The numbers used in this study such as portfolio balance, expenses, taxes, etc. were selected to demonstrate the process method only. I developed this sequence of steps to create my own personal path to retirement and expect this to be only a guide. Each retiree is unique and their plan can only be addressed by going through some kind of process that leads them to a successful outcome.
The purpose of this article is not to recommend any investments, but to outline a Top-Level-Procedure using multiple methods of investment styles depending on years until retirement and/or your portfolio size. I have chosen two examples for this study for investors to understand and make their own decision about the direction they need to take to achieve their goal and not a recommendation of any specific method. Any future extrapolation assumes constant control of a set of conditions that might not hold true over time. It is understood that adjustments may be necessary to remain on track to achieve your goal. This study is driven by income only and not capital appreciation. All results are based on investment cost and not market value.
This article is a simplified step-by-step paycheck replacement procedure and can be used as a starting point to lead to your own personal retirement plan and finally to your investment selection. You need to find out where you are going first before selecting the type of investments to accomplish your final direction.
I went through this process myself and have decided that HYI (High Yield Investing) will be the best investment style that meets my goals based on both years until retirement (3 years) and my portfolio size. I just finalized my investment method this year and did not have the decades of dividend compounding using the DGI (Dividend Growth Investing) method. A couple of 50% cuts in my 401K, poor mutual fund selections and high expenses did not help. With an in-service-withdraw while still working and using a self-directed-brokerage account I'm now generating a large dividend income that I'm reinvesting into other companies or adding to existing ones to get me to my own personnel goal. I'm not an expert at dividend investing; all I can do is start and see where the journey leads me. I thought I'd share what I have learned this year and will constantly tweak my method and/or investment selection over the next few years. If you're learning curve is like mine, Seeking Alpha articles and member comments are an excellent source.
- To determine the portfolio balance, I'm going to use a 10% return on investment as a baseline. This is my current method of investment HYI (10% ROI (Return-on-Investment), 0% yield growth).
- IRA withdraw is 70% (Payout Ratio) of dividend income, the remaining 30% is reinvested back into the portfolio. This will make sure portfolio growth is maintained
- The IRA withdraw is increased each year at a 3% incremental rate. Basically giving you a raise each year.
- Household expenses are determined ahead of time and for this study the starting value is 42K (see Table1) and incremented at a 2% inflation rate. The reason for low expense inflation on the total, is because a large percentage of the expense is fixed mortgage principle and interest that does not change.
- With the expenses known I can calculate the portfolio balance I need using my baseline of 10% income yield. If 42K is 70% of the total dividend generated by the portfolio for the first year then the total dividend generated should be 60K (total = 42K(70%) + 18K(30%)). At this point if 60K (10% yield) is the total dividend income for the portfolio the balance must be 600K, (balance = 10 times 60K). This is what I'm using in this study and is a good first pass portfolio size estimate.
- I'm making Social Security to be approximately 1/3rd of total income adjusting for inflation (COLA at 2%). For this study 22K was used for simplicity. These numbers are for demonstration only, so the bottom line is total income of 64K (SS=22K + IRA withdraw =42K)
- For the DGI method I'm going to use 4.0% yield and a yield growth of 6.5% based on a study by SDS (Seductive Dividend Stocks), here. The DGI method is designed for 25+ years of compounding growth for wealth building. With a shorter time frame income requirements may not be meet for every investor.
- The tax rate is fixed at 15% of total income, (SS + IRA withdraw) to over compensate tax liability. I just wanted to put some tax number that might typically be applied for both state and federal income and understand it might be more or less this value.
