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For many Americans, retirement is seen as an impossible dream. For me (mid 30's), the idea of accumulating enough wealth to retire is very questionable, as is whether Social Security will be around until after the Baby Boomer generation is at full retirement age. Some people say Social Security is fine, others say it is not. Personally, I am not counting on Social Security; I am making plans to ensure my family's financial security without it.

The 4% Rule

Currently, the most touted retirement distribution plan includes the 4% rule. This means that in your first year of retirement you distribute 4% of your savings, and then adjust for inflation every year after. This plan is geared to work along with Social Security. Recent research suggests that 4% may be too much and the distribution will have to be brought down to 2.8%. This means that you have to distribute less money than previously thought in order to last 30 years, relying more on Social Security. For argument's sake we will stay with the 4% number.

To me this does not seem very feasible, let me demonstrate; taking into account someone setting aside $5000 a year into a 401(K); increasing 3% for inflation every year. Then receiving a 9.75% annualized return, which is what we should expect based on the S&P 500's past performance.

Year

Savings Added

Portfolio Equity

1

$5,000.00

$5,000.00

2

$5,150.00

$10,637.50

3

$5,304.50

$16,979.16

4

$5,463.64

$24,098.26

5

$5,627.54

$32,075.38

6

$5,796.37

$40,999.10

7

$5,970.26

$50,966.78

8

$6,149.37

$62,085.41

9

$6,333.85

$74,472.59

10

$6,523.87

$88,257.53

11

$6,719.58

$103,582.22

12

$6,921.17

$120,602.66

13

$7,128.80

$139,490.22

14

$7,342.67

$160,433.18

15

$7,562.95

$183,638.37

16

$7,789.84

$209,332.95

17

$8,023.53

$237,766.44

18

$8,264.24

$269,212.91

19

$8,512.17

$303,973.33

20

$8,767.53

$342,378.26

21

$9,030.56

$384,790.70

22

$9,301.47

$431,609.26

23

$9,580.52

$483,271.68

24

$9,867.93

$540,258.60

25

$10,163.97

$603,097.79

26

$10,468.89

$672,368.71

27

$10,782.96

$748,707.62

28

$11,106.45

$832,813.05

29

$11,439.64

$925,451.96

30

$11,782.83

$1,027,466.36

After 30 years of saving for retirement we will have that magic $1 million. A 4% distribution will start us at $40,000 a year. We will increase this by 3% a year based on inflation. According to the model, a retiree will have enough money for 30 years with Social Security to supplement.

Social Security

Last year, the Associated Press wrote an article that states retirees are receiving less Social Security than what they paid into it. This amounts to negative equity or essentially losing money for retirement.

The major contingent of Social Security does not seem viable for future generations. Also, life expectancy is an issue; the longer people tend to live the higher life expectancy goes. The third problem with depending on Social Security is that I would like to leave money to my children. I am a huge advocate for upward social mobility; the idea that a person can climb the social ladder and make a better life for their children. If I am able to leave my children money then it will give them a better chance to build a better future for their children. Generational pay it forward, if you will.

Dividend Stocks

Here is my very simple alternative. It involves buying into long-term dividend stocks. The basis is to buy a stock that has paid a solid dividend for many years. Granted this does not mean they will continue to pay dividends, but nothing is guaranteed in life. If a company reduces or stops paying the dividend you can reduce or close your position and look for another stock.

Berkshire Hathaway (BRK.A) (BRK.B) is one of the best examples of this. Berkshire's top six holdings make up over 75% of their portfolio. Berkshire uses the dividends from their top six holdings to store away cash in pursuit for that next elephant. Berkshire's top six holdings are:

Wells Fargo (WFC) - 2.70% Yield

Coca-Cola (KO) - 2.70% Yield

International Business Machines (IBM) - 1.60% Yield

American Express (AXP) - 1.20% Yield

Procter & Gamble (PG) - 2.80% Yield

Wal-Mart Stores (WMT) - 2.40% Yield

With the following graph, we will look at how the same 9.75% annualized increases with a dividend stock. Let's look at a portfolio that receives a 2.5% dividend as well as a 7.25% return in stock appreciation. We will use the same $5000 added a year, adjusted for inflation every year. We will reinvest the dividends as we do not need the money until retirement.

