My last post got me thinking.
With so many possible scenarios out there, there is no one size fits all.
Everyone’s personal situation is different. And everyone has different character traits, which may be more suited to certain types of investing.
Because peoples circumstances change, their investment choice may change over time too.
I want to talk about a few possible retirement income strategies, and let you have a think about each of them.
The 4% rule
If you’ve been around the early retirement scene a while, you’ll have heard this before.
I can’t say I know a lot about this approach. Since it involves selling-off shares to create income, I quickly realised it wasn’t for me.
Some wiser heads will probably realise my ignorance after reading this overview!
It’s a retirement strategy most commonly followed by investors taking the global index-fund approach. The theory goes, since long term average stockmarket returns are around 5-6% or more after inflation, the investor can safely withdraw 4% of his portfolio to live off in retirement.
While it sounds pretty simple, and it’s always great to have a rule of thumb to go by, I do have some concerns. Not with the approach itself. But with some investors who might not be thinking it through.
I think more than a few people using this retirement income strategy, probably aren’t suited to what this actually entails.
Since ‘withdrawing’ 4% of the portfolio each year, is necessary to meet income needs, this means selling some shares. Why? Because dividend yields on global index funds are around 2% or so.
How will investors feel selling shares each year? When the market is going up, maybe it’s not so bad.
But when the market is down 20%, or even 50% or more, how will they cope… emotionally?
We’ve spoken about how beneficial dollar-cost averaging is. Well, this is dollar-cost averaging in reverse. Unfortunately, you’ll be selling more shares at a lower price, and less shares at a higher price, to create your income.
Because you need a certain dollar amount of money to pay your bills, you don’t have much choice.
This opens up new risks. If trying to go around this problem (by withdrawing more when the market is up, and less when it’s down), you’ll essentially be trying to time the market. Since timing the market successfully is virtually impossible, this is an losing battle. Consequently, this will add stress to the process and won’t make for a very enjoyable retirement income, in my view.
Having to sell shares to create income when your investment is dramatically in the red, would be unsettling to say the least!
I think many folks following the global indexing approach, aren’t appreciating this aspect of the 4% rule.
Don’t get me wrong, I think index funds are great. But if I was going down this road, I would personally strive to live only off the dividend flows that the index funds pay out.
Simply put, I wouldn’t be comfortable having to rely on the sanity of the sharemarket for my retirement income. As the market dropped, I would have to sell an increasing amount of shares, to create the income needed to pay my bills. There is no guarantee the market would recover quickly after a crash. And a portfolio could be decimated quite quickly as it’s market value drops, and chunks are being sold off.
Despite this, there’s still plenty of research suggesting it’s a valid strategy for creating retirement income.
I’ll discuss this more at a later stage. But for now I’ll just say, this strategy is not for me. Not because it doesn’t work…
But simply because it doesn’t suit my investing personality.
Psychologically, this retirement income strategy just doesn’t sit well with me.
To me, relying on the sharemarket being rational is not something I want to do, to pay my bills. More accurately, it’s not the market that is irrational… it’s the short-term focused participants of the sharemarket, that sell and run at the first sign of trouble. The huge continued selling pressure leads to market crashes.
I’m reminded of a great old quote from economist John Maynard Keynes, “markets can stay irrational longer than you can stay solvent”.
I would much rather live on a strong and steady flow of dividend income. Since dividends are related to company profits (more steady), and not to market prices (more volatile), I’ll sleep much better at night.
Live off rents
Many property investors aim to fully pay off their investment mortgages. This is so they can live off the rental income in retirement.
Rental properties certainly offer a relatively stable source of income. After all, people always need a place to live, and rental properties are a tangible and valuable asset.
However don’t be mistaken, rents can and do decline. Believe me, we have a few investment properties in Perth, where the rent is more than 20% lower than it was 4 years ago.
Living off rents from mortgage-free properties can be a relatively stress free retirement income strategy. But with average rental yields in Australia so low after costs, it will take close to $2m to achieve an income of $50,000.
Of course, there is always high yield property too. But remember, it will take a rental yield of 9%, to pocket around 6% yield after costs. Typically, costs eat away at around a third of the rental income.
We can achieve this same 6% yield, with less hassle, by investing in a listed investment company like BKI. The current yield of BKI Investment Co. is around 6.3%, including franking credits. More info can be found on their latest monthly portfolio statement, with plenty of other info on their website.
Live off interest
I’ve read that even now, with savings accounts paying a pathetic 2-3% interest, some people are still relying on this for retirement income. Either they have a boatload of money, or they absolutely hate risk.
But here’s the thing. They are taking a massive risk by having all their money in the bank. Effectively, they are guaranteeing that after tax and inflation, they are going backwards. That is a certainty!
