Five Great Choices

The Traditional Approach

Traditional safe withdrawal rate studies focused on liquidation strategies. They sold shares as needed to maintain a steady income stream (in terms of buying power). Most studies used a portfolio lifetime of 30 years.

Today, we have five alternatives. They all leave the traditional approaches in the dust.

TIPS

A TIPS-only portfolio makes a great baseline. It is surprisingly competitive. In recent times, TIPS have been available with (real) interest rates of 2.0%.

A TIPS-only approach assumes only that TIPS will continue to be available. If you build a TIPS ladder, you avoid possible losses from selling before maturity.

With 2% TIPS, you can withdraw 4.0% safely for 35 years before running out of money. You can withdraw 4.46% for 30 years before running out of money.

Valuation Informed Indexing (VII or Lucky 7)

Valuation Informed Indexing (VII or Lucky 7) is a liquidation strategy that varies stock allocations in accordance with stock valuations. It increases income dramatically. Satisfactory measures of valuation include P/E10, P/D10 and Tobin’s q.

The Retirement Risk Evaluators include optimized mechanically defined Valuation Informed Indexing programs. You can learn to do better. Train yourself on the Scenario Surfer.

Valuation Informed Indexing works with slices of the S&P500 index (Large and Small Capitalization, Value and Growth) as well as the index as a whole. You can use the P/E10 of the S&P500 with these segments.

At today’s valuations, Valuation Informed Indexing allows you to withdraw up to 5.5% of our original balance (plus inflation) safely if you use corporate bonds and preferred stock instead of TIPS. With TIPS, you can withdraw 5.0% (plus inflation) safely.

Dividend Overview

With a dividend based strategy, you never sell any shares for income. You do sell shares, at times, to maintain or improve dividend quality. You live off stock dividends and any interest that you are receiving from other investments.

The income stream from dividend approaches can be erratic. The worst case outcome (hyperinflation) could cause a worst case temporary drop in buying power of 25% judging from the S&P500. If smoothed over a few years, the worst case drop is 20%.

Because of this, the actual performance of Valuation Informed Indexing and dividend strategies are closer than indicated.

Before investing, I recommend that you read the Morningstar Dividend Investor newsletter and Ben Stein and Phil DeMuth’s book “Yes, You Can Be a Successful Income Investor!”

Dividend Blend

A dividend growth strategy starts at a lower initial withdrawal rate, but it grows much faster than inflation. A high yield approach starts with a much higher yield, but which grows slowly, if at all, possibly falling behind inflation. A blended dividend strategy combines these two and adds a cash management account. For analysis purposes, I assume a cash equivalent such as TIPS, but in reality, you should buy more of your investments as you go along.

It is easy to identify the initial dividend yield of a stock or an Exchange Traded Fund (ETF). It can be difficult to estimate the dividend growth rate accurately.

I use Josh Peters’ investment goals in the Morningstar Dividend Investor to identify what is reasonable to expect. Using the low end of his (nominal) dividend growth rate requirements, such a blend produces a continuing withdrawal rate of 5.5%.

I also use Josh Peters’ optimistic goals and the performance of DVY to date. These lead to continuing withdrawal rate estimates of 6.5% of the original balance (plus inflation).

Finding a suitable high yield asset can be difficult. Typically, it requires a preferred stock, Master Limited Partnership, a REIT or another investment with unusual characteristics that includes the return of capital. But do not despair. I have found that even a fixed mortgage (6% interest, 20 or 30 years) can meet the need.

Dividends and Income

If you use care, you can build high yield portfolios that support a withdrawal rate in excess of 6% of the original balance (plus inflation). You must use due diligence. You must be careful. Often, a high yield signals corporate stress. But just because the yield is high does not mean that an investment carries more risk. Conceptually, if a corporation can support a long term return of 10% (nominal), it carries less risk to a retiree if the return is strictly from dividends alone than an alternative that requires capital appreciation as well as dividend income to deliver the same return.

Such a portfolio can include junk bond funds. Keep in mind that the net asset value of such funds typically decline over the years. You must reinvest simply to maintain the nominal value.

As a rule, an income strategy requires that you reinvest about 30% of your yield to keep up the buying power of your portfolio. With a yield of 9% or more, you can withdraw 6%+ of your original balance and still keep up with inflation.

Typically, the per share value of your holdings fall behind inflation, but because of reinvestment, the buying power of your total holdings will grow.

Delayed Purchase

A delayed purchase strategy starts with one approach, often TIPS-only, and switches to an alternative, often a dividend strategy, when valuations become favorable. You can do even better if your original holdings consist of preferred shares and corporate bonds.

The combination of a delayed purchase and a simple dividend strategy lifts the continuing withdrawal rate above 5% (plus inflation). The combination of a delayed purchase with a Dividend Blend lifts the continuing withdrawal rate above 6% (plus inflation).

Cautions

I recommend limiting withdrawals to 5.0% (plus inflation) during the first five years to protect against being blindsided. Valuations are likely to be much better by that time, allowing you to do even better.

The portfolio requirements are very specific. Withdrawal rates do not automatically apply to every portfolio following a general strategy.

Have fun.

John Walter Russell
July 6, 2008