3 Ways To Measure Retirement Preparedness

Summary

• Everyone needs to know how to calculate if they're ready to retire.
• We present three metrics you can use to help you figure out if you're ready, and adjust course if you're not.
• All types of investors can benefit from a self evaluation.
• Looking for a helping hand in the market? Members of High Dividend Opportunities get exclusive ideas and guidance to navigate any climate. Learn More »

Photo by flyzone/iStock via Getty Images

Co-produced with Treading Softly

It feels good to be prepared. We love to have our ducks in a row.

"Hope for the best, prepare for the worst" is a motto many live by. Yet when it comes to retirement savings and planning, many hope for the best and don't make a plan at all.

Often I get asked "how can I know I'm prepared?" Today I want to share three ways you can measure your retirement preparedness. Some of them will be more meaningful for income investors than others, but all of them are worth considering to create a holistic view of whether you're prepared enough to retire.

Debt to Income Ratio ('DTI')

Often we hear of debt to income ratios when applying for a mortgage. Banks and lenders want to ensure your ability to cover your debts is sufficient before extending you a large loan. Debt to income ratio, or DTI, is often expressed as 28/36. This basically means most lenders want only 28% of your total income to be tied to covering your mortgage, and 36% of your total income to cover your mortgage plus other recurring debt payments.

I encourage retirees and near-retirees to pay down and remove as much debt as possible. Focus on high-interest-rate debts first. These will likely be your debts with the highest monthly payments. The DTI ratio is determined only by the amount you have to pay monthly, not your balances. This is a limitation of the measure, but also means that to get a better DTI ratio, focus on those high interest debts that have big monthly payments first.

Cut down your debt as much as possible before punching that time clock for the last time. Not only will it bring peace of mind, but also free up money for the long term. Most people make less money when they retire than they do during their working years.

So what's your DTI? It's easy to calculate. Take your debt servicing costs and divide them by your income. If they are all the same each month, you can do it for one month, or add it all up and figure it out annually. Does your DTI exceed the 36% maximum? Then it's time to tighten the screws on your debt and get that paid down. I suggest retirees get this ratio as close to 0 as possible.

Why do I like this measure? It focuses on income, just like I do. It has limitations as it does not focus on balances but on servicing costs. Then again, you don't pay the balance each month, you pay what it takes to service that debt.

Financial Independence Number ('FIN')

Ever heard of the FIN? Most likely not. It's not one that gets a lot of attention, but it's tied directly to the 4% withdrawal rule. How you calculate it is you take your annual spending and multiply it by 25. This is the ballpark amount you need to have saved to have a comfortable 30 years of retirement while withdrawing 4% annually.

Spend $40,000 annually to cover all your bills, expenses, and pleasure spending? Your FIN is $1,000,000. Now you can see why they say you need $1 million to retire comfortably.

This assumes that your spending will remain flat throughout retirement. As we've discussed before, this is often not the case. Many retirees find their spending increases due to all the extra time they have on their hands. This metric tries to convert your spending levels from the total invested assets you have saved during your lifetime. I don't believe in the 4% rule, but I know many of you do. So while I do not put much weight into this number, I wanted to include it for the benefit of my readers who are growth investors and focus on the total account value, and want to follow the outdated 4% withdrawal rule.

My investments are worth so much more than liquidating them at 4% annually. My "Model Portfolio" yields 9%-plus, no need to sell anything for living costs if I have money pouring in from the assets I have amassed during my working life. Still, it's nice to see a low DTI number and a portfolio nearing the FIN simultaneously.

Retirement Replacement Ratio

This ratio brings us back to familiar territory, which is "income generation." This metric says that in order to maintain your standard of living in retirement, your retirement income needs to equal 70% of your pre-retirement income generation.

If you make $100,000 annually, it says you need $70,000 in retirement income. This would be inclusive of your pensions, annuities, Social Security, and portfolio income or withdrawals from your investment balance.

Retirees and near-retirees should aim above 70% since, as mentioned above, retirement spending can often exceed pre-retirement spending, depending on travel plans, etc. I would suggest aiming closer to 80% or above to enjoy a higher level of comfort.

