You're Retiring: Where Is Your Income Going to Come From?

by: David Van Knapp

As an owner of Vanguard funds, I get a newsletter called In the Vanguard. An article that I received on Friday, March 4 caught my eye. It’s about retirement spending. Here are some excerpts (all italicized phrases appear in the original):

You've worked your whole life, invested well, and amassed substantial savings. Now in retirement, you have to spend that money….To make those savings last, you need a strategy for deciding how much you can spend each year—bearing in mind that you can't control market returns, the inflation rate, or how long you'll live….

Colleen M. Jaconetti, an investment analyst with Vanguard Investment Strategy Group…and Francis M. Kinniry Jr., a principal in the group, recently coauthored a research paper titled A More Dynamic Approach to Spending for Investors in Retirement. In it, they examine two familiar strategies [for making withdrawals] and present a third—a hybrid of the others that is more dynamic and flexible.

[The three strategies are:] …dollar amount grown by inflation, percentage of portfolio, and percentage of portfolio with ceiling and floor, the hybrid.

The first two methods have some clear drawbacks. Withdrawing a set amount adjusted each year for inflation provides a stable spending stream, but Ms. Jaconetti noted that "because this strategy is indifferent to the performance of the capital markets, retirees may accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform." Conversely, if you simply withdraw a fixed percentage of your portfolio each year, "you'll (almost) never run out of money, but your income will fluctuate, substantially at times." The benefit of the third approach, Ms. Jaconetti said, is that "you're not cutting back too far if the market goes down and not overspending when you have an excess return. It limits both the upside and downside potential for spending."

The researchers tested the three scenarios….For each strategy they ran 10,000 simulations starting with the following assumptions: a 35-year time horizon; a portfolio asset allocation of 35% U.S. stocks, 15% international stocks, and 50% U.S. bonds, rebalanced annually; a starting balance of $1 million; and first-year spending of 4.75% of the portfolio. The ceiling and floor limits [of the hybrid model] were 5.0% and 2.5%, respectively. (Taxes were excluded from the calculation.) The starting withdrawal of $47,500 "is a reasonable spending amount, given the asset allocation and time horizon," Ms. Jaconetti said.

For each strategy, the researchers examined the percentage of simulations in which the portfolio still existed after 35 years. The results: for dollar amount grown by inflation, a 71% survival rate; for percentage of portfolio with ceiling and floor, 89%; and for percentage of portfolio, 100%....

"We thought an 85% success rate would be reasonable," Ms. Jaconetti said. "Striving for a 100% chance of not running out of money would likely result in a significantly lower initial annual spending amount."…

The dollar amount grown by inflation and percentage of portfolio methods have been more commonly used by individual investors in the past, while the percentage of portfolio with ceiling and floor method was more widely used by institutions such as foundations and endowments….

No matter what strategy an investor may adopt, flexibility is crucial, Ms. Jaconetti said. Retirees need to be ready to deal with volatile investment returns, unexpected expenses, or sharp changes in inflation. The best way to stay prepared, she said, is to keep your fixed expenses relatively low. "Keeping fixed expenses like mortgage, car payments, and food as low as possible will likely allow investors to be more flexible with their annual spending," Ms. Jaconetti said. "If your fixed expenses are a large portion of your total expenses, you'll have a harder time cutting back when the markets are not doing well."

Do you notice anything in particular? I noticed two things: First, the article suggests that a safe initial withdrawal rate is 4.75%, which is significantly higher than the commonly seen 4%. You probably caught that too.

But it is the second point that I think is far more important. “Now in retirement, you have to spend that money.” Once again, we have experts simply presuming, without discussion, that depleting your assets is how you will fund retirement. It’s what’s known in the trade as a total-return strategy: Save as much as you can until retirement, then in retirement start spending it and hope it doesn’t run out.

