An Easy 5%

Here is how to put together a portfolio with a 5% Safe Withdrawal Rate. It lasts indefinitely. It keeps up with inflation.

Choosing an Approach

I chose a dividend blend. It locks in the income stream immediately. It does not require as much care as a straight income approach.

A dividend blend consists of two portfolios. The first has a high initial yield, but limited growth. The other has a lower initial yield, but rapid growth. Excess funds from the high yield portfolio in the early years are used fill in any deficiency during the middle years. Eventually, the higher growth portfolio takes over.

I include TIPS in the cash management account.

You never sell any of your investments for income. Occasionally, you sell shares to maintain or improve the quality of your portfolio holdings. At times, you replace shares that have appreciated enough to get ahead of themselves with quality higher yielding shares.

The downside is that the portfolio balance is likely to decline along with that of the overall market.

Requirements

I used the “Simp Auto Allocator” (Simplified Automatic Allocator) from my Yahoo Briefcase to establish requirements. [My Yahoo username is jwr19452000.]

Yahoo Briefcase

I assumed that my portfolio with the lower initial dividend yield would grow at least as fast as the S&P500. That is, I assumed that it would grow its nominal dividend amount by at least 5.5% per year.

I assumed that the portfolio with the higher initial yield had zero dividend growth. It would consist of traditional corporate bonds or preferred stock.

I set the inflation rate at 3% per year. I set the TIPS interest rate at 2%. I set the allocation of the two portfolios at 50%-50%.

I set the initial investment balance equal to $100000. I set the withdrawal amount equal to $5000, which is 5% of the initial balance. I set the initial TIPS balance equal to zero.

This left two numbers undefined: the initial dividend yields of the two portfolios.

I chose the initial yield of the growing portfolio equal to 4% after making sure that it makes sense. I determined that the yield of the portfolio with a high initial yield should be 6.5%.

I found that this works with a TIPS yield of 0% as well as with 2% in the cash management account.

Finding Investments

I chose the stock screener at Yahoo Finance to find stocks with a current yield above 4%. I required that their current P/E be under 20. I required that the market capitalization be above $25 billion. I got 38 matches. This included GE, drug companies, telephones and oil companies as well as the financials that have been beaten down sharply. By allowing a capitalization down to $5 billion, I was able to increase the number of choices to 89. By allowing a capitalization down to $1 billion, I was able to increase the selection to 208 choices.

I went to Quantum Online dot com to look at preferred stocks. I brought up the screening form. I required a 6.5% coupon. I set a minimum call date of 1/1/2012. I required a Moody’s credit rating of Aa2 or better. I got three choices. I set the credit rating on level lower to Aa3. I got 16 choices. All but one were banks. I set the credit rating down to A1. I got 36 choices.

To get the high interest rate and a high credit rating at the same time almost always comes from a bank. You need to accept a lower credit rating to include utilities.

Quantum Online

Alternatives

One alternative is to increase the initial yield of the preferred stock portfolio. I set a requirement of 7.5% coupon with a rating of A1 and got 20 choices. I found that I could reduce the high yield allocation to 30%. This puts 70% of the initial balance into the more diversified portfolio with its yield of 4% and dividend growth rate of 5.5% nominal.

Another alternative is to use iShares Exchange Traded Fund PFF for the high income vehicle. It provides better diversification among companies. It is new. It provides a very high yield.

Another alternative would be a straight income approach. This require greater care, but it is still easy to reach a 5% (plus inflation) continuing withdrawal rate.

I went back to Yahoo Finance. With a Yield of 5%, a P/E below 20 and a market capitalization above $5 billion, there were 61 matches.

Final Remarks

There are lots of ways to reach a 5% (plus inflation) Safe Withdrawal Rate that lasts indefinitely.

I use TIPS in the cash management account strictly for purposes of analysis. You will do better if you reinvest surplus cash into your basic portfolios. If a holding has zero growth, reinvest about 30% of the interest to keep up with inflation.

I like the idea of holding back some funds for Valuation Informed Indexing or a Delayed Purchase approach. Doing so would protect your capital against a sharp downturn in prices, something that I expect to happen within the next 5 to 10 years. The trick is to provide an adequate amount of current income in the meantime.

Have fun.

John Walter Russell
August 16, 2008