This ratio looks at where you are now and its sole purpose is to help you maintain that same standard of living. Some of you will purposefully desire to live a simpler life and will need less income, others will want to live the "high life" and spend more. I suggest aiming higher than you expect, so this way if you end up living a simpler life, you're still entirely safe. The last thing you want in retirement is to be out of money.

A Stock I Hold in My Retirement Portfolio

I will give you an example of a stock that helps me achieve my income replacement ratio. It is Capital Southwest Corporation (CSWC), one that I hold in my retirement portfolio, and carries a forward yield of 9% (because it just hiked its dividend). It's a solid business development company that makes its money by lending to middle-market businesses - the heart of the U.S. economy. It is one of many picks in the "Model Portfolio" that I share with members of my investment community. Our model portfolio targets an overall yield of 9%-plus, and offers an array of great income picks. CSWC invests in first-lien debt, the lowest risk position in the capital stack, and has a great track record covering its dividends and paying "special dividends" when it has excess cash.

First lien loans are currently 91% of the CSWC portfolio. They are first in line to collect if something goes wrong. These loans tend to be the safest, but carry a lower interest rate than loans further back in the collection line. I like this approach as it's best to play it on the safe side.

Mix Them All Together

In the end, no one metric is truly able to capture everything you need to have in place for retirement. Financially speaking, these three metrics can help you determine how prepared you are now for retirement. Taking stock of your Debt to Income ratio, knowing your Financial Independence Number, and determining your Retirement Replacement Ratio can all help create goalposts to ensure a stable or even better, a successful retirement.

As income investors, our goal when approaching the market is one of income-first orientation. We demand a strongly covered, well-supported, reliable yield from our portfolio. Sometimes the highest and most stable dividend payers can be mid-cap or smaller cap stocks, so they come with more volatility and you will have to accept this. But this will mean that your Retirement Replacement Ratio and Debt to Income ratio will both be easier to achieve than for others who invest in low-yield or no-yield securities and assets. Likewise, it also reduces the all-encompassing importance of the Financial Independence Number which many live and die by.

You can have a wonderful retirement, and high-income investing can make that not only possible, but easier in most cases.

Analyst’s Disclosure: I am/we are long CSWC. 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.

Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities. Any recommendation posted in this article is not indefinite. We closely monitor all of our positions. We issue Buy and Sell alerts on our recommendations, which are exclusive to our members.

Comments

[fun times!]

Solid contribution. Thank you Rida. I'll check out CSWC. First I've heard of it. fun times!

[RetireSmart]

Nice article. I have one year to go before retirement. Debt free and should be generating 100% of current income with HDO's help. I think the biggest worry I have is the political winds of tax and inflation.

[ALLDAY1]

@RetireSmart
Plan for the worse, and you will be just fine. Most scenarios are telegraphed, even the executive orders were as they were everything that President Trump had proposed or accomplished. To say that he accomplished nothing is only held by the views of individuals who see the current mess on the Southern Border and say it is Trumps fault. While I did not agree with everything that President Trump did the current mess on the border is not his fault and while the border crisis was not solved by him
he took steps to almost stop the flow until our do nothing congress could fix it . Now neither will happen and it will cost us taxpayers "BIGLY"
Patch the leak first and than fix it, hard to do when the DAM HAS BURST and starting from Scratch is the only option.

Allday

[Phil in OKC]

@RetireSmart You may find some confidence in Rida's thoughts on the impact of politics on the stock market. Perhaps he might expand his thoughts, but he has always said politics has a relative short and inconsequential negative impact on the stock market.

[Rida Morwa]

@RetireSmart Thank you for your comment and for conveying your concern.,
Actually, one of the best hedges for inflation and rising interest rates is through high dividend stocks. We have been preparing ahead of time for several months now, is through floating rate loans, floating-rate bonds, preferred stocks, and CLOs. There are many high-yield products that can protect you against rising interest rates, and increase your income in the process.

All the best, Rida

[MAYHAWK]

I am actually spending more in retirement than I did working since I no longer have the need to save. My dividends exceed my spending by a fair amount so my nest egg continues to grow, along with my income. The sacrifice of the earlier years is paying off now.

