By Eli Inkrot
When I consider the topic of retirement the first thing that comes to mind is John Maynard Keynes 1930 essay titled “Economic Possibilities For Our Grandchildren.”
Back in 1930 people were not thinking about long walks on the beach in your 80’s or a few decades of leisurely golf and jazzercise.
Retirement is a new concept – at least if you grant that the last half century or so still counts as “new.”
Here, I’ll show you what I mean:
Source: Work In Retirement, Merrill Lynch
I can’t vouch for the early 1900’s, but the more recent period details the current situation well in my view.
People are living longer than ever before. The average life expectancy is now up to 80 and beyond. The assumed “normal” retirement age is around 65, the actual number is closer to 62.
You ought to be thinking about 20 years of retirement – or even more if you achieve early retirement.
What strikes me about the John Maynard Keynes essay is that he foresaw this coming. Keynes knew that small economic improvements would lead to substantial results over the long-term.
He indicated that a larger issue in the future would not be solving the “economic problem” but instead trying to figure out what to do with an abundance of time. So here we are today.
Keynes also indicated that the average work week, one hundred years hence, could only be 15 hours. And even then, this would only be to give workers small tasks and routines to stay active.
As a result of this statement, the late Keynes now takes a good deal of indefensible flak. Today’s blog writer will dig up a stat that suggests the average work week is 35 or 40 hours and point out how far off Keynes judgment has been, scoffing at the notion.
Yet here’s where things get really interesting in my view. Keynes did not call the essay “Economic Guarantees For Our Grandchild.” Instead, he simply indicated that they were “possibilities.”
This concept is perhaps more important than you first realize.
Keynes pointed out that humans had “needs” which fell into two classes.
The first is what he called “absolute” which I would describe as “basic” or “fundamental.” Think shelter and food, the things that you must have to continue living. These needs can surely be satisfied.
The second class of “need” that Keynes described is the desire to be better than others. To feel more accomplished, have more possessions or otherwise feel superior. Contrary to basic needs, this desire may never be satisfied. As the general population gains more, so too will this “need.”
In today’s parlance, I’d call it the “keeping up with the Joneses” desire. Only more than keeping it up, it’s an aspiration to keep up and then zoom past them in your new Ferrari.
It reminds me of a classic Benjamin Franklin quote:
“It is the eye of other people that ruin us. If I were blind, I would want neither fine clothes, fine houses or fine furniture.”
Which, incidentally, brings us to the most important part of figuring out retirement…
I’m actually more of a fan of the phrase “financial independence” – having the ability to spend your time as you choose.
I think the term “retirement” conjures up the image of a golden watch or some golf commercial you happen to see on a Sunday afternoon.
Some never actually “retire” and instead simply focus on doing what they enjoy – whether that happens to produce money or not. I think that aspect should be celebrated and not diminished.
The most important part of figuring out retirement or financial independence or even a gap year (or ten), is going to be your expenses. That’s the baseline, that’s where you start.
The unfortunate part is that I cannot easily detail what your expenses happen to be (or what they should be).
It’s unfortunate in that it makes this article a bit one-sided (not in that I want to control your expenditures). It’s a personalized decision. Highly personalized in fact.
To this point I’d simply like to indicate one thing. Spending ought to reflect your personal desires and passions.
If you’re spending money just to impress your neighbor, that’s often a quick path toward being both unhappy and broke.
If you enjoy expensive cars, and learning about them and using them and working on them, then that’s a fine passion and you can plan for that accordingly. But if you’re only buying a new car because your neighbor just got the newest series, you’re flirting with an insatiable desire to “keep up.”
Given a limited amount of dollars, you don’t want to be throwing away a good chuck on them on stuff you don’t care about. That forcibly detracts from the stuff you do care about. And this applies to all expenditures. Thinking about whether or not something is actually important to you can better define your expenses and goals.
Whether you spend $20,000 a year or $80,000 will have a large influence on your ultimate success. I’m not suggesting that you spend as little as possible. Instead, I’m simply indicating that you ought to think about spending in a way that works toward your ambitions and cut out the stuff that doesn’t really move the needle.
Thinking About The Portfolio
With that, I’d like to think about the other side of retirement: income; in this case specifically with dividend paying securities.
