risk dividend stocks could help provide a steady income allowing you to rely less on selling securities to harvest their capital gains. Of the 220+ dividend stocks that I currently follow, only six carry the lowest risk rating of 1.00. They are:
Parker-Hannifin Corp (NYSE:PH) is a global maker of industrial pneumatic, hydraulic and vacuum motion/control systems, including related pumps, valves, filters, hoses, etc. Its products are used in everything from jet engines to autos, trucks and utility turbines. The company has paid a cash dividend to shareholders every year since 1927 and has increased its dividend payments for 38 consecutive years. Yield: 1.8%
Hormel Foods Corp. (NYSE:HRL) is a multinational manufacturer and marketer of consumer-branded food and meat products. The company has paid a cash dividend to shareholders every year since 1949 and has increased its dividend payments for 57 consecutive years. Yield: 1.8%
Wal-Mart Stores, Inc. (NYSE:WMT) is the largest retailer in the world, with a chain of over 10,000 discount department stores, wholesale clubs, supermarkets and supercenters. The company has paid a cash dividend to shareholders every year since 1973 and has increased its dividend payments for 38 consecutive years. Yield: 2.3%
Medtronic Inc. (NYSE:MDT) is a global medical device manufacturer with leadership positions in the pacemaker, defibrillator, orthopedic, diabetes management and other medical markets. The company has paid a cash dividend to shareholders every year since 1977 and has increased its dividend payments for 35 consecutive years. Yield: 2.3%
Walgreen Co. (NYSE:WAG) is the largest U.S. retail drug chain in terms of revenues, this company operates more than 8,000 drug stores throughout the U.S. and Puerto Rico. The company has paid a cash dividend to shareholders every year since 1933 and has increased its dividend payments for 38 consecutive years. Yield: 2.6%
Community Trust Bank Corp. (NASDAQ:CTBI) owns and operates Community Trust Bank, Inc. of Pikeville, KY, which provides commercial banking services in Kentucky and West Virginia; and a trust company. The company has paid a cash dividend to shareholders every year since 1988 and has increased its dividend payments for 32 consecutive years. Yield: 3.7%
Astute entrepreneurs will tell you it is good to diversify your income streams to minimize the risk of one or more of the streams drying up. The same is true in retirement planning. We shouldn't rely on any single income stream (social security, pension, 401(k), etc.), but instead we should look to diversify our income streams. Quality low-risk dividend stocks make an excellent addition to our retirement portfolio, and the good new is, you don't have to wait until you retire to figure out what income it will generate.
Full Disclosure: Long WMT, MDT, CTBI. See a list of all my dividend growth holdings here.