How The 4% Retirement Rule Converts To Dividend Investing

by: Intelligent Speculator

Click to enlargeA common rule that has been applied both by individual investors and financial planners/brokers is the 4% rule. What is it? Basically, if you try to plan your retirement, you should expect to be able to retire 4% of your capital in the first year. Then, you can increase the amount that you withdraw every year to account for inflation. If I take someone with a $1,000,000 retirement savings portfolio retiring today that would mean:

$40,000 to spend this year

If inflation is 2.5%, that would mean $41,000 to spend next year and so on

The objective is to set realistic expectations of how much should be spent and how much should be saved in order to avoid outliving your retirement savings. The rule has been a great rule of thumb and one that I personally think is very useful when planning years and even decades ahead. Since retirees generally end up having a very conservative portfolio, the 4% withdrawal does mean selling assets over time and eventually leaving some amount for family but not a whole lot in most cases.

Enter Dividend Investing

One of the main differences between retiring with a traditional savings portfolio and a dividend portfolio one is that the ultimate goal is to be able to live off of the dividends and hopefully avoid selling any of the stocks. In such a way, there is very little to worry about in terms of outliving your expenses but it also means being able to leave a significant amount behind when that moment comes. I think those benefits are very significant.

Ideally, I think someone would look for a dividend portfolio that is similar to the Ultimate Sustainable Dividend Portfolio, a portfolio that yields 3% or so but that can generate dividend growth of 4% very easily. I consider those assumptions to be very conservative.

The one thing that you could say though is that living off of 3% in those initial years makes a major difference right? I mean earning $30,000 or $40,000 is far from the same thing. I agree, so let's change things a bit. In those earlier years, We will adjust the payout to 3.5% by selling some capital. It's not ideal but I think it's a fair compromise. Obviously, this could be adjusted up or down depending on your specific needs but let's try this out. So basically in:

Scenario #1 - 4% Rule:

John withdraws 4% on year 1 then adjusts this amount for inflation - John gets a 4.5% total return since he must become very conservative

Scenario #2 - 3% Dividend Rule (adjusted 3.5%)

John withdraws dividends, a dividend yield of 3% that increases by 4% per year. In the first 10 years, he actually withdraws 3.5% thus reducing capital but also dividend growth to 3%. I will assume an average total return of 5.5%, very realistic given the portfolio being less risky.

I will also assume that after 20 years, the amount being withdrawn will only increase by the inflation rate (unfortunately, at some point, we become older and less able to travel, etc).

Let's assume inflation of 2%

First, take a look at my data, which you can download here as well:

4% rule

Year Capital Return Withdrawl New Capital
1 $1,000,000.00 $45,000.00 $40,000.00 $1,005,000.00
2 $1,005,000.00 $45,225.00 $40,800.00 $1,009,425.00
3 $1,009,425.00 $45,424.13 $41,616.00 $1,013,233.13
4 $1,013,233.13 $45,595.49 $42,448.32 $1,016,380.30
5 $1,016,380.30 $45,737.11 $43,297.29 $1,018,820.12
6 $1,018,820.12 $45,846.91 $44,163.23 $1,020,503.80
7 $1,020,503.80 $45,922.67 $45,046.50 $1,021,379.97
8 $1,021,379.97 $45,962.10 $45,947.43 $1,021,394.64
9 $1,021,394.64 $45,962.76 $46,866.38 $1,020,491.03
10 $1,020,491.03 $45,922.10 $47,803.70 $1,018,609.42
11 $1,018,609.42 $45,837.42 $48,759.78 $1,015,687.07
12 $1,015,687.07 $45,705.92 $49,734.97 $1,011,658.01
13 $1,011,658.01 $45,524.61 $50,729.67 $1,006,452.95
14 $1,006,452.95 $45,290.38 $51,744.27 $999,999.07
15 $999,999.07 $44,999.96 $52,779.15 $992,219.88
16 $992,219.88 $44,649.89 $53,834.73 $983,035.04
17 $983,035.04 $44,236.58 $54,911.43 $972,360.18
18 $972,360.18 $43,756.21 $56,009.66 $960,106.74
19 $960,106.74 $43,204.80 $57,129.85 $946,181.69
20 $946,181.69 $42,578.18 $58,272.45 $930,487.42
21 $930,487.42 $41,871.93 $59,437.90 $912,921.46
22 $912,921.46 $41,081.47 $60,626.65 $893,376.27
23 $893,376.27 $40,201.93 $61,839.19 $871,739.01
24 $871,739.01 $39,228.26 $63,075.97 $847,891.30
25 $847,891.30 $38,155.11 $64,337.49 $821,708.92
26 $821,708.92 $36,976.90 $65,624.24 $793,061.58
27 $793,061.58 $35,687.77 $66,936.72 $761,812.63
28 $761,812.63 $34,281.57 $68,275.46 $727,818.73
29 $727,818.73 $32,751.84 $69,640.97 $690,929.61
30 $690,929.61 $31,091.83 $71,033.79 $650,987.65
31 $650,987.65 $29,294.44 $72,454.46 $607,827.63
32 $607,827.63 $27,352.24 $73,903.55 $561,276.33
33 $561,276.33 $25,257.43 $75,381.62 $511,152.14
34 $511,152.14 $23,001.85 $76,889.26 $457,264.73
35 $457,264.73 $20,576.91 $78,427.04 $399,414.60
36 $399,414.60 $17,973.66 $79,995.58 $337,392.67
37 $337,392.67 $15,182.67 $81,595.49 $270,979.85
38 $270,979.85 $12,194.09 $83,227.40 $199,946.54
39 $199,946.54 $8,997.59 $84,891.95 $124,052.18
40 $124,052.18 $5,582.35 $86,589.79 $43,044.74
Click to enlarge