This is not the first time that I have written about this strategy. Last August, in “Financing Retirement: Asset Allocation,” I described two articles in the then-current AAII Journal that, in discussing retirement, simply assumed that the proper way to think about saving for retirement is:

  • Maximize your capital before you retire.
  • Make your capital a lot “safer” as you approach retirement.
  • In retirement, withdraw capital at a “safe” rate.

The AAII withdrawal assumption matches the process described in the Vanguard article. They differ only in detail.

Why do seemingly all retirement experts gravitate to the capital withdrawal method of funding retirement? It’s the same approach implied in the ING “What’s Your Number” advertisements, where people carry around numbers like $1,888,456 to signify how much they need to accumulate before they start depleting their resources in retirement.

Let’s say that Wall Street’s financial wizards invented an entirely new product for retirees, called RIPS (for Rising Income Protection Security), with these characteristics:

  • Negligible fees.
  • Provides income at a reasonable rate, say 4% the first year.
  • The income is taxed at a favorable rate.
  • The income grows every year, faster than inflation in most years.
  • Principal can be retrieved at any time without penalty.
  • Over long time periods, principal grows or contracts approximately in line with the stock market, although usually with less volatility.
  • No matter what the principal does, the income stream grows every year, usually faster than inflation.
  • When you die, the entire product can be bequeathed to your heirs, and for taxation purposes, its cost basis resets to its current value.

Do you think that retirees might be interested in RIPS? I think interest would be huge. Why doesn’t Wall Street tout such a product? Perhaps because there is no money in it for them. Negligible fees, no loads, infrequent tiny commissions.

But the product already exists without fanfare or a cool name. It’s called a dividend-growth stock. A portfolio of well-chosen dividend-growth stocks has all of the characteristics listed. Specifically to the point of planning for retirement, the question I have is, Why don’t retirement experts even mention that such an alternative exists? Every dollar you receive from a growing dividend stream is one less dollar that you will have to withdraw from your nest egg in retirement. It is quite possible that, when combined with a pension, Social Security, and other sources of income, the dividends from a dividend-growth portfolio may mean that you never need to withdraw a penny of your assets to live on in retirement. Or that your withdrawal rate can be cut down to 2% or 1%, much safer than 4% or 4.75%. Your withdrawals may decline over time as the dividend stream outpaces inflation.

Let’s go over some of the key distinctions of RIPS, aka dividend-growth stocks, compared to other retirement investments.

  • Unlike non-dividend stocks, dividend-growth stocks provide a stream of income that grows every year. Prior to retirement, those dividends can be reinvested to grow the portfolio—and the income stream—even faster than the rate of dividend growth itself. After retirement, the dividend reinvestment can stop and the dividends taken as income. The income stream will still increase every year as the dividend payouts are increased by the companies.
  • Unlike bonds, the income stream from dividend-growth stocks is not fixed. It grows every year, usually faster than inflation.
  • Well, TIPs and I-bonds sort of do that too, but their income rarely exceeds inflation (they are indexed to a measure of inflation). RIPS income growth usually exceeds inflation.
  • Unlike bonds, the principal value of dividend-growth stocks can rise over long time-frames to a higher value than that originally invested. It is also subject to market risk and can decline.
  • But whatever happens to the principal value, it does not impact the income stream.
  • Unlike annuities, the income stream is not fixed.
  • When you die, there is something to leave to your heirs. With annuities, your principal is kept by the insurance company.

The above represent my own beliefs, but they are hypotheses. I am not a professional in the field of retirement planning. I am seeking someone to shoot holes in my position. I know that there are financial planners and others in the retirement and investment industries who read Seeking Alpha. Why are the unique characteristics, benefits, and risks of dividend-growth portfolios ignored? Why are dividend-growth stocks never singled out as an investment category well suited to the needs of retirees, instead of being lumped in with all other stocks? Why are the rising-income-generating qualities of dividend-growth stocks never mentioned? Why is the dollar-for-dollar offset of dividend income against capital withdrawals never discussed?

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