A Step-By-Step Guide To Spending More In Retirement

| About: T. Rowe (PRDGX)


A diversified portfolio is the obvious alternative to excessively concentrated retirement approaches such as dividend-based strategies.

The drawback of a diversified, total-return retirement approach is the confusion surrounding how to generate a consistent cash-flow stream that isn't force-fed to you through dividend distributions.

I walk through an example of how to design and manage a total-return portfolio for ongoing cash flow and relate its numerous and significant advantages over dividend-based approaches.

Retirees are fond of dividend stocks for their ongoing cash flow needs. The thinking is, if you buy a basket of companies with large distributions, or ones with moderate distributions that are growing, then you'll never have to sell shares. It's a paycheck without the work.

Unfortunately, there's an under-appreciated risk in this approach: Dividend-growth portfolios tend to be concentrated in the US large cap asset class. And large caps, like all asset classes, can go long periods of time with little-to-no returns. If your dividends don't grow fast enough to keep pace with your spending needs (or if they are unexpectedly cut), and you have no price appreciation to make up the difference, you could see your retirement portfolio dwindle or be forced to slash your spending. My article yesterday dealt with this risk in detail.

Such a scenario was very possible if you happened to retire with a dividend-growth portfolio at the beginning of the "lost decade" in 2000. Over the next 10 years, US large cap stocks produced negative returns (including dividends).

Asset Class/Portfolio (Symbol)

(%) Weight In Globally-Diversified Portfolio

2000 to 2009 "Lost-Decade" Return

US Large Cap Stocks (MUTF:DFELX)



US Dividend Growth Stocks (MUTF:PRDGX)



US Large Value Stocks (MUTF:DFLVX)



US Small Cap Stocks (MUTF:DFSCX)



US Small Value Stocks (MUTF:DFSVX)



US Real Estate Securities (MUTF:DFREX)



Int'l Large Value Stocks (MUTF:DFIVX)



Int'l Small Cap Stocks (MUTF:DFISX)



Int'l Small Value Stocks (MUTF:DISVX)



Emerging Markets Stocks (MUTF:DFEMX)



Emerging Markets Value Stocks (MUTF:DFEVX)



Emerging Markets Small Cap Stocks (MUTF:DEMSX)



Globally-Diversified Portfolio



Click to enlarge

But the decade wasn't "lost" for investors who held value stocks, small cap stocks, small value stocks and foreign stocks, whose returns ranged from +4.4% to +13.9% a year. A globally diversified portfolio, despite 20% to languishing large cap stocks, managed +6.7% a year. Dividend-growth stocks did a little better than the S&P 500 as well, +2.8% a year. But that's not nearly sufficient to fund the 5% annual withdrawals many retirees hope to achieve from their portfolios.

So broad asset-class diversification is highly recommended in retirement, not only for higher potential long-term returns, but also for the diversification benefits during periods when US large cap stocks struggle.

But there's a problem for retirees who adopt a globally diversified portfolio framework and need ongoing income from their portfolio. Namely, where does it come from? Some dividends? Some share sales? What about bear markets? Should this portfolio include bonds too? Even at low interest rates? I could be here all year writing articles on the questions I get. Instead, I thought a step-by-step example might be more effective.

I am going to model a similar retirement scenario as I used in my previous article: a retiree with $1M starting in 1999 needing $50,000 in year one ($60,000 would have worked but that level outraged too many readers) and adjusted annually by inflation in subsequent years. This time I ended the example in 2015.

How To Think About Stocks and Bonds

First, let's settle on an appropriate asset allocation for our retiree. We know that a diversified stock portfolio will serve as the foundation, as stocks are the only asset class that can be expected to generate sufficient returns to achieve a 5%+ annual withdrawal rate. We'll use the same stock allocation as our previous article and detailed in the table above - global diversification and liberal amounts of high-returning value, small cap and small value stocks.

But we might also want to consider added protection from the periodic bear markets we will encounter along the way. No one can accurately predict when they'll begin or when they'll end, but that doesn't prevent us from being prepared for them by having enough of our annual income set aside in short-term bonds so that we can sell bond fund shares and spend the proceeds during years when stocks are down. Once stocks have recovered, we can return to spending stock fund shares (a combination of dividends and share price appreciation).

How Much In Bonds?

So we'll start with about 4 years of income in bonds ($200,000), with the goal of keeping 2-4 years at all times. The short-term bond portfolio will consist of the DFA One-Year Fixed Income fund [(MUTF:DFIHX), 25%], the DFA Two-Year Global Fund [(MUTF:DFGFX), 25%], the DFA Short-Term Government Fund [(MUTF:DFFGX), 25%] and the DFA Five-Year Global Fund [(MUTF:DFGBX), 25%]. This is a very short term (2-3 year maturities) and very high-quality (AA ratings or better) approach with an emphasis on return of principal instead of return on principal. Remember, stocks will drive returns, bonds are designed simply to help us weather bear markets. To avoid any allegations of data mining or hindsight bias in portfolio construction, I've intentionally chosen these allocations and funds because they appeared in a 1998 version of DFA's Matrix Book (see page 50 here).

