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.
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 fantastic. 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’s 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.
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 7%, including franking credits. More info can be found on their latest monthly portfolio statement, with plenty of other info on their website.
Or you can read my full review of BKI here.
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!
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.
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.
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…
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You are correct, there are so many options! Everyone needs to decide which one, or combination will work best for them. For me personally it will be a mix of dividends and possibly profits from p2p lending and selling off shares. Possible other income streams based around hobbies as well not fully considered retired.
Thanks for sharing!
I was going to include hobbies, but then as you say, that’s not technically retired income 😉
Howdy Young fella.
With the 4% rule it’s typically used with a combined stock and bond portfolio. Generally there’s an inverse relationship between these. In a crash stocks go down, bonds go up. Hence bonds act as a volatility dampener helping to smooth capital in tough times. In good times the 4% is coming more from stocks and vice versa. Trouble is the inverse relationship hasn’t always worked so it can’t be guaranteed to hold every time. Is the investor willing to take this risk? Not me that’s for sure. A cash buffer can help but still it doesn’t meet the important SANF test for me personally.
Living on Rent is terrible. Too many bloody big expenses unexpectedly at times completely stuffing up one’s cash flow. And absolutely not true “passive” investing.
Like you Living on Dividends works wonderfully for me. Bliss on a stick. Nothing to do but watch the inflation protected (at a minimum) dividend income roll into the bank account. But unlike property it’s all income, NO expenses!
Thanks for clarifying Austing!
I admit my ignorance here. I haven’t done much reading on the topic, as it just doesn’t sit right with me.
A cash buffer as well as bonds, that sounds like a fair drag on long-term performance?
Yeah, those dreaded maintenance or repairs calls/emails really aren’t what one wants to be getting in retirement.
You sum it up right there mate… the simple fact that it’s all that juicy income and no bills makes it much more enjoyable 🙂
“A cash buffer as well as bonds, that sounds like a fair drag on long-term performance?”