Example of expenses
A mortgage is a possibility for some retirees. I placed a large number in the mortgage area to simulate worst case scenario and realize most retirees will typically pay off their mortgage. I wanted to over compensate for expenses in this study to amplify the differences between both investment methods. Of course these numbers are just made up and do not depict actual values. I'm sure some SA commentators will have fun picking this apart, have fun.
|Mortgage/Inc/tax||$ 1,580.00||$ 18,960.00|
|Phone/Internet||$ 70.00||$ 840.00|
|TV cable/dish||$ 95.00||$ 1,140.00|
|Garbage removal||$ 30.00||$ 360.00|
|Food/household||$ 1,100.00||$ 13,200.00|
|Electric||$ 150.00||$ 1,800.00|
|Heating||$ 175.00||$ 2,100.00|
|Auto Ins||$ 100.00||$ 1,200.00|
|Extra savings||$ 200.00||$ 2,400.00|
|Total yearly Expense||$ 42,000.00|
DGI method is a good consideration that will allow you to build a portfolio that grows to exponential returns after decades of reinvesting the dividends. If you have 25+ years and plan ahead you can see the rewards in Chart-1 as the balance growth is accelerating in the final years.
Chart-1 shows an example of investing $600K starting in 2014 and reinvesting all dividends. The bottom curve (blue-diamond) is just a simple yield of 4.0%, the DGI second curve (red-square) illustrates a 4.0% yield with a growth of 6.5% and the HYI top curve (green-triangle) indicates a 10% yield with 0% growth. As can be seen after 27 years the DGI method over takes HYI and starts its exponential assent. For early investors DGI is an excellent consideration to build wealth. An interesting observation is the difference between the yield only (blue-diamond) curve and the DGI (red-square) curve is the acceleration factor of the 6.5% yield growth.
The chart below illustrates the inability for a new DGI portfolio to handle the drawn-down of income from a fixed portfolio balance, in this example set at 600K. The withdraw rate will quickly deplete the ability to outlive your income. Many retiring investors must start to think about how they will plan for paycheck replacement. The poor selection of mutual funds in 401K accounts and just a few years before retirement, you must begin thinking about income replacement.hu
Chart-2; the picture changes from Chart-1 if we take out $42K (Table1, expenses) from the IRA account and increase the withdraw rate by 3% each year. The DGI method (red-square) starts out at $24,000 in dividends, well below the 42K withdraw value, the deficit just continues to increase until the DGI portfolio runs out of money in 2033. On the other hand the HYI method (green-triangle) that produces $60K in dividends in the first year exceeds the $42K withdraw value by $18K and that amount gets added back into the portfolio for future growth. The yield only (blue-diamond) income runs out of funds after 16 years.
This chart indicates how the withdraw rate effects the dividends generated by both investment methods.
Chart-3; this chart displays in one picture the results from withdraws taken from each investment portfolio (DGI/HYI). The center line (purple-X) shows the withdraw starting at $42K and increasing by 3% each year. The third line DGI (red-square) indicates the shortage of investment income to cover the $42K expense; assets need to be sold to cover expenses. Over time the DGI method will run out of sustainable income. The top HYI line (green-triangle) not only generates more than enough income, but the surplus capital is put to work back into the portfolio adding to the growth over time.
The following chart displays the actual portfolio income generated after withdraw for each year. It's the same as Chart-3, but with numbers for each year.
Chart-4; this chart is another way to see the effect of expense withdraw from each portfolio type (DGI/HYI). The center dollar amount is withdrawn each year and is incremented by 3%. The bottom amounts are the dividends generated by DGI portfolio and the top amount is from the HYI portfolio. This whole study is related to investment time (years for compounding growth) and portfolio size (the more the better) and when you need to start withdrawing income.
This is a simple bar chart to show the accelerated growth of total income starting in 2014 (SS = 22K + IRA withdraw = 42K) you could expect each year in retirement. Future inflation is unpredictable, but if you can plan for it, and come close, you will be just that much ahead of the pack. Starting in 2014 your income will be 64K and by2038 your income is greater than 120K.