A lot of people like to quote the Trinity Study indicating something along these lines:
“A safe withdraw rate for a retirement portfolio is 4%.”
That’s a highly simplified conclusion from the study, but I’ll give you an example of what that would mean.
Let’s imagine that your annual expenses are $25,000 per year.
Based on a 4% withdraw rate, that equates to needing a portfolio balance of $625,000 to begin (you can think about it as 25 times your expenses as well).
The concept of the 4% withdraw rate is that you should be able to withdraw this amount each year and live off of that portfolio indefinitely. It works because the portfolio is comprised of profitable businesses generating earnings year-after-year. So the profits (and dividends) are likely to be growing even as you’re subtracting from the balance.
Incidentally, I have previously done some work on this concept and came to the conclusion that this idea is a fine baseline, but there are a lot of different withdraw rates that could work out there. That is, I’d consider this as more of a guideline instead of a steadfast rule.
You can also think about the time to retirement in terms of your savings rate. It works on a similar concept as the withdraw rate mentioned above, but puts it in different terms. Here’s a link from Mr. Money Mustache on “The Shockingly Simple Math Behind Early Retirement” that could be helpful.
While both are reasonable guidelines, I personally prefer the idea of the “crossover point” as presented in the book “Your Money Or Your Life.”
Source: Your Money Or Your Life, Vicki Robin, Joe Dominguez
When the book was published they were talking about interest income, but naturally dividend income works just as well (perhaps better).
Here’s the basic concept: once your passive income eclipses your expenses you’ve reached the “crossover point;” the moment when you don’t have to work anymore and your expenses will still be covered.
Incidentally, this is why the expense part is so important. If you make say $3,000 a month and spend $3,500 you’ll never reach this point. If you make $3,000 and spend $2,500, you’d be able to invest $500 a month and slowly but surely your passive income will grow.
Here’s where things get really exciting. If you make $3,000 a month and spend say $1,500, that has a double effect.
Not only are you now able to invest more money, but this simultaneously reduces the amount of passive income that you need to achieve. The higher your savings rate the more you can contribute and the lower your ultimate portfolio balance or cash flow stream has to be.
Getting To The Crossover Point
Let’s think about getting to the crossover point. You can adjust the numbers according to your own situation, the idea is to get a feel for the process.
We’ll say you start out at $0 and have the ability to contribute $10,000 per year. You have a variety of investing options, but for this demonstration perhaps you elect to go with a strategy of selecting high quality dividend paying companies. Think about the Coca-Cola’s (KO), Johnson & Johnson’s (JNJ) and Procter & Gamble’s (PG) of the world.
The Dividend Aristocrats Index and Dividend Kings List are great places to identify high quality dividend growth stocks in general. For a specific list of dividend stocks suited for retirees, take a look at these 10 dividend stocks for retirement.
We’ll suggest that the average dividend yield is 3% and you expect this to grow by 6% annually.
In the first year your starting $10,000 investment would generate $300 in dividend income.
That’s nice, but not exactly the type of cash flow that screams “early retirement.”
In the second year you’d expect that $300 to turn into $318, as the companies collectively increase their per share payouts. In addition, if you elected to reinvest that $300 in dividends you could be receiving an additional $9 in income.
So based on your original $10,000 investment $300 in dividends in year one would become $327 by year two. Which is also why your total income can grow much faster than a company’s per share payout.
If you added another $10,000 your income would increase by $300, leading to a total amount of dividends received of $627 by the end of year two. We haven’t yet reached retirement, but be patient – it’s a compounding process.
I’ll save you the ongoing math and provide a summary:
The math above shows the amazing power of compounding accrued by long-term investing.
Once again expenses become especially important. Under the above circumstances it would take you 20 years to reach retirement or financial independence if your expenses were $15,000 per year, as compared to double that amount of time – 40 years – if you wanted to spend $100,000 a year. The numbers are not inflation adjusted, but the point is to illustrate the concept.
Moreover, it’s important to think about the expenses and income in a “net” sense. If you have a social security or pension payment coming in or other income source, you may only be looking to supplement this rather than covering all of your expenses completely.
That’s how I’d start to think about the process if you’re considering retirement or financial independence in the future.