Dividend Portfolio

Year Capital Return Withdrawl New Capital
1 $1,000,000.00 $55,000.00 $35,000.00 $1,020,000.00
2 $1,020,000.00 $56,100.00 $36,050.00 $1,040,050.00
3 $1,040,050.00 $57,202.75 $37,131.50 $1,060,121.25
4 $1,060,121.25 $58,306.67 $38,245.45 $1,080,182.47
5 $1,080,182.47 $59,410.04 $39,392.81 $1,100,199.70
6 $1,100,199.70 $60,510.98 $40,574.59 $1,120,136.09
7 $1,120,136.09 $61,607.49 $41,791.83 $1,139,951.75
8 $1,139,951.75 $62,697.35 $43,045.59 $1,159,603.51
9 $1,159,603.51 $63,778.19 $44,336.95 $1,179,044.75
10 $1,179,044.75 $64,847.46 $45,667.06 $1,198,225.15
11 $1,198,225.15 $65,902.38 $47,493.74 $1,216,633.79
12 $1,216,633.79 $66,914.86 $49,393.49 $1,234,155.15
13 $1,234,155.15 $67,878.53 $51,369.23 $1,250,664.45
14 $1,250,664.45 $68,786.54 $53,424.00 $1,266,026.99
15 $1,266,026.99 $69,631.48 $55,560.96 $1,280,097.52
16 $1,280,097.52 $70,405.36 $57,783.40 $1,292,719.48
17 $1,292,719.48 $71,099.57 $60,094.74 $1,303,724.31
18 $1,303,724.31 $71,704.84 $62,498.53 $1,312,930.62
19 $1,312,930.62 $72,211.18 $64,998.47 $1,320,143.34
20 $1,320,143.34 $72,607.88 $66,298.44 $1,326,452.78
21 $1,326,452.78 $72,954.90 $67,624.41 $1,331,783.28
22 $1,331,783.28 $73,248.08 $68,976.89 $1,336,054.47
23 $1,336,054.47 $73,483.00 $70,356.43 $1,339,181.03
24 $1,339,181.03 $73,654.96 $71,763.56 $1,341,072.43
25 $1,341,072.43 $73,758.98 $73,198.83 $1,341,632.58
26 $1,341,632.58 $73,789.79 $74,662.81 $1,340,759.56
27 $1,340,759.56 $73,741.78 $76,156.06 $1,338,345.27
28 $1,338,345.27 $73,608.99 $77,679.19 $1,334,275.08
29 $1,334,275.08 $73,385.13 $79,232.77 $1,328,427.44
30 $1,328,427.44 $73,063.51 $80,817.43 $1,320,673.52
31 $1,320,673.52 $72,637.04 $82,433.77 $1,310,876.79
32 $1,310,876.79 $72,098.22 $84,082.45 $1,298,892.56
33 $1,298,892.56 $71,439.09 $85,764.10 $1,284,567.56
34 $1,284,567.56 $70,651.22 $87,479.38 $1,267,739.39
35 $1,267,739.39 $69,725.67 $89,228.97 $1,248,236.09
36 $1,248,236.09 $68,652.99 $91,013.55 $1,225,875.53
37 $1,225,875.53 $67,423.15 $92,833.82 $1,200,464.87
38 $1,200,464.87 $66,025.57 $94,690.49 $1,171,799.94
39 $1,171,799.94 $64,449.00 $96,584.30 $1,139,664.63
40 $1,139,664.63 $62,681.55 $98,515.99 $1,103,830.20
Click to enlarge

Now take a look at the amounts that these investors can take out:

(Click to enlarge)Click to enlarge

And the remaining capital:

(Click to enlarge)Click to enlarge

Assumptions

Of course, over a 40 year period, changing inflation rates or returns by even a small amount is enough to make a major difference. That is why I tried to be much more conservative. If you asked me what I would really expect, the difference between these two solutions would be much more drastic. That being said, I would love to hear any type of criticism or comments regarding those assumptions or the conclusion.

What Is Your Action Plan?

I don't think it's a big surprise to see that an investor that relies on a dividend focused portfolio down the road will end up doing much better than someone that basically switches its portfolio to a low risk, little return portfolio. There are some critical parts to making this work though.

#1-Psychology Switch: If an investor, especially an aging on looks at day-to-day or month-to-month variations in the value of the portfolio, it can certainly become a source of anxiety and in such a case, switching to dividend ETF's might be a better way to do it. If however a retiree is able to look at the portfolio from the perspective of the annual dividends and focus on making that number grow, I think it's much easier to remain focused.

#2-Dumping Stocks Before They Decrease Dividends: I've discussed this in the past, it's important to spot the signs early, growing debt, less growth in revenues, earnings and dividends, etc. These should all be warning signs that there might be a better stock out there.

#3-Portfolio Optimization: This is something that I've discussed a lot and am now doing with the USDP. Actually if you missed it, seeing last week's post about the small changes that I made gives you a good idea. Why? I don't believe in buying a portfolio of great dividend stocks and then just sitting on it. Things changed. Companies evolve and so do their industries/competitors. That means that even a very long term portfolio should have a strong focus on keeping the right names.