[Cuip99]

Good advice. I reduced my debt but paying off my mortgage and automobiles. I am essentially debt free. Credit card accounts are paid off monthly. The checking account has a hearty balance in it. I have a safety fund too. Plus I have cash from my brokerage accounts ready to go. We can live on my military pension and SSN plus VA compensation. I agree that one must reduce his/her debt prior to or just after retiring.

[Rida Morwa]

@Cuip99 Thats great to hear you paid all of that off so effectively. Living debt free can be a great feeling.

[Paperhawk]

@Rida Morwa Debt-free, set-free, and stress-free. Often downshifting as a sexagenerian from the big house to a newer, smaller, more energy-efficient home allows an extra "tax-free" chunk of cash to clear the boards (zero debt) and be ready for the next 30 years (or forty) years. There are grandchildren to enjoy.

[Maknora]

I own 2 bdc's..cswc and main. I'm glad someone toots the horn for cswc as there is not many articles about them. I chose cswc since I live 5 minutes from them and found them through a friend and see the local business they invest to. But one question I have is, does buying cswc at this price make sense? Or should I wait for a dip? I want more.

[Rida Morwa]

@Maknora I like CSWC and often if you plan to hold them forever, trying to game the price does not make a ton of sense. That being said, my buy under prices remain part of HDO for my members, you can check us out with a free trial here: seekingalpha.com/...

[ALLDAY1]

@Maknora
Of course I do not make recommendations, but I will ask you some questions. What if a dip does not occur? What if a dip does occur what do you decide is a dip? Those are just 2 of the question I had always asked. Keep also in mind that I do not drip. If you believe that the stock is valued as per your specification of a good value or based on a source you can trust. Currently Yahoo values it as being overvalued, I personally believe it to be fair valued but using an example that was taken from my Merrill Lynch account this is what is Stated

***************************
QUANTITATIVE STOCK REPORT|April 02, 2021| Nasdaq GS : CSWC Capital Southwest Corporation Recommendation[as of April 01, 2021]:HOLD Risk Evaluation:MODERATE Price:22.41 (Apr 01, 2021 close)Trading Currency:USD Country:United States GICS Sector:Financials Sector Ranking:market weight SPGMI's Quality Ranking:NRGICS Industry:Asset Management & Custody Banks Business Summary:Capital Southwest Corporation is a business development company specializing in credit and private equity and venture capital investments in middle market companies, mezzanine, later stage, mature, late venture, emerging growth, buyouts, re-capitalizations and growth capital investments. It does not invest in contd...[as of April 01, 2021]Quantitative Model Drivers Recommendation: HOLD Valuation,Quality Growth, Street Sentiment, Price Momentum Negative Neutral, Positive Neutral, Neutral Price Performance, Risk Evaluation :MODERATE, Asset/Market Size, Risk Moderate, Financial Leverage Risk Moderate, Price Volatility Risk Moderate, Liquidity Risk Hi .

Now as you can see, based upon valuation reports the recommendation is HOLD. Merrill Lynch doe not have an evaluation . But the report came from their research site .
Model Ranking Commentary NasdaqGS: CSWC's HOLD recommendation is based on its score from CFRA's quantitative model for the United States.Growth and Valuation model sub-categories are the largest positive and negative drivers, respectively, of the HOLD recommendation.Growth includes factors that measure EPS growth and stability and cash flow growth and stability.Valuation includes factors such as price to earnings, price to EBITDA, and price to cash flow.NasdaqGS: CSWC's overall score ranked in the 69th percentile of all stocks in the model universe.( (1 = best and 100 = worst)
*****************************
What do I do ? I buy a little say 50 shares or less, wait a month do the same, and do not worry about a dip. If the dip exceeds my expectation buy a little more than 50 shares .

What I do of course is not a recommendation but is what I do when looking for a stock that I am interested in but unsure.

Will it work for you ? Only you can be that judge

Wishing you all the best.

Allday

[Maknora]

@ALLDAY1 wow. Thank you for that detailed explanation. I will look into it!

