The debate over the "best" income strategy for retired investors will probably rage on forever.
This article will discuss some of the characteristics and potential benefits of two of the more popular income strategies available to the retiree: the "4% withdrawal rule" and dividend growth investing, or DGI.
Which might work "better" for a hypothetical 65-year old couple ?
"4% Withdrawal Rule"
Financial advisor Bill Bengen is generally credited with devising the popular "4% withdrawal rule" in the 1990s and it is still widely used today for retirement planning.
The basic premise is that during the first year of retirement the investor will withdraw 4% of a balanced stock/bond portfolio for expenses and increase that amount by the rate of inflation in subsequent years.
So if a 65-year-old retired couple had a $1M nest egg they would withdraw $40,000 in year 1, $41,200 in the second year, $42,436 in the third year, etc., assuming that inflation is 3% annually.
Based upon historical market performance and a 60%/40% mix of stocks and bonds Mr. Bengen projected that the retiree wouldn't run out of money during a 30-year retirement period which began in the mid-1990s and would have withdrawn a cumulative total of $1.87M by the mid-2020s. Hopefully the original $1M would have grown sufficiently, and at the right times, to meet this goal.
Variants of the "4% rule" exist and include different initial withdrawal rates, retirement time horizons, spending increases, and stock/bond allocations. As I like to say sometimes the possibilities are endless (which could be a problem).
Dividend Growth Investing
Dividend growth investing also has many forms and variations. The retiree would typically own a portfolio of stocks that pay dividends, and usually increase the payments annually. The resultant income stream will be higher every year. The investor would spend only the dividends generated and not have to sell shares of the underlying equities.
So if the prudent investor had a dividend growth portfolio of 30 stocks worth a total of $1M, that yields 4%, they can spend the $40,000 generated for current year expenses. In the second year, based upon a weighted average 3% growth rate the dividend income increases to $41,200. In year 3 the income rises to $42,436. At the end of their projected 30-year retirement period the investor would have collected about $1.9M without having to sell any shares and could leave a legacy. It wouldn't have mattered whether or not the $1M grew or not (although probably it would have based upon historical results).
So what is the "best" strategy to employ?
Running a few simulations provides an eye-opening experience. A modified withdrawal strategy (similar to the "4% rule") will be compared to two different DGI strategies.
Let's start off w/ a few basic assumptions.
My friends John and Jan, both age 65, have saved $1M in a balanced portfolio and need $30,000 in the first year of retirement to compliment Social Security and other income sources. They expect that expenses will increase each and every year.
The allowable withdrawal rate (2.97%) is in the 3rd row, 2nd column of the chart (below) created by Dr. Wade Pfau, a noted retirement income expert, based upon inflation-adjusted spending (CPI-U) and a portfolio consisting of a 50/50 mix of stocks and bonds ("Moderate").
The long-term trend based upon the linear regression analysis (solid blue line) indicates that inflation is declining, remains subdued, and has averaged about 2.6% per year over the past three decades. That seems to be a good number to use for the John/Jan withdrawal strategy.
However, before they pulled the plug, John and Jan wanted to have an outside review of their plan and came to me, a long time proponent of DGI.
I suggested that they consider generating income using a DG portfolio of 30 blue chip stocks created using my Optimal Dividend Growth method which I wrote about here.
I even suggested that they wouldn't need to use all of their bonds towards income generation. The equity portion ($500,000) and only some of their bonds would be needed to generate the necessary income.
The ODG stock portfolio would initially sport a modest yield of 3.5% and based upon my past experiences would increase income at a compounded average rate of 5.8% (this is based upon SP500 data from 1960 to 2018).
A side by side comparison of the modified withdrawal (2.97%) strategy is compared to the DG strategy below. Over the course of a 30-year retirement the DG strategy will provide more cumulative income than the modified withdrawal strategy ($1.41M vs. $1.34M).
A caveat is that additional income sources would be needed during the first 17 year period to make up the annual difference between the two strategies. About 1/4 of the bonds ($133,100) can be converted to cash and withdrawn as needed during years 1-17. The remainder of the bonds ($367,000) can be used for other purposes. The total income generated by the combined DG stock/cash portfolio (worth $633,000) would be $1.54M over the three decades.
Alternatively some of the bonds ($357,000) could be converted to DG stocks, creating a total stock portfolio worth $857,000, to generate income. A caveat is that there would be more overall risk (i.e. more stocks) in the portfolio. The total income generated by this modified DG strategy would be $2.41M.
So what is the "best"?
It might be in the eye of the (biased) beholder. However, the DG strategy using a $500,000 stock and $133,000 cash portfolio would be my clear winner. It uses a smaller total value, with less risk (i.e. contains more cash), to generate the necessary income. A side benefit is that John and Jan would have additional funds ($367,000) that can be used for other purposes. Although the modified DG strategy would generate more income ($2.41M vs. $1.54M) it does so at the expense of added risk in the portfolio. It's always available if John and Jan decide they want that added income.
The modified withdrawal strategy, while still likely to be positive at the end of the retirement horizon based upon the work of Mr. Bengen and Dr. Wade Pfau, would be an unknown entity and there might not be a lasting legacy. The DG portfolio (stocks + bonds + cash) would likely be fairly intact at the end and could be used for a legacy.