Chart-5; illustrates income from social security including a fixed COLA increase of 2% per year for this study. The IRA portfolio withdraws, starting at 42K and increasing by 3% each year. This income is common between both DGI and HYI portfolio methods. The fixed income is just 0 dollars and does not add to the total income for this study.
Total expense breakdown to include 15% tax (both state and Fed) on total income (both social security and IRA withdraw), household expenses determined in Table1 (adjusted for 2% inflation), and extra monies to be used for additional expenses.
Chart-6; lists the expenses paid each year. The bottom bars are taxes paid that include both state and federal at a rate of 15%. The taxes may be more or less, but are held at a constant rate for this study. The expenses (calculated in Table1) may include a mortgage, electric, heat, etc. that allows for 2% yearly increase for inflation. The top bar is extra monies that can be used for medical and/or emergency conditions.
- Everyone should make a plan for retirement. It should start with years before retirement, your current portfolio size, your estimated social security and household expenses. Then add in some inflation and mix, your all set. I believe this should be done before you start selecting what stock investments you need to reach your goal.
- With the DGI method you need to maintain two variables to achieve your goal (yield and yield growth). If your have many years before retirement this method will build wealth. There are many DGI Seeking Alpha members that are good sources for stock selection.
- As an alternative the HYI method will focus on one variable and that is ROI (Return-on-Investment). In my example the 10% ROI is all I focus on and make sure each stock investment in the portfolio holds up to its income contribution otherwise it gets kicked off my investment bus and I find another. I do not focus on stock market price except when I'm in a buying mood.
- A systematic plan using a top down approach is a good start to creating a paycheck replacement. You have to know what you're trying to achieve before stock selection.
- You never want to be forced to sell shares for income, do not get rid of the goose that's laying those golden eggs! If you have a small portfolio and have a few years to build an income generator you may have to find an alternative to DGI.
- If you do decide to create a HYI generator care must be taken to not chase yield, but to research good investments that can maintain their high yield.
- As demonstrated if you take a percentage (70%) of income generated by a portfolio and reinvest the remainder (30%) your high yield and zero growth stock selection will still grow the portfolio. Just like blue-chip DGI stocks a payout ratio anywhere between 60 to 70% will allow for continued dividend growth.
In the Test Engineering field we run SHMOO plots to determine operational parameters for semiconductors. The SHMOO calculator I'm building varies two variables, Y-axis for yield and X-axis for yield growth. The variables I can adjust before running the SHMOO is the starting portfolio balance, withdraw expenses from the portfolio and the percent increase for withdraw each year. The values in the matrix are the ending portfolio value after the total number of years; this is also a variable that can be entered. The Green and Red cells indicate if we end up with more or less money than we started with. In this example green would indicate greater than 600K.
When I first build this calculator, I spent an hour varying the input fields and running many What-If scenarios to help me determine the best possible outcome for my individual retirement needs. The variations are endless, changing the portfolio balance, withdraw amount and even your raise you want each year. Put in your total years you want to be withdrawing income and it will tell you if you will run out of money. With your input selection anywhere in the green you will not run out of portfolio money as long as you can maintain portfolio yield and yield growth each year. The yellow cell to the left depicts my baseline 10% yield, 0% growth. The center yellow cell is a DGI 4% yield with a 6.5% yield growth.
Note: the total years variable in the matrix table below indicates 24, if 2014 is year 0 the 24 will bring you to 2038 as the charts above indicate.
The SHMOO calculator can also project future growth of a portfolio size. Lets say an investor has 50K balance and adds 5K increasing by 1% each year. After 30 years the balance can be selected depending on yield and growth.
The matrix runs 25x25 calculations giving 625 result. You can select your portfolio yield/growth and predict the future balance. This can only work if the yield/growth can be maintained as a constant.
The SHMOO calculator is being created that will also generate chart plots just like Chart-2 and Chart-3 in this article.
Disclosure: The author is long AGNC, NLY, HTGC, TCPC, BDCL, MORL.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.