Funding your retirement
When most people think about finally cleaning out their desks (or toolboxes, or whatever the case may be) for the last time, the first exhileration of finally being “free” is quickly tempered with the not-quite-so-fun question about how they are going to support themselves. For people who do not have pensions, or whose pensions are not adequate to fund their retirement fully, savings for retirement are an absolute necessity. Broadly speaking, there are two models for funding your golden years: retirement nest egg, and retirement cashflow.
Historically, the more common model has been the nestegg. You try to make pile of money that is big enough that it will last longer than you do. I remember a great-aunt of mine who followed this model. She (somewhat morbidly, although always with good humour) used to say that she could only live until she was 92 because that was when her money was going to run out. The good news, if you can call it that, is that she timed things right, and passed away early in her 91st year. Still, I can’t help but think that even if she didn’t seem to feel too much stress at the thought of running out of money, I certainly would. (Then again, maybe she didn’t share all of her financial worries with a teen-aged grand-nephew.)
Retirement nest egg model
Simply put, with the nest egg model, you try to save enough money so that when you are no longer adding to your pile of money, the pile will be big enough that, with reasonable withdrawals, and barring a catastrophe, the pile will last longer than you do. The generally accepted amount of withdrawals of a suitably-sized nest egg is 4%. (A fellow named William Bengen is the reason why.) You must work backwards from there. Just to throw out a working number, if you wanted to live on $50,000 per year, and were planning to be retired for 25 years, the total nest egg would need to be $1.25 million to begin. The first year, you would sell $50,000 worth of assets, and use that money to live on for that year. In subsequent years, the withdrawals would grow in proportion to inflation, so that purchasing power would remain the same. Assuming the inflation and market returns of investments of your nest egg cancel each other out, your money would last 25 years after retirement. If you retired at 65, this would give you steady income until the age of 90.
The problem is that this leaves precious little room for error. Inflation has been low for a generation in North America, so it’s not something that is in the forefront of people’s — especially young people’s — minds. It should be. It’s simply a matter of time until higher inflation returns. Personally, I think that we’re in for quite a ride once interest rates start to creep up, but that, as they say, is another post.
The other major vulerability to with this model comes into play if you’re invested in the market, which, unless your nest egg is truly enormous, you must be, to fight off the eroding effect of inflation. Long term, markets go up, so on average, owning stock is a good idea. The thing is that markets also go down from time to time. Sometimes they go way down. If a major downturn happens in the first few years of your retirement, your annual withdrawal will eat up far more of your nest egg than the staight-line calculations of a few paragraphs ago would suggest. All of a sudden, with no increase in your standard of living, you could go from withdrawing an inflation-adjusted initial 4% to 5%, 6%, or 7%, or even more. Again, if you’re unlucky enough that this happens in the first few years of retirement, the repercussions will be magnified though the rest of your retirement. At that point, you’ll have a choice of either going back to work, or adjusting your standard of living downward.
To be fair, there is also the possibility that the markets will do great, and inflation will stay low for your first few decades of retirement. This may indeed happen, but hoping that you happen to retire at the right time in the ecomonic and inflation cycle isn’t really a plan in the conventional sense of the word, now it is? The only way to really insulate yourself from these risks is to have a nest egg that is so huge that it would be able to support the next generation or two of your family. If amassing that amount of money were as easy as that, we’d all do it, wouldn’t we?
Retirement cashflow model
The less common of the two models is the cashflow model. This model also relies on building up savings during your working life, but it relies more heavily on investments doing well after retirement. At first blush, this might sound like a recipe for disaster, but done properly, stocks can indeed provide you with steady, reliable income. A portfolio of well-chosen, conservative stocks can provide inflation-adjusted income for, well, forever. The best part is that the amount you need to save with the cashflow is much smaller than with the nest egg model.
Using our $50,000 figure from the discussion about building a nest egg, if you can get an average dividend return of 10%, you would need only $500,000 to retire. That $500,000 would throw off $50,000 every year without ever affecting the principal. Because the principal is never touched, the amount you can collect each year never goes down. You could live to 150, and you would never run out of money.
Let’s consider the problems we saw earlier with the nest egg model, and consider how a cashflow model handles the same issues. The potential probems with a nest egg approach were mainly 1) the danger of a major market downturn early in retirement, and 2) inflation eating into your spending power, thereby necessitating larger-than-expected withdrawals against the principal.
1) A major market downturn early in retirement
This really isn’t a concern. Remember that the idea is to spend only the dividends that are generated from your investments. The principal remains untouched. As strange as it sounds, the price of the stock is pretty-much irrelevant, since this plan never requires you to sell your stock.
2) Inflation eating into your buying power
We all know that prices have a tendency to go up over time. While you are working, this isn’t so much of a concern, as wages also tend to rise over time. So, even though the number on the price tag on an item gets higher through the years, the relative value of that item doesn’t really change. (Yes, there are exceptions with certain items rising in price faster than inflation, but on average, as long as your wage keeps up with inflation, higher prices don’t hurt your buying power.) When you retire, though, your ever-rising wage is no longer in the picture. The trick is to have investments that also rise with inflation over time. Certain dividend-paying stocks fit this description. Certain stocks have been paying uninterupted dividends for decades. Certain stocks have been raising their dividends on an annual basis for decades. These stocks are called Dividend Aristocrats.
If this is so easy, why doesn’t everybody do this?
Time and Patience.
With the safety of stable, well-established companies with ever-rising dividends, comes a problem. They’re popular investments. Because of this, the stock price of these companies is high. Because of the high stock price, the yield is low. Remember that being able to retire with $500,000 in investments was predicated on getting a 10% annual return. It is possible to get that kind of return from high-quality companies, but only if you bought them a long time ago. As time passes, the dividend increases, and the yield you collect on the money you originally invested goes up. But you need to know that for a yield to go from, say, 5%, to 10%, can easily take a decade or more. Many people simply do not have the patience required to make investments that require decades to mature. As the share price goes up, they get tempted into selling their stock and collecting their short-term profits, not realizing in so doing, they have just cut their future cashflow off at the knees.
If you sell your stock this this way, yes, you get to feel great that you bought low and sold high, but you also have to remember that if you’re going to repurchase a stock of similar quality, with a similar yield, you have just set yourself back by the same number of years is has been since you first bought the orginal stock.
The lesson here is that if you start early and can avoid the tempation to sell your stocks for a short-term profit, you will have to save far less during your working life, and you will have a more secure and never-ending income in retirement; one that can even form the basis of inter-generational income for your family.
Other advantages of the retirement cashflow model
There isn’t time to go into detail at this point, but
- Collecting dividends (cashflow model) has tax advantages over selling assets (nest egg model) so you get to keep more or your money. (Registered accounts obviously affect this equation.)
- As you near retirement, the amount of money you’ll be collecting from dividends will be substantial (enough to live on, actually!) Delaying retirement two years would have an enormous effect. Consider: current dividend income of $50,000. Delay retirement by two years, thereby allowing yourself to reinvest that money ($50,000 + $50,000 = $100,000). Your stocks are now worth $600,000. Granted, because you bought the stocks recently, you won’t be collecting a 10% yield, but the extra 100k at 5% still equals an extra $5,000 per year, forever.
The key point here, though, is that you can’t wait until the traditional retirement-planning time of life. By the time you’re in your early fifties, you’re already up against it if you want to give your dividends time to grow.
The earlier you start, the less you have to set aside, and the more it will help you in the future, so get started sooner, rather than later!