How To Earn 6% Income With Half The Risk (Retirement Series)

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Includes: ABBV, ARCC, BBN, CHY, CVS, D, DEA, DVY, ENB, GBDC, HD, HDV, HQH, HYG, IEF, JNJ, JPM, KYN, LMT, MAIN, MCD, MMM, MO, MSFT, NLY, NOBL, NRZ, O, OHI, PCI, PEP, PFF, PG, QQQX, RFI, STAG, STK, STOR, UPS, UTF, VCLT, VIG, VLO, VNQ, VTR, VYM, VZ, XOM
by: Financially Free Investor
Summary

The markets are once again at their all-time highs, after a very volatile 2018.

The market gains may be too tempting. But what should a conservative investor (or a retiree) do at this critical juncture?

We suggest income-oriented strategies to capture the majority of the market gains with much less risk than the broader market.

We provide a multi-prong strategy that will aim to generate 6% income and market-comparable results while lowering the overall risk with less volatility.

Once again, the markets are near their all-time high barring some hiccups due to trade tensions this past week. It's already the longest bull market in history. However, it's widely believed that bull markets simply don't die of old age. Generally, bull markets end when there are some underlying structural issues with the economy or an economic downturn. They also can end due to sudden external shocks or geopolitical issues. None of this is visible right now. The broader economy is still doing well, and there are no recession clouds on the horizon. There appears to be some trade-related friction, but that's part of a process that should eventually resolve. Even the Fed has turned away from their hawkish stance to a more dovish one.

In the last decade, investing in the broader stock indexes like the S&P 500 has been a very successful strategy, especially if you are focused on the total return. S&P 500 posted a whopping 350% return including the reinvested dividends during the last 10 years (April 2009 – April 2019). Does it mean this trend will continue for the next decade? No one knows for sure. However, in all likelihood, the next 10 years for the S&P 500 may not be as attractive as the previous ten years. The risks have definitely increased.

Conservative investors, especially retirees (or soon-to-be-retirees), face this difficult question every day:

  • To stay invested and risk the gains of the last ten years?
  • Or to stay out of the market and risk missing out the big gains of a rising market, even a possible melt-up situation (another 20-30% gains in 2019 and 2020).

In this article, we will try to focus on strategies where we can avoid extreme risks while still be invested and generate decent gains and enough income.

Can Retirement Timing Matter?

It absolutely can. Folks who may be planning to retire in the next two to three years need to pay more attention. Why? Because it can have a great impact on how long their retirement savings would last. By the word “retirement,” we mean you need to withdraw money from your investment funds. We are assuming that a typical retiree would need to withdraw some level of income from their retirement savings in addition to other sources of income like social security and some cases, the pension.

Retirement timing can matter greatly, especially if you are an index investor. It's especially true if most of your funds are tied in your 401Ks since the majority of them offer broad index funds.

Below we present a comparison of how a retiree with a starting investment capital of $1 million would have fared if he/she had retired between the year 2000 and 2018. We assume that 100% of the money was invested in the S&P 500. In this illustration, we also assume that the retiree would withdraw 4% income (based on the initial capital) and increase it as per the rate of inflation each subsequent year. For example, let’s say John retired on Jan. 1, 2000, and invested $1 million in S&P 500. He also withdrew $40,000 as income in the first year, and then increased the income amount by the rate of inflation in each subsequent year. We repeat this exercise for each subsequent year as the starting retirement year.

Starting Retirement Year

Initial Capital

Inv. Ending Capital (Jan. 1st. 2019)

Annualized Total Return (Excl. Income)