Year

Starting Balance

Annual Contribution

Dividends

Equity Increase

1

$0.00

$5,500.00

$137.50

$6,036.25

2

$6,036.25

$5,665.00

$292.53

$12,842.12

3

$12,842.12

$5,834.95

$466.93

$20,498.09

4

$20,498.09

$6,010.00

$662.70

$29,092.62

5

$29,092.62

$6,190.30

$882.07

$38,723.01

6

$38,723.01

$6,376.01

$1,127.48

$49,496.17

7

$49,496.17

$6,567.29

$1,401.59

$61,529.64

8

$61,529.64

$6,764.31

$1,707.35

$74,952.61

9

$74,952.61

$6,967.24

$2,048.00

$89,907.03

10

$89,907.03

$7,176.25

$2,427.08

$106,548.90

11

$106,548.90

$7,391.54

$2,848.51

$125,049.63

12

$125,049.63

$7,613.29

$3,316.57

$145,597.56

13

$145,597.56

$7,841.68

$3,835.98

$168,399.57

14

$168,399.57

$8,076.94

$4,411.91

$193,682.96

15

$193,682.96

$8,319.24

$5,050.06

$221,697.42

16

$221,697.42

$8,568.82

$5,756.66

$252,717.20

17

$252,717.20

$8,825.89

$6,538.58

$287,043.53

18

$287,043.53

$9,090.66

$7,403.35

$325,007.28

19

$325,007.28

$9,363.38

$8,359.27

$366,971.80

20

$366,971.80

$9,644.28

$9,415.40

$413,336.15

21

$413,336.15

$9,933.61

$10,581.74

$464,538.57

22

$464,538.57

$10,231.62

$11,869.25

$521,060.28

23

$521,060.28

$10,538.57

$13,289.97

$583,429.74

24

$583,429.74

$10,854.73

$14,857.11

$652,227.20

25

$652,227.20

$11,180.37

$16,585.19

$728,089.80

26

$728,089.80

$11,515.78

$18,490.14

$811,717.13

27

$811,717.13

$11,861.25

$20,589.46

$903,877.27

28

$903,877.27

$12,217.09

$22,902.36

$1,005,413.56

29

$1,005,413.56

$12,583.60

$25,449.93

$1,117,251.88

30

$1,117,251.88

$12,961.11

$28,255.32

$1,240,408.76

Total

$1,240,408.76

$31,010.22

Investing in this manner of buying into long-term dividend stocks, with the assumption that the average portfolio meets these parameters we could end up with almost $1.25 million and an annual dividend of $31,000.

This means we will only have to sell $9,000 to match the other model; considerably maximizing how much we have to distribute in retirement. The dividends may be used as the replacement for Social Security. If the money is not needed, then it can be reinvested back into the portfolio to allow it to grow even more.

Challenges

Now, simply because a stock has or does pay a dividend does not guarantee it will continue to pay dividends. Or perhaps a company may lower its dividend as we saw many companies do after the 2008 crash. A few items to keep an eye on when looking for a dividend stock.

Free Cash Flow - Make sure the company has more money coming in than going out. If the company has negative cash flow and pays a dividend, it is not likely that company will be able to sustain the dividend.

Buyback - When a company has enough free cash flow, it may return value to the shareholders via share repurchasing. This will lower the amount of shares it has to pay a dividend to.

Dividend Growth - Not only can companies pay a dividend, they may increase the dividend.

These are three things to look at when looking at a company to buy into. Remember, if you are buying into a company for the dividend you want to make sure the company is able to pay out the dividend for many years.

Conclusion

The idea of saving for retirement only to spend it down for the next 30 years is antiquated. In a world that has more employees than jobs to fill, people need to be smart about their money and invest with a strategy so that their income should never run out.

The new research states that distributing 4% will not see someone through retirement. The 2.8% distribution means a retiree is more dependent on Social Security. Neither of these seems to work well.

Start investing in long-term dividend paying stocks and reinvest the dividends over time. The earlier you start, the more time you have. Use the dividends as the main source of income and sell your equity in stocks as needed. If you do not need the entire amount, reinvest the money to make sure your retirement lasts.

Source: Retirement In A World Without Social Security