- 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 »
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.
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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.Rida Morwa leads the investing group High Dividend Opportunities where he teams up with some of Seeking Alpha's top income investing analysts. The service focuses on sustainable income through a variety of high yield investments with a targeted safe +9% yield. Features include: model portfolio with buy/sell alerts, preferred and baby bond portfolios for more conservative investors, vibrant and active chat with access to the service’s leaders, dividend and portfolio trackers, and regular market updates. The service philosophy focuses on community, education, and the belief that nobody should invest alone. Lean More.
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.
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