Approx. Income Withdrawn

Approx. Total Annualized Return

2000

$1,000,000

$424,130

-4.41%

4.0%

-0.41%

2001

$1,000,000

$822,652

-1.08%

4.0%

2.92%

2002

$1,000,000

$1,343,630

1.75%

4.0%

5.75%

2003

$1,000,000

$2,367,632

5.53%

4.0%

9.53%

2004

$1,000,000

$1,678,089

3.51%

4.0%

7.51%

2005

$1,000,000

$1,535,655

3.11%

4.0%

7.11%

2006

$1,000,000

$1,541,224

3.38%

4.0%

7.38%

2007

$1,000,000

$1,312,297

2.29%

4.0%

6.29%

2008

$1,000,000

$1,288,596

2.33%

4.0%

6.33%

2009

$1,000,000

$2,694,231

10.42%

4.0%

14.42%

2010

$1,000,000

$2,101,836

8.60%

4.0%

12.60%

2011

$1,000,000

$1,857,571

8.05%

4.0%

12.05%

2012

$1,000,000

$1,912,590

9.71%

4.0%

13.71%

2013

$1,000,000

$1,679,973

9.03%

4.0%

13.03%

2014

$1,000,000

$1,258,690

4.71%

4.0%

8.71%

2015

$1,000,000

$1,135,415

3.23%

4.0%

7.23%

2016

$1,000,000

$1,173,820

5.49%

4.0%

9.49%

2017

$1,000,000

$1,082,565

4.05%

4.0%

8.05%

2018

$1,000,000

$914,400

-8.56%

4.0%

-4.56%

As you could see, the years 2000, 2001 and 2002 were particularly bad years to start retirement and start withdrawing income. Similarly, the years 2006, 2007 and 2008 were less attractive, as they happened to be just before the financial crisis of 2008. So, the timing of retirement and when you start income withdrawals matter.

The point we are trying to make is that with pure index investing, there are real risks to the financial well-being of those who have recently retired or very close to retiring or anyone who cannot tolerate big drawdowns. However, we believe there are ways to mitigate these risks by using other strategies, as discussed in this article.

How Can We Stay Invested Without Losing Sleep?

We do not know what the markets are going to do tomorrow or in the next three years. No one else knows either. In spite of the risks in the markets, we don’t think moving to cash or bank deposits would be a good strategy. Though, everyone should have a small part of their savings (probably one to two years’ worth of living expenses) in cash. To be sure, today’s retirees who may have 30 years or more in retirement do need the market gains to stay ahead of inflation.

Fortunately, we have several options:

The first thing that every retiree or a near-retiree should do is to keep a certain amount of cash reserve. Generally, one to two years of basic living expenses should suffice for most folks. It ensures that you do not have to sell stocks at the worst possible time to withdraw cash. The cash reserve could be invested in ladder CDs (bank deposits with varying maturities).

Once you have reserved the cash bucket, we should divide our remaining investible cash into at least three parts or buckets, as we like to call it.

  • DGI Bucket (35-40% of the capital)
  • Risk-Adjusted 6% Income Bucket (35-40 % of the capital)
  • High Income 8% Income Bucket (25% of the capital).

The First Bucket: A DGI Bucket for All Seasons (35-40% of capital)

For this bucket, the more active do-it-yourself type investors should invest in individual dividend-paying, blue-chip stocks. You could follow any DGI (dividend growth investing) model, and there are several great models available on SA.

For a sample of a DGI portfolio, you could take a look at our "Passive DGI Core Portfolio." This DGI portfolio invests in about 35 solid, blue-chip stocks which have a history of raising their dividend payouts year after year.

A smaller sample portfolio of 20 DGI stocks, is presented below:

Ticker

Sector/ Industry Segment

Yield %

(05/07/2019)

Company Name

(VZ)

Communications

4.21%

Verizon Communications Inc.

(HD)

Cons. Cyclical -Home Improvement/ Retail

2.67%

Home Depot Inc.

(MCD)

Cons. Cyclical- Restaurants

2.35%

McDonald's Corp.

(PEP)

Cons. Defensive- Beverages

2.90%

PepsiCo, Inc.

(MO)

Cons. Defensive -Tobacco

5.89%

Altria Group Inc.

(PG)

Cons. Staples

2.80%

Procter & Gamble Co.

(ENB)

Energy - Midstream

5.99%

Enbridge Inc.

(XOM)

Energy - Oil/Gas Major

4.33%

Exxon Mobil Corporation

(VLO)

Energy -Refinery

3.97%

Valero Energy Corporation

(JPM)

Finance- Banking

2.76%

JPMorgan Chase & Co.

(ABBV)

Healthcare - Drugs

5.39%

AbbVie Inc.

(JNJ)

Healthcare - Drugs

2.69%

Johnson & Johnson

(CVS)

Healthcare - Pharmacy

3.71%

CVS Health Corp.

(MMM)

Industrial - Diversified

3.04%

3M Co.

