There are many recent doom-and-gloom articles regarding the relative retirement preparedness of the average American. The numbers are pretty scary.
The median net worth of Americans aged 65 to 69 years, which is right around the time most people retire traditionally, is only $193,000. While this would theoretically provide nearly $8,000 to supplement Social Security (and possible pension) payments when following the 4-percent Rule, it's not quite so simple.
According to the Census Bureau data that's referenced above, only $66,000 of the $193,000 net worth is held outside of home equity. Obviously, home equity is not the most liquid form of wealth, and $66,000 will provide about $2,640 in yearly spending when following the 4-percent Rule. That's a whopping $220 a month.
While it might pay a few recurring bills, $220 a month will likely not lead to a comfortable retirement if there is nothing other than the average Social Security payment coming in. About 23 percent of Americans over age 65 rely on Social Security for 90 percent of household income. The average payment as of April 2018 was $1,411 for retired workers and $735 a month for their spouses. If both worked, a monthly income of $2,800 could be expected, if not, the payout would be around $2,146, or slightly less than $26,000 a year.
This means that any additional expense would have to come from somewhere else. This somewhere else would likely be personal savings, especially with the continuing demise of the traditional pension plan.
Where To Invest
Warren Buffett has famously recommended that a simple low-fee index fund that follows the S&P 500 is the best option for those who do not have the skill that he does. The argument that index funds beat managed funds has generally held true.
Vanguard has two low-cost ETFs that would fit this bill quite well. First is the S&P 500 ETF (VOO). The second option is the Vanguard Total Stock Market Index ETF (VTI). The former tracks only the S&P 500, so it is invested only in large-cap stocks. The latter attempts to track the entire US stock market. It includes just about every publicly traded company in the US, including small-cap stocks.
There are a couple of major differences outside of the actual index that each tracks. The first is the price. As these are ETFs, investors have to purchase full shares with most brokerages. As of May 30, 2018, VTI traded at $139.20. VOO traded at $247.18. This means that those who are still in the accumulation phase who have little to invest each month will be able to build their share count in VTI more quickly, which will allow for quicker compounding.
The second difference is the dividend yield that each offers. VOO, as it tracks larger, more established companies has a higher yield. As of 5/30/2018, VOO had a dividend yield of 1.90 percent. VTI, on the other hand, includes small-cap companies that are less likely to pay out a dividend. Therefore, the dividend yield was nine basis points lower, at 1.81 percent. This is not a huge spread, but it can add up over time.
The overall returns over the past five years have been within a single percentage point when compared against each other, and both have exceeded an 80-percent return over that time (VOO only dates back to 2010, so there is no ten-year track record).
Both ETFs come with a very low 0.04 percent management fee. This means that an investor would pay only $0.40 per $1,000 invested, which is a very nominal amount.
How Dividends Increase Operating Income And Cut Risk
Those who are nearing retirement could expect to see dividends rolling in from the ETFs that they hold in IRAs, 401k accounts, and personal savings. For every $100,000 that a hypothetical investor could bring in, he or she would bring in about $1,810 in dividend income annually from an investment in the Total Stock Market ETF or $1,900 from the S&P 500 ETF.
This could offset the 4-percent Rule to a large degree, meaning that the hypothetical retiree would not have to take out 4 percent of their nest egg to actually realize a 4 percent level of spending power. With the ETFs noted above, the 4-percent Rule actually would become more of a 2.2-percent Rule.
The average retiree noted above who has only $66,000 in net worth would receive a dividend payout of nearly $1,200 over the course of a year, and would only have to withdraw $1,400 to earn achieve the expected level of spending power.
The dividends would thus cut down on the risk that would come from a poor sequence of returns. This would occur if the market declined by 30 or 50 percent in the first year or two of retirement. The lower draw-down in the share count would be beneficial in this instance and would preserve more capital.
How To Cut Down On Withdrawals
The best way to cut down on withdrawals would be to reach for higher yields to provide more passive income. Of course, this would come with a bit of heightened risk, but there are ways to cut down on the risk that could come with the higher yield.
The ideal would be to invest in funds that are highly diversified and that come with little in the way of management fees. A couple of good options that would allow for a high yield with a good level of diversification would be Vanguard's Real Estate ETF (VNQ) and its High Dividend Yield ETF (VYM). The former comes with a current yield of 4.27 percent, according to Vanguard's website. The latter has a current yield of 3.05 percent. The fees are more than VOO or VTI, but VYM comes with a management fee of 0.08 percent while VNQ's is 0.12 percent.
The companies that are included in VNQ and VYM are also included in VTI, but these ETFs are intended to add some income. It should be noted that these higher dividend payments come with less in the way of growth.
While VTI and VOO have both seen more than 80 percent growth in the past five years, VNQ has grown only 25 percent and VYM has grown by 70 percent over the same period when the accumulated growth is tabulated.
However, the higher dividend yield could provide a higher level of income in the immediate term and would require less in the way of share liquidation as a result. If one were to use a strict 4-percent Rule, an investment in the Real Estate ETF could allow some additional investment (about 0.27 of the holdings) just from the income that the fund provides based on the current payout. Of course, it should be remembered that the payout would likely go down for all of these funds during a recession.
For those who are looking to cut down on the risk that comes from a bad sequence of returns, investing in more than just VTI or VOO could be a good option. This would be even more important for those who have small portfolios going into retirement, as a big drop in portfolio value when combined with share liquidation to provide money for expenses would have a doubly bad effect on portfolio value.
Funds like VYM or VNQ could be used to diversify and bring up the average yield of a portfolio so that fewer shares would need to be liquidated in such a situation. This would leave more shares in the account when the inevitable rebound from a recession occurs.
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.
Additional disclosure: I am not an investment professional. This article is intended for educational and entertainment value. Investors should do their own due diligence before making investments as capital losses are possible.