You want to be cognizant of both the expense side and income side, realizing that there’s an inherent connection between the two. Now we can get to the “fun” part (although I personally like both sides).
Once You’re In Retirement
Thinking about this side is “fun” in that the outcomes may be broader than you first imagine. Let’s continue with the example of holding a collection of dividend paying securities.
If your annual expenses (or annual supplemental expenses) are say $25,000 and you have a portfolio generating $25,000 per year you’re in pretty good shape.
I’ll show you why this is the case…
When you hold a collection of dividend growth companies, you’d anticipate the yearly income to grow through the years. Your expenses may grow as well, but likely not at the same rate as the overall dividend income.
During the last decade Kimberly-Clark (KMB) grew its payout by 7% per year, McDonald’s (MCD) by 18%, PepsiCo (PEP) by 11%, Johnson & Johnson by 9%, Colgate-Palmolive (CL) by 10% and the list goes on and go.
Granted this doesn’t mean that future payouts will grow as robustly, but it follows that profitable companies that have a history of paying out a portion of their earnings tend to get more profitable and pay out more dividends over time.
In keeping with above example, if your expenses grew by 2% and your income grew by 6% each year, this would mean that suddenly you’d go from “breaking even” in terms of income less expenses to having a $1,000 surplus in the second year.
In the third year the surplus would increase to over $2,000 and then over $3,000 and so on. After 10 years of this, your portfolio could be generating $14,000 more per year than you’re spending.
This has a variety of important ramifications. While it’s likely that your dividend income could grow faster than you expenses, it’s also possible that you could see lower dividend payouts from time to time as well. There are two basic ways to combat this: thinking about diversification and starting with or creating a buffer.
With regard to diversification we’ve all heard the phrase “don’t put all of your eggs in one basket.” The same basic notion applies here. No matter how great of a company you think Coca-Cola happens to be, or how spectacular Emerson Electric’s (EMR) dividend history has been, an adverse event is always possible.
If BP or Wells Fargo made up 20% of your income a few years ago, your passive income would have taken an extraordinary hit. If these securities only make up 3% of your income, there’s still a hit but it’s much less pronounced.
The second thing to think about is creating a buffer. This can be done in one of two basic ways. You could start out with an “extra” cash allocation. So instead of relying solely on $25,000 worth of annual income you could also have a couple years’ worth of expenses in a liquid account as well. This tactic takes a bit longer to build up, but it certainly could provide a sense of security should something not go as planned.
Another way to approach it is through time. In keeping with the example, if in the second year you receive $1,000 more in dividend income than you need you can take a few approaches: spend the extra funds, keep them aside or reinvest. The second two actions act as buffers. Just like you created a gap between earning and spending during your working years, you could think about creating a gap between passive income and expenses during retirement.
The interesting part about all of this is that once you get to your desired income level it becomes more and more difficult to not get richer through time.
Let’s think about why this happens.
When Coca-Cola pays a dividend it’s doing so out of its profits. So the company sells its beverage concentrate, pays all of the expenses related to making that product, all the salaries, marketing, building utilities, all of it. After Coca-Cola does all of that, there’s still money left over.
About half of this goes to the shareholder in the form of a cash dividend. The other half is used to buy out partners (share repurchases) and redeploy into the business to grow even more. So even with half of the profits being paid out, the other half is still working for you productively in the company. In turn Coca-Cola tends to get more profitable over the years and investors are willing to pay more for the shares.
So if you simply collect the dividend payment, it becomes more and more likely that your dividend and share price will be higher through time as well. In order for the value of your holdings to stay the same or decrease you would need to start selling some shares.
Additional Possibilities: Selling Shares
This is good news in that it naturally creates a buffer for your retirement income. If you’re only taking the dividend payments, this means your wealth is likely to continue increasing through the years as well.
However, it’s also good news in that it highlights a variety of additional possibilities that are out there for reaching your retirement goals.
For instance, if you’re near retirement and do not have your desired passive income goal this does not mean that all hope is lost. Remember, if you only take the dividend component there’s a good chance that you will become richer over time. As such, that means that you could both collect dividends and decide to sell a portion of your shares to supplement your goals.
