Something Simple

Here is a simple way to reach a continuing withdrawal rate of 6% (plus inflation).

The Dividend Blend

Split your money between a diversified dividend oriented Exchange Traded Fund (ETF) such as DVY and a preferred stock ETF such as PFF. Add a REIT or REIT fund, if you like.

Make a spreadsheet or work everything out by hand. Take excess income in the early years to fill in the income gap during the middle years. Depend on DVY to grow enough to supply most of the income in the later years.

DVY currently yields more than 5%. It should grow faster than the S&P500. Assuming that it only matches the dividend growth of the S&P500, it will grow at 5.5% per year (nominal). PFF yields more than 8%. It has no dividend growth.

Looking at the Simp Auto Allocator (Simplified Automatic Allocator, available as a free download from my Yahoo Briefcase, username jwr19452000) and assuming 3% inflation, you can withdraw 6.2% of your original balance (plus inflation) even if your cash management account only matches the inflation rate. I assumed a 50%-50% mix of DVY and PFF.

Overstated Diversity

Both DVY and PFF are diverse in terms of the number of companies held. In terms of industries, however, they are concentrated heavily in financials.

DVY is about 40% in financials. PFF is even more concentrated.

Price Risk

Although this dividend blend should supply an excellent income stream, the price of both DVY and PFF is likely to fall along with the rest of the market. Their prices are already under pressure because of their heavy weighting into financials. For that reason, I recommend a delayed purchase, a form of Valuation Informed Indexing.

Based on Scenario Surfer results, I recommend a minimum stock allocation of 20% at all times. However, you can substantially improve performance if you wait for the stock market P/E10 valuation to fall to a historically typical level of 14, almost one half of today’s prices. We should see this fall within the next 5 to 10 years. Based on the studies that I have seen, as well as my own research, I expect P/E10=14 to occur closer to Year 5 and the stock market bottom, at even more attractive prices, around Year 10. There is a lot of uncertainty around the exact numbers.

In any event, I recommend that you keep some of your powder dry, possibly investing in short term TIPS or CDs. Remember that future dividend yields will be twice as much as today’s.

Inflation Risk

Allow for a possible reduction in buying power if inflation rises far above 3%. Judging from the S&P500 experience since 1950, the worst case drop in buying power would be 25% (to 75% of the real value of your income stream). This could cause your inflation adjusted income to drop temporarily to 4.5% (plus inflation) of your original balance. The buying power of your income stream would later recover. It would eventually surpass inflation.

This is much, much better than a typical liquidation approach where you sell stocks for income. That approach claims a Safe Withdrawal Rate of 4% (plus inflation) up to Year 30, after which you may end up with nothing.

Caution

We may see even more bad news among financial companies. This may drag down the income stream of DVY and PFF. This is another reason to delay purchase for the next few years. Be very careful.

Have fun.

John Walter Russell
August 19, 2008