So much for low risk. Essentially, this is the riskiest option there is. The income is very low. It has no growth component. It’s not tax-effective. It can also fluctuate a fair bit due to interest rates. Yuk!
Probably the worst retirement income strategy out there. Aside from parking your cash buffer in here, this is not a home for investment funds.
Ideally, it’s better to keep as little as possible in cash, since it offers the lowest long-term returns.
We don’t know when the next sharemarket crash is going to be. So we’re silly if we think that hoarding cash and waiting for the market to drop, so we can scoop up shares at bargain prices, will be a winning strategy. Nobody knows when the next recession or crash is coming.
The most sensible thing to do is to keep investing!
What about interest from P2P lending?
Earning interest by lending your money to other people, instead of the bank, is much more profitable. Effectively, you become the bank!
If you missed it, catch my full overview on Peer-to-peer lending here.
With current rates for longer-term (5 year) lending around 8-9%, it can deliver a pretty juicy income stream.
There’s also a special deal for my readers – a $100 signup bonus from RateSetter, to give you a ripper 1-year return to get started.
The downside? Your income won’t grow. Unless you re-invest some of the interest along with the principal, the income you receive will basically stay the same. Think of it like interest from a bank. Although it’s a higher rate, unless you put more in there, or re-invest the payments, the income won’t grow.
One option in retirement to create a growing income from P2P Lending is this…
Invest in the 5 year market, where the interest rate is around 9%. And as you receive your 9% interest, take 7% as income and re-invest the other 2%, along with the principal.
Now, next year your income will be 2% higher, as you have 2% more funds on loan earning interest. Repeat the process each year, and the income will grow.
Effectively, repeating this process results in a 7% yielding income stream, which grows at a rate of 2%. This should mean that your P2P lending income keeps up with inflation, even in retirement.
Bearing in mind, P2P lending hasn’t had a chance to prove itself during a recession yet. So although RateSetter has a provision fund in place, we won’t know how effective it truly is until loan defaults are high.
Built-in growth component to dividends and rents…
As companies earn more profits over time, they can afford to pay larger dividends to shareholders. And as the population earns higher wages, they can afford to pay more in rent for a property.
So on average, dividends and rents tend to grow over the years along with inflation. Quite often, the growth in income will exceed inflation. Especially so, if you’ve chosen good quality companies, or well located properties.
Live off dividends
Now we come to my preferred source of retirement income. Truthfully, it deserves an article in itself. And I’ll get around to it soon. But for now, here’s why you might consider dividends as a source of retirement income.
The gross yields on Australian shares are very good, when compared with other assets. Dividends have historically grown at a faster rate than inflation. This is very important in maintaining your purchasing power as an early retiree.
It’s incredibly easy to setup a portfolio of shares which is well diversified across many different sectors – banking, healthcare, energy, consumer, materials etc.
With one purchase of shares in a listed investment company like Argo, we get broad diversification at very little cost. Most importantly, it means our dividend income is coming from many different sources. So obviously, this is very different to living off the rental income from 1 or 2 properties.
As an example, Argo’s dividend income is sourced from a wide variety of companies, all over Australia. Some companies in the portfolio also have earnings from overseas. These companies are working hard to increase their earnings, lower their costs, and ultimately reward their shareholders.
Luckily, all this requires very little work on our part. The managers of Argo build and monitor that portfolio for us. Just getting a couple of dividend statements each year is about as strenuous as it gets.
Clearly, there are many possible sources of retirement income. And all of them have their own set of risks.
So there aren’t really rights and wrongs, only preferences. You might choose to combine a couple of these options together to create the investment portfolio that best suits you.
Obviously, I’ve settled on my own strategy that I’m happy with. And as I continue converting our property equity into a dividend stream, I’ll be very comfortable using dividends as our primary source of retirement income.
P2P lending also provides us a nice yield and a bit of fun experimental-investing on the side.
But what suits me, may not suit you. And that’s perfectly fine. Everyone’s different.
The aim of this article is to get you thinking about where your retirement income is going to come from, and what that looks like in practice. I probably didn’t think about this hard enough in my earlier investing years.
It’s really interesting how different investment approaches suit different people. Especially so in retirement, where we are fully reliant on our investments to provide income. This is when unexpected emotions come into play, and can even have damaging effects.
Finally, don’t just swallow the pill you’re given. Don’t follow a certain way of investing just because everyone else is doing it. Do some further research and see if it really suits you or not.
Because remember, one day it will just be you and these investments… so you’d wanna be damn comfortable with where your early retirement income is coming from!
What’s your retirement income going to look like? Where’s it coming from? Share your plans in the comments…