A lot of people have the ambition to never sell shares, which is a good goal. However, that doesn’t mean that this is the only way. As an illustration you could have collected all of the dividend payments from Johnson & Johnson over the last decade and sold off 2% of your shares per share, and still ended up richer than when you began.
It’s not talked about as often, but selling a percent or two of your portfolio each year doesn’t have to be an exhaustive path to zero. If you’re currently collecting a 3% dividend yield, but need 4% or 5% instead, having this sort of information in mind can be useful.
Of course you don’t need to take my word for it. Here’s a particularly interesting excerpt from Warren Buffett’s 2012 Berkshire Hathaway (BRK.A) (BRK.B) annual letter, indicating effectively the same idea:
“Let me end this math exercise – and I can hear you cheering as I put away the dentist drill – by using my own case to illustrate how a shareholder’s regular disposals of shares can be accompanied by an increased investment in his or her business. For the last seven years, I have annually given away about 4 1⁄4% of my Berkshire shares. Through this process, my original position of 712,497,000 B-equivalent shares (split-adjusted) has decreased to 528,525,623 shares. Clearly my ownership percentage of the company has significantly decreased.
Yet my investment in the business has actually increased: The book value of my current interest in Berkshire considerably exceeds the book value attributable to my holdings of seven years ago. (The actual figures are $28.2 billion for 2005 and $40.2 billion for 2012.) In other words, I now have far more money working for me at Berkshire even though my ownership of the company has materially decreased. It’s also true that my share of both Berkshire’s intrinsic business value and the company’s normal earning power is far greater than it was in 2005. Over time, I expect this accretion of value to continue – albeit in a decidedly irregular fashion – even as I now annually give away more than 4 1⁄2% of my shares (the increase having occurred because I’ve recently doubled my lifetime pledges to certain foundations).”
Selling shares in addition to collecting dividends is a very real alternative that is available to you. It may not be your first choice, but it should nonetheless be remembered as a possibility.
Additional Possibilities: Options & Preferred Shares
Beyond using dividends alone, or collecting dividends and selling some shares, there are other ways you can structure your retirement portfolio.
For instance, if you’re looking for an extra percent or two in annual income you could think about owning quality dividend paying stocks and simultaneously selling covered calls on your positions. While you may give up some of your upside, you can slightly or materially increase your cash flow in this manner.
If you’re looking to add a percent or two of income, you can routinely do this by agreeing to sell your shares at a 10% to 20%+ higher price. If you’re looking to double your dividend cash flow, you could agree to sell at a 0% to 10%+ higher price and accomplish this. Options are aptly named – they can provide flexibility.
Alternatively, you could think about selling cash-secured puts with funds that have not yet been allocated. In this case you can generate 1% to 10%+ annual cash flows depending on the price at which you’d be happy to own a given security.
Or beyond your typical dividend growth company and utilizing options, you could think about using preferred shares to meet your goals. The total return is apt to be lower, but your starting yield can also be materially higher. If you’re looking for a consistent 5% to 6% yield, without a concern about the capital appreciation component, this could be a good area to review.
The ability to retire with dividend paying stocks is probably broader than you first imagined.
When you’re thinking about retirement (be it with dividend paying stocks or otherwise) the most important aspect is going to be your expenses. In thinking about these regular expenditures it’s important to be cognizant of your goals and spend your limited funds only on items that truly matter to you. I can’t tell you what your expenses should be, but that’s the most essential step in the process.
From there you can start to think about how to get to your goal. Once you have your expense number in place, you can “back out” a portfolio number to get a feel for what you might need. A very quick way to do this is to multiply your annual expenses by 25, but remember that this is simply a baseline and not an absolute.
One of the best ways to think about retiring with a dividend-paying portfolio is to think about getting to the “crossover point” – the moment when your dividend income exceeds your expenses. Once this point is hit, it becomes more and more difficult to not get richer over time.
Yet even if you don’t reach this mark, it should be underscored that not all is lost. You have alternatives that can help supplement your income ranging from selling shares and utilizing call options to using put options and considering preferred shares.
All of these alternatives could reduce your total return expectation, but they could also help significantly in reaching your retirement goals. Although the process is highly individualized, the ideas of thinking about how much you will need and the different ways that you can get there are universal.