(UPS)

Industrial - Logistics

3.62%

United Parcel Service, Inc.

(LMT)

Industrials - Defence

2.64%

Lockheed Martin Corporation

(DEA)

REIT

5.77%

Easterly Government Properties Inc.

(VTR)

REIT-HC

5.19%

Ventas, Inc.

(MSFT)

Technology-Software

1.41%

Microsoft Corporation

(D)

Utility

4.71%

Dominion Energy Inc.

AVERAGE ----->

3.80%

ETFs instead of individual stocks:

For folks who may like to keep it simple and may not have the time or inclination to manage a portfolio of individual stocks, a basket of good dividend-focused ETFs could do a respectable job. You would want to diversify among various ETFs, even if some of their holdings overlap. By diversifying, we will not tie our fortunes with one particular strategy or a fund manager. For the vast majority of investors, diversification is one of the most important tenets of investing. We select eight ETFs allocated equally.

ETF Name

Symbol

(05/07/2019)

(% of Total)

Vanguard High Dividend Yield ETF

(VYM)

3.05%

10.99%

Vanguard Dividend Appreciation ETF

(VIG)

1.89%

6.81%

ProShares S&P 500 Dividend Aristocrats

(NOBL)

2.08%

7.50%

iShares Core High Dividend ETF

(HDV)

3.27%

11.78%

iShares Select Dividend ETF

(DVY)

3.35%

12.07%

iShares U.S. Preferred Stock ETF

(PFF)

5.91%

21.30%

Vanguard Real Estate ETF

(VNQ)

3.96%

14.27%

Vanguard Long-Term Corporate Bond ETF

(VCLT)

4.24%

15.28%

AVERAGE Portfolio YIELD >>> 3.47%

3.47%

100.00%

Bucket-2: The Risk-Adjusted 6% Income Bucket (35-40% of capital)

This will be our risk-adjusted bucket and a sort of a hedge against any future market downturns. In many ways, it's the most important bucket because it will help us stay on the course and not deviate from our strategy during the times of crisis or a recession. This strategy is even more important in the current market environment that the bull market is so mature. However, in the meantime, we will keep earning about 5-6% income and at least 8-10% total long-term returns.

We will provide below one example of a risk-adjusted portfolio.

  • 6% Risk-Adjusted Portfolio (based on QQQX, HYG, and IEF)

This portfolio can earn roughly 5-6% income in dividends and distributions, with one third less volatility and drawdowns that are less than half, when compared to the S&P 500.

Note: We also offer many such portfolios as part of our Premium SA Marketplace service. Please see details at the end of this article or at the top just below our logo.

6% RA Portfolio (based on QQQX/HYG/IEF):

Portfolio Structure:

In this portfolio, we will hold only one asset at a time out of three chosen assets, which have a relatively low correlation with each other. Two of the assets have a relatively high yield as well:

  • Nuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX)

QQQX is the asset our system will hold for a majority of the time. In other words, the system will hold QQQX when the stock market is doing relatively well. In our back-testing, QQQX was held for the longest duration (about 55% of the time) out of our 136 months test duration. QQQX has a positive correlation of about 80% with the S&P 500 and provides a quarterly dividend and yields about 7.10%.

  • iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

HYG is our bond proxy (high-yield corporate bond). Our back-testing model held this asset for about 20% of the total duration. HYG has a positive correlation of about 55% with the S&P 500. HYG currently provides a yield of over 5.25%.

  • iShares 7-10 Year Treasury Bond (IEF)

This is the mid-term Treasury and our risk-hedge asset. The system will switch to Treasuries during the times of stress or corrections and recessions. For our test duration, IEF was held for about 25% of the time. IEF has a negative correlation of about -45% with the S&P 500. IEF currently yields 2.48%.

The method and back-testing results:

We will assume that we invested $100,000 on Jan. 1, 2008, and stayed invested until April 2019. We will be using the relative momentum method, which will consider the performance of the three securities in the last three and four months. Our model will pick the top performing security (out of three) to invest for the next rotation period (monthly basis).

The rotation period will be for one month. That means we will check the performance of the assets every month and rotate the assets as needed on a monthly basis. One could use a quarterly rotation, but the results may be slightly inferior, especially the drawdowns.