[ALLDAY1]

Have held CSWC since Feb. 2020 and have added to it , a great stock at least for me and currently at 1451 shares with a CB average across 2 portfolios of $14.27. It would be much lower but my initial buy was 255 shares at 17.78 and I could not figure out why the stock continued to fall and as a result started to buy again when it was on the upswing, even today if I have extra cash ( meaning enough to buy 1 or 2 shares I will do so as it hardly moves my cost basis.
There are several stocks that I have that have been great stocks for me but I see little articles written about them CSWC is just one of them so maybe they are the unknown ones..I can say that even at it's current price I consider CSWC to be a bargain. Of course when I am up +76.65% + dividends, I would have no other opinion.
Wishing the best for everyone.

Allday

[PendragonY]

@ALLDAY1

Gotta love no commissions. I have several stocks that I buy a share or two when I have a bit of extra cash. That adds up over time.

[trag]

Does CSWC take some equity in the businesses to which it loans?

I'm trying to figure out how it can pay out 9% from the interest that would be paid on loans at today's interest rates, minus losses from defaults.

[Rida Morwa]

@trag It is easy. BDC generally charge a very high-interest rate on loans. Plus they are allowed to take some leverage on their capital, so if they charge a 6% interest rate, they can double that if they leverage twice. Note that BDCs are much safer than banks in general because banks can leverage many times more than BDCs.
For your 2nd question, yes CSWC does take a portion in the equity of some of their investments for more upside.

[PendragonY]

@trag

Yes, CSWC does frequently take an equity position in the companies it lends to. It also gets between 10% and 11% on the loans it makes.
seekingalpha.com/...

Plus as Rida points out, they use leverage as well.

[trag]

@Rida Morwa Thank you. I appreciate the explanation.

[gettingold]

Good sound advice. I will be 100% debt free by the time I retire in 4 years. I don't carry credit card balances. This year my mortgage will be paid off in June and my 2019 SUV in December. The other car is paid off. I do have a HELC which should be gone late 2023 or sooner, depends on the market, if down I will put more money into the market rather then extra payments. My plan is to replace 100% of my take home income, after 401K and Health Insurance, about $105,000. So as of t-minus 4 years (age 65 + 3months so that my wife and I have Medicare) with no SS until I hit 66 & 10 months I am at $87,000 replacement. This will be SS and my 401K, $ only from income, no cashing in my investments. This is truly a blessing from God and great advice from Seeking Alpha.

[Rida Morwa]

@gettingold It makes me very happy to hear of your success with your portfolio. Congrats!

[Secluded1]

Re Alex Mcpherson's partner and friend...I am glad that your joint endeavor with the 42 unit apartment is doing well but I'd be reluctant to be part of another venture with him/her. There are any number of investment options that pay significantly better than a CD.with only a bit more risk.

Academic excellence can often be trumped by boots on the ground life experience. Over the years I have met and done business with folks that were quick to let me know of their academic accomplish-
ments even if their expertise was not particularly germane. At the end of the day I have usually done quite well financially in those transections. Perhaps it is the hubris which encourages me to milk the cow dry.

[Michael123a]

@Rida Morwa: I totally agree with you on CSWC, and we really do not agree on most other picks. Still waiting for that OXLC in depth study and reco's that you promised two years ago!

[Rida Morwa]

@Michael123a I've been holding OXLC for a long time now, what exactly are you waiting for?

[PendragonY]

@Michael123a

Well, here is one.

seekingalpha.com/...

[Michael123a]

@Rida Morwa A write up and whether or not you believe it is time to add or sell OXLC.

[Alex Mcpherson]

Can someone with a Golden tongue help me. Maybe I’m delusional but since discovering Seeking Alpha, Rida & his team , I feel the best I’ve felt about investing ever.
I talk to smart good friends of mine who think I’m crazy. One graduated first in his class from law school, we own a 42 unit apartment together, it’s doing fine . Any cash he gets he puts in a CD. I’ve told him about the high yield approach to investing. Scares the H out of him. Why do I feel so comfortable? What am I missing? Got a one phrase catchy saying to get a smart person to question a firmly held erroneous conviction? I don’t!

[Rida Morwa]

@Alex Mcpherson I'm glad you're seeing such success and comfort using our Income Method!

