It is one of the most frequently asked questions: When will I be able to retire? The answer however, is often complicated. Many different factors affect the age that somebody will be able to retire. There are two different ways that I look at it:
- 1) The amount you need in savings to retire
- 2) The annual income you need to retire
These two are highly correlated, as more often than not your annual investment income is derived from your savings. When I think about retirement, I try not to worry about the amount of savings that I would like, but rather the annual income that I will need. Ideally, I would like my assets to be generating more income than I predict that I will need. This way I can continue to increase my income stream through reinvestment while never having to cut away at any capital. I believe that the best way to do this is through dividends.
Step 1: How much will I need?
This is in my opinion the most important question to ask because it requires an investor to set a final goal. In order to accurately assess this amount, an investor must establish what kind of a lifestyle he or she would like to live in retirement. Let's say that Jim is a 25-year old who has started to think about retirement. Jim feels that he could live the very comfortable lifestyle that he desires on $50,000 a year in today's purchasing power. Adjusting for 2% annual inflation, Jim will shift this goal to about $100,000, the expected value of $50,000 in 35 years when he would like to retire. Accounting for taxes, Jim would feel comfortable with $135,000 in pre-tax income 35 years down the road.
Step 2: How will I generate my goal income?
This is where personal investing preferences come into play. There are a variety of ways that a retiree can produce income, some of which are listed below:
- Defined Benefit Plans (Pensions)
- Social Security
- Income Generating Portfolio
In the past, company pension plans and social security have been a foundation for most people's retirements. In today's world, fewer and fewer companies are offering pension plans and most of these are likely to be phased out in the near future. Social Security is another big issue going forward, as it looks to be unsustainable where it currently stands. In the calculations that I use for my own retirement, I assume that I will receive no Social Security and anything that I do get will be considered a bonus. I believe that the 401k and IRA options are great because they allow for the great advantage of tax-deferred compounding. Jim from Step 1 will focus on a do-it-yourself dividend growth portfolio over the rest of his career, while making the maximum contributions to his 401k and IRA. He will rely on his portfolio for his main source of income in retirement.
Step 3: When can I reach my goal?
The last step in the process of planning for retirement is determining at what age you will be able to achieve your goals. This is impacted by numerous factors such as starting age, contributions, and growth rates of the portfolio. It is pretty clear that the earlier you start, the more you contribute, and the higher growth you can get, the better off you will be. Additionally, people with a pension are at a significant advantage over those who do not, as it is basically an annuity. Let's take a look at the expected age at which Jim will reach his retirement goals with only his dividend growth portfolio, using a variety of scenarios.
His portfolio will consist of the following stocks, with a brief rundown of the dividend statistics. I believe each is an ideal stock for retirement:
|Company||Yield||Payout Ratio||3 Yr Div Growth|
|Aflac, Inc. (AFL)||2.76%||23%||6.2%|
|AT&T, Inc. (T)||4.92%||71%||2.4%|
|Chevron Corp. (CVX)||3.13%||30%||9.7%|
|Intel Corp. (INTC)||4.16%||42%||15.8%|
|Lockheed Martin (LMT)||5.25%||55%||20.3%|
|Altria Group (MO)||5.20%||74%||8.7%|
|Target Corp. (TGT)||2.14%||32%||24.7%|
|Walgreen Co. (WAG)||2.68%||49%||26.0%|
Assuming an equal weight in all of the equities listed above, Jim would have a portfolio with a current yield of about 3.7% and three-year trailing DGR of 14%. I will project 8% dividend growth going forward until Jim retires, although it is impossible to know for sure what the actual growth will be. It may be necessary for Jim to switch stocks occasionally to maintain the 8% growth rate. Let's take a look at three different scenarios so that Jim can retire at 60, all of which assume dividend reinvestment since Jim will not need the income while working.
Scenario A- Start Age 30, Initial Investment $40,000, Monthly Contributions $920
Scenario B- Start Age 25, Initial Investment $30,000, Monthly Contributions $460
Scenario C- Start Age 25, Initial Investment $10,000, Monthly Contributions $660
What does this mean for me?
It is easy to see how important it is for Jim to start investing as early as possible from these scenarios. If he can build a strong foundation from a young age, Jim will be able to get his dividend machine running by beginning the compounding process. This will allow him to have flexibility so that he does not require larger monthly contributions down the road. I personally prefer to invest for retirement using dividend growth stocks because I feel that these give me the best chance to create income for myself without having to draw down from my capital. I also believe in the importance of diversification, as no significant portion of a retiree's income should come from a single source. By following the steps listed above, investors can create their own plan for retirement and take the necessary steps to ensure that they reach their goals.