We will provide back-testing results since January 2008. The reason we picked up 2008 as the starting period is that this is how far back we can go with some of our investment picks. However, it does include the 2008-2009 recession period.

Performance of 6% QQQX model vis-à-vis S&P 500 - Without any withdrawals:

Comparison of 6% Income Model with S&P-500 (No Income Withdrawn) Starting Capital: $100,000

<-------- QQQX/HYG/IEF RA Model ------->

<-------------S&P 500 ---------------->

Year

Annual Return

Year-end Balance

Income Drawn

Net Year-end Value

Annual Return

Year-end Balance

Income Drawn

Net Year-end Value

Jan-08

$100,000

$100,000

2008

8.17%

$108,170

$0

$108,170

-36.81%

$63,190

$0

$63,190

2009

62.58%

$175,863

$0

$175,863

26.36%

$79,847

$0

$79,847

2010

2.82%

$180,822

$0

$180,822

15.06%

$91,872

$0

$91,872

2011

19.63%

$216,317

$0

$216,317

1.89%

$93,608

$0

$93,608

2012

6.72%

$230,854

$0

$230,854

15.99%

$108,576

$0

$108,576

2013

12.38%

$259,434

$0

$259,434

32.31%

$143,657

$0

$143,657

2014

16.07%

$301,125

$0

$301,125

13.46%

$162,993

$0

$162,993

2015

0.30%

$302,028

$0

$302,028

1.25%

$165,031

$0

$165,031

2016

-6.73%

$281,702

$0

$281,702

12.00%

$184,834

$0

$184,834

2017

32.51%

$373,283

$0

$373,283

21.70%

$224,944

$0

$224,944

2018

5.60%

$394,187

$0

$394,187

-4.56%

$214,686

$0

$214,686

2019

5.51%

$415,906

$0

$415,906

18.16%

$253,673

$0

$253,673

Performance of 6% QQQX model vis-à-vis S&P 500 - with inflation-adjusted 6% withdrawals:

The performance of the 6% Model becomes even more striking compared to the S&P 500 if we were to withdraw 6% income every year with 3% upward adjustment for inflation each subsequent year. An early loss in the S&P 500 fund in 2008 and the 6% (inflation-adjusted) withdrawals every year give no chance for it to recover. In fact, an initial investment of $100,000 in S&P 500 fund ends up with only $90,000 at the end of April 2019, while the 6% QQQX model ends up with a balance of over $275,000 while providing inflation-adjusted 6% income all along.

Comparison of 6% Income Model with S&P-500 (6%Income Withdrawn) Starting Capital: $100,000

<-------- QQQX/HYG/IEF RA Model ------->

<-------------S&P 500 ---------------->

Year

Annual Return

Year-end Balance

Income Drawn

Net Year-end Value

Annual Return

Year-end Balance

Income Drawn

Net Year-end Value

Jan-08

$100,000

$100,000

$100,000

$100,000

2008

8.17%

$108,170

$6,000

$102,170

-36.81%

$63,190

$6,000

$57,190

2009

62.58%

$166,108

$6,150

$159,958

26.36%

$72,265

$6,150

$66,115

2010

2.82%

$164,469

$6,304

$158,165

15.06%

$76,072

$6,304

$69,768

2011

19.63%

$189,213

$6,461

$182,752

1.89%

$71,087

$6,461

$64,626

2012

6.72%

$195,032

$6,623

$188,410

15.99%

$74,959

$6,623

$68,337

2013

12.38%

$211,735

$6,788

$204,946

32.31%

$90,416

$6,788

$83,628

2014

16.07%

$237,881

$6,958

$230,923

13.46%

$94,884

$6,958

$87,926

2015

0.30%

$231,616

$7,132

$224,484

1.25%

$89,025

$7,132

$81,893

2016

-6.73%

$209,376

$7,310

$202,065

12.00%

$91,720

$7,310

$84,409

2017

32.51%

$267,757

$7,493

$260,264

21.70%

$102,726

$7,493

$95,233

2018

5.60%

$274,838

$7,681

$267,158

-4.56%

$90,890

$7,681

$83,210

2019

5.51%

$281,878

$7,873

$274,006

18.16%

$98,321

$7,873

$90,448

As you would notice, the main advantage coming from this kind of portfolio is that drawdowns will be much lower than the broader market in a crisis or a major correction. In our models, the maximum drawdown was only about -16% in comparison to -50% for the S&P 500. So, if you are a retiree, or you are someone who cannot stomach large drawdowns and likely to panic and sell at the worst time, these models definitely offer a unique advantage. It will provide most of the upside of the market but limit the downside.