[TheHornet]

@Alex Mcpherson
You can both be right. He might be doin the best thing possible for his personal risk profile. If that’s the case, it is the only sane course of action. The worst possible thing is for people with absolutely no stomach for risk not to recognize this fact. His returns will be poor, but much better then the returns you observe when people who do not know themselves invest like somebody they are not.

We are all different. I am a portfolio manager but I would never encourage my friends to follow what I am doing, because I know their risk profile, needs, willingness and time to conduct research is not the same as mine. Hence their portfolios should reflect their reality, not mine.

[Alex Mcpherson]

@TheHornet
Well said. My friend has always been very talented at personally owned commercial & residential real estate. We have partnered on several, for us, large properties. They all had risk. So far, they all worked out very well. When it comes to stocks, bonds, etc.
his track record is dismal.
Your insight is spot on, I’ll try to keep it in mind. Thank you!

[RBinMarietta]

I am fortunate to have a small pension that will cover monthly basic expenses (like utilities, groceries, autos) in retirement and our home is paid off. So Social Security should be adequate for most other expenses. But I have set up my portfolio to generate the "fun money" for retirement plus a sizeable emergency fund. As of now, I'm earning more than 4% in dividends - so when I stop DRIPping that, there should be plenty for travel etc. And, I don't touch the principal! (And I don't worry much about the ups and downs of the market, as long as the dividends keep coming in!)

[PendragonY]

@RBinMarietta

Sounds like you have a very good plan to manage retirement. Good job.

[John R. Clark]

Thanks to our host author for raising a crucial though often neglected topic. The sooner you start planning for retirement ahead of that day, the better.

In my view, the 4% withdrawal rule works on average for a population of retirees over the long term. But for a given person or couple, that is no more useful than knowing the average lifespan. An untimely personal or market event could deplete YOUR wealth base beyond hope of regaining the 4% standard, if you're not prepared.

Probably the rule will work as long as 1) you keep annual draws under 4% of your base to start, AND 2) on top of that base you hold several years' worth in cash equivalents at all times, for use during a market slump rather than sell off equities at distressed prices. This may not be the best way to ensure preservation of capital, but it works when you do it.

The biggest thing perhaps is to play strong home defense --- be wise and frugal with your income. Forty- plus years ago my father wrote to me about a used Grumman Yankee 2-seat aircraft that he wanted to buy. "It is about all I can afford as a sole owner." I know that he had the means for a costlier make and model, but chose better from a lifetime of frugality, including (then) 31 years with my mom and 25 as a recreational pilot of many crafts. Dad enjoyed his little plane for a long time, even once flying round trip from Seattle to Oshkosh, WI --- solo, at age 72, just a month out of chemotherapy. He and Mom retired with millionaire's estate.

From this and many contrary cases, I presume to suggest for all who long to buy their first "dream" home, luxury car, or RV in retirement --- pause, think, and test. Maybe rent a specimen once or twice to see how enduring the thrill. If you boggle at the cost of doing so, imagine yourself spending many times more to buy, use, insure, maintain, store, and eventually sell the item --- all to be paid for out of your wealth base.

This is not to disparage all luxury spending, only to say be wise about your contemplated outlay and possible better choices.

We know a couple who bought a bed and breakfast hostel in New England before checking out of their first stay, and not knowing a lick about the business. They soon regretted it but were stuck with this "investment" for years until finding a buyer. The point here is how much cheaper million- dollar advice is than a million- dollar lesson.

To a sensible retiree, frugal does not mean stingy or self- denial of all pleasure. It means optimizing your own choices by using your own plain sense (to include listening to other views and admitting mistakes). Finding out all you can do this way is fun!

Thanks for reading and enjoy your weekend!

[Rida Morwa]

@John R. Clark Thank you for sharing your thoughts! I agree following wise advice can save you a ton of money in the long run.

Experience is a great teacher, but exceptionally harsh and unforgiving. We are wisest when learning from others.

[A2 Arrogant Arse]

Year over year producer prices have increased more than 4% as reported just this morning. Also, taxes may be going up and our bull market is getting old. So... how do you think HDO selections will perform over a two year period should we see a 20 to 40 percent drop in the markets accompanied by 4 to 6 percent inflation?