Retirement Spending… Step By Step

This sounds easy enough, but how does it work in practice? The best way to describe it is to walk through a year-by-year example, including unique attributes each year that the total return investors would have encountered. This is as close as you can get to the actual experience of retiring with a total-return portfolio without having actually done it. So here we go…


Stock Return

Stock Balance

Bond Return

Bond Balance

Portfolio Withdrawal

Best-Performing Asset Class











EM Small Cap (+85.4%)







REITs (+28.4%)







US Small Cap (+22.8%)







Bonds (+7.8%)







EM Value (+76.2%)







EM Value (+39.5%)







EM Value (+30.8%)







EM Value (+37.9%)







EM Value (+45.6%)







Bonds (+5.1%)







EM Small Cap (+99.7%)







US Small Cap (+31.3%)







REITs (+9.0%)







EM Small Cap (+24.4%)







US Small Cap (+45.1%)







REITs (+31.1%)







Int'l Small Cap (+5.9%)

Click to enlarge

The table is organized as follows: it lists the yearly return and the amount left in the stock and bond funds after the withdrawal has been taken out, while also summarizing that withdrawal amount ("portfolio withdrawal"). The asset class "return" and "balance" columns that are bolded and italicized indicate which part of the portfolio funded the withdrawal each year (stocks from 1999 to 2001, 2003 to 2007, 2009 to 2010 and 2012 to 2014; bonds in 2002, 2008, 2011 and 2016). The final column presents an interesting statistic from each year: which asset class had the best overall returns. Your best bet is to walk through the example, year-by-year, to get a true understanding of what the periodic results would have been.

When To Spend Stocks, and When To Spend Bonds?

You'll find that in most years, stocks produced double-digit positive returns that were more than sufficient to generate the annual withdrawal and reinvest some of the gains, and a fraction of dividends and appreciated shares would have been utilized for cash flow needs. But there were a few years where stocks performed poorly and it would have been advisable to not sell stocks while they were down. In 2002, 2008, 2011 and 2015, you could have simply sold shares of the short-term bond funds to meet the withdrawal needs; high-quality, short-term bonds were reliably positive during every period when stocks were down. This result would not have changed had this been a period when interest rates rose instead of declining (unless you mistakenly opted for longer-term or lower-quality bonds).

Importantly, we're not assuming that the bond funds earned enough interest to meet the total withdrawals during bear markets, the stable nature of short-term bond fund prices allowed us to sell shares without taking a significant haircut. And while you temporarily dipped into bond fund principal, you knew that when stocks recovered you'll be able to reinvest future bond fund coupons to replenish their value and even rebalance out of stocks and back into bonds after a few years of strong stock returns (this was done once during the period: after 2012).

Always Be Selling High

I wanted to call attention to the final column, because it reports an under-appreciated fact of a multi-asset class portfolio - there's almost always something doing VERY well, unlike a dividend-based approach, where every holding can potentially lose ground during bear markets (and dividends can be cut or eliminated). As a matter of fact, there were only 3 years (out of 16) when the best performing asset class was only up single digits. There were 5 different years where there was an asset class that produced over a +40% return. Three of these years saw individual asset classes earn between +76% and +99%. Those returns on even the smallest asset class would be sufficient to fund almost the entire year's withdrawal without worrying about any of the other holdings or any of their dividends.

Of course, the conclusion is what matters. Using a total-return approach, with a few years of future income set aside in short-term bonds for emergencies (unexpected bear markets), you were able to navigate a very challenging 16-year period that included two of the worst 5 bear markets in modern history. And net of a substantial, 5% a year withdrawal rate that would have torpedoed a dividend-growth approach, the portfolio had grown to almost $1.8M.

Importantly, you were always prepared for what was to happen next:

  • because you diversified your stocks broadly, you weren't sabotaged by the "lost decade" for US large cap stocks - value, small cap, small cap value and foreign stocks saved your bacon.
  • When blue chips returned to favor in 2011, you had sufficient exposure to benefit from their above-average returns.
  • Bear markets weren't a bother, you patiently sold bond fund shares while you waited for stocks to recover, knowing you had plenty of dry powder should the downturn last longer.
  • In quite a few years, individual asset classes had significant outsized returns such that your entire withdrawal could be funded from the sale of one or two extraordinary performers while the remainder of the portfolio could be left to grow and compound.
  • You weren't boxed into an arbitrary withdrawal rate based on the benevolence of some corporate "bigwig" and its dividend policy.
  • And you didn't have to pay taxes on any more of your portfolio than you decided to sell.
  • You could have applied a bit of smart estate and tax planning as well - putting low-returning bond funds in IRAs to dampen growth, future RMDs and ordinary income taxes, while locating higher-returning stocks in taxable accounts where they would be primed to benefit your heirs in the future from a step-up in cost basis.
  • But most of all, you were able to spend more of your retirement portfolio without dipping into principal. With a dividend-growth approach, in order to grow your portfolio to $1.8M by year-end 2015 (as you did with the total-return approach), you could have only taken $20,000 per year (2%) adjusted for inflation (see this link). If you had taken $50,000 per year adjusted for inflation from a dividend-growth portfolio, your ending balance in 2015 would have only been $529,920, a loss of principal of almost 50% (see this link).

So whether you need more income than you can squeeze from dividend stocks today, wanted to understand how to employ a balanced approach to retirement spending, or you simply recognize the unnecessary risks of putting all of your retirement assets in one basket, bookmark the article and utilize this step-by-step guide to spending more in retirement.

Any questions or comments? Let me know.

Past performance is not a guarantee of future results. Mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Model portfolio returns are acheived with the benefit of hindsight and do not consider the practical or investor-specific issues that would have had an influence on the results. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, product, or service.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.