The Third Bucket: High-Income Bucket (25% of capital)

This is our high-income bucket. We will aim for roughly 8% income from this portfolio. Even though this bucket will only be 25% of the total investable assets but will produce the majority of the income. Obviously, this will be riskier than our other two buckets.

So, why do we have this bucket at all if it is riskier? There are several reasons. First, this will boost the overall income of the portfolio to a very respectable level which can be sufficient for most folks to live on while allowing us to be conservative in other buckets. Second, this bucket will provide exposure to many different types of asset classes that the DGI portfolio may not provide. Lastly, it contains no more risk than the S&P 500 due to its diversification among various asset classes. The 2008-2009 recession showed us that a diversified CEF/REIT portfolio lost similar to the S&P 500 after counting the high level of distributions. But they also recovered much faster than the S&P 500.

This basket will consist of high-income securities, mainly REITs, mREITs, BDCs, and some CEFs. Its main purpose is to generate a high income, roughly 8%. This bucket will help compensate for a lower level of income from the DGI bucket.

Security Type

Symbol

Fund/Company Name

Yield (05/07/2019)

BDCs/mREIT

(ARCC)

Ares Capital Corporation

8.89%

(MAIN)

Main Street Capital Corporation

6.08%

(NLY)

Annaly Capital Management, Inc.

11.89%

(GBDC)

Golub Capital BDC

6.95%

(NRZ)

New Residential Investment Corp.

11.90%

REIT

(O)

Realty Income Corp.

3.87%

(OHI)

Omega Healthcare Investors

7.46%

(STAG)

STAG Industrial

4.97%

(STOR)

STORE Capital Corporation

3.94%

(VTR)

Ventas, Inc.

5.19%

CEFs

(RFI)

Cohen & Steers Tot Ret Realty

7.09%

(UTF)

Cohen & Steers Infrastructure

7.59%

(BBN)

BlackRock Taxable Municipal Bond

6.36%

(KYN)

Kayne Anderson MLP

8.98%

(HQH)

Tekla Healthcare Investors

8.30%

(PCI)

PIMCO Dynamic Credit Income

8.40%

(STK)

Columbia Seligman Premium Tech

9.21%

(CHY)

Calamos Convertible and High Income Fund

9.21%

AVERAGE

7.57%

The total income on a $250,000 portfolio would be roughly $19,000. The correlation factor of this portfolio with the broader market is less than 0.55.

Total Portfolio Income:

Capital

Income/ Yield

Income Amt.

**Max. Drawdown in 2008/2009 (approx.)

Bucket 1 (DGI)

$350,000

3.80%

$13,380

35%

Bucket 2 (RA 6% Income)

$400,000

6.0%

$24,000

5%

Bucket 3 (High Income)

$250,000

7.57%

$18,925

50%

TOTAL/Average

(3-Bucket Strategy)

$1,000,000

5.62%

$56,225

27%

S&P-500

$1,000,000

2% (approx.)

$20,000 (approx.)

50%

**The maximum drawdown is based on our estimates after including the dividend/distributions. Some of the securities have inception dates after 2009 and were excluded while calculating the estimates; hence these are only rough estimates.

Conclusion

Generally, over any 20-year or 30-year rolling-period, the broad market indexes should provide reasonable returns. In fact, they have had an excellent run during the last 10 years, which had been difficult to beat by most strategies. However, short term, it's a different story. The broader indexes provide no safety net in case of ugly corrections or during recessionary times.

In retirement, our goals are different. The goal here is not to beat the market or S&P 500 constantly. In retirement, the goals are high enough income, preservation of capital and long-term returns (after income) that at least exceed the rate of inflation. To put it another way, it's very important that the drawdowns are limited and preferably be under 25%. We believe the strategies described above, when combined, can help achieve all of the above goals, how lofty they may seem to be.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, IIF, CHI, JPS, JPC, TLT. 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: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.