[Rida Morwa]

@A2 Arrogant Arse I think the rotation into value that has been occurring is going to accelerate. Value stocks are still very undervalued and are likely to outperform the broader indexes.

For inflation, I think that is a few years out but we are starting to position our portfolio to hedge against it. We have some articles that will be coming out soon addressing that issue head-on.

[PendragonY]

@A2 Arrogant Arse

AN expected spike in the rate was larger than expected, but it is still expected to be transitory. And the bond market is reacting under that expectation.

seekingalpha.com/...

[Phil in OKC]

I would like to add one more aspect to retirement, which is this: Be very cautious and conservative with your life's savings of investing capital. Do not get greedy and exceed recommended maximum allocation percentages in any single position. Things can and do go "bump in the night" in the stock market, and keeping your losses in any single position to a low percentage of your total portfolio, will allow you to SWAN.

[Rida Morwa]

@Phil in OKC That is very good portfolio advice, I strong encourage investors to keep their allocations in check.

[PendragonY]

@Phil in OKC

Exactly. Position sizing is a very important mitigation strategy.

Risk management has two different sub-tactics. One is risk avoidance, where you look to ensure you avoid things that might go bad. The other is risk mitigation which is where you seek to limit the damage if things go bad. Position sizing and diversification are risk mitigation tactics. Both are important.

[glinsight]

The ideal DTI is of course 0/0. Using your FIN approach can work, though you might want to use a number higher (or lower!) than 4%. But you first need to get a real idea of your spending, needs and wants, both now and in the future. While I never used FIN as described, it does have the real advantage of looking at you actual spending needs rather than debt or income.

As to Retirement Replacement Ratio, your pre-retirement income is almost irrelevant; it’s your pre-retirement *spending* that you need to understand.

Consider this: In the years leading up to retirement, you might save/invest 10% of your income, or 30%, or 50%. This is highly variable, making it impossible to use a rule of thumb based solely on your income. I’ll assume you invest 20% and go on. You probably pay 6.25% into social security and 1.45% into Medicare, more if self-employed. Right there, retirement reduces your expenses by 27.5%. Ideally, you’ve also eliminated all/most debt, so that number might be higher. In addition, if your income is lower, so is your income tax. Add all this together and you might be very comfortable on half your previous income.

[Rida Morwa]

@glinsight I agree not all of these metrics are as useful as others. However, these are all widely accepted metrics that advisors will use to help gauge a clients "retirement readiness" so I wanted you to have those tools as well.

[trag]

@glinsight That can work in the opposite direction too, though.

Constantly increasing property values, mean that property taxes keep ratcheting upwards.

I live in a modest 1700 ft^2 house that I bought 24 years ago. I'd like to stay here, but I can easily imagine property taxes increasing by $10,000 per year over the next ten years.

Ten years from now I could need almost an extra $1000/month just to pay property taxes...

[Brucejfern]

Keep in mind 10 cents of each dividend is supplemental relating to a huge one time extraordinary gain on sale. CSWC chose to retain and pay out at rate of $0.10/quarter going forward. I don't recall how many quarters remain in that particular payout..... just an FYI to new investors because in a sense you are buying in and paying for this prior booked gain versus that $0.10 not being any function of NII going forward.

[Rida Morwa]

@Brucejfern Good information to share, yes. I like CSWC even without the supplemental dividends.

[PendragonY]

@Brucejfern

While they are one-time gains on the sale of businesses, the account isn't filled only by one such transaction. In 2019 they had $1.10 per share in the account, and in 2020 (despite the paying of $0.40 a share) they had $1.09 remaining.

[Brucejfern]

@PendragonY

I believe almost all of the remaining gain as of today is from the one time transaction in 2020. When I strip away the supplemental dividend I still like TSLX better on a yield to yield basis taking out supplemental dividends by both.

TSLX flushed out a huge supplemental dividend all at once last year $.0.50/share and this year $1.25/share, last night, and has an estimated $0.61 for future supplemental dividends over and above the current supplemental dividends paid quarterly.

CSWC should use this opportunity to raise equity as TSLX and ARCC did recently because CSWC is so much smaller than TSLX and CSWC's premium to NAV is getting too high for me.