Back of the Envelope 6%

Here is a simple way for traditional retirees to withdraw 6% (plus inflation) while leaving an inheritance. You can adjust it for any level of risk.

Three Components

I make use of three components:

1) A single premium immediate annuity (SPIA),
2) Corporate bonds and/or preferred stocks and
3) High quality dividend stocks.

A traditional retiree can easily buy a single premium immediate annuity with inflation matching at 6% of the original balance. Put half your money into one of them.

Corporate bonds and/or preferred stocks should be able to do at least as well as 3% TIPS. If so, you should be able to generate an inflation matching income stream of 6% of the original balance for 10 years while liquidating only one third of the inflation adjusted balance. [Refer to the TIPS Table (button on the left) and 3% TIPS and the remaining balance after withdrawing 6% for 10 years.] Put your remaining half into such an investment.

After 10 years, take the principal from the corporate bond/preferred stock portfolio and place it into high quality dividend paying stocks. You should be able to get 9% dividends at that time from high quality companies. Your income will be two thirds of this, which is 6% of your original investment in bonds.

You have two income streams at all times. Each pays 6% (plus inflation) of what you invest in it.

If you want to stress safety, you can put more into the annuity. If you want to leave a bigger inheritance, you can put more into the other investments.

Early retirees can duplicate the bond and stock investments. They cannot match the annuity income of a traditional retiree. They can get the same income, but they must accept a higher level of risk.

Why It Works

I recently had the insight that corporate bonds and preferred stocks should be able to beat treasuries by at least one percent. They are the equivalent of 3% TIPS. This makes them a highly attractive alternative to 2% TIPS.

A 3% TIPS ladder allows you to withdraw 6% (plus inflation) for 10 years while leaving two thirds of the principal untouched.

Dividend amounts from high quality companies typically advance faster than inflation. Today’s overall stock prices are about double what is typical. (Today’s P/E10 is close to 24. A typical price level is P/E10=13 or 14.) It is almost certain that valuations will fall in half within ten years. Prices will probably fall further, but the odds of P/E10’s falling below 10 are close to 50%-50%.

Today’s dividend yield from exchange traded fund DVY is close to 4.5%. Finding 9% dividend payers among high quality companies should be straightforward. DVY might do the job itself.

Have fun.

John Walter Russell
May 23, 2008
Link added: May 26, 2008

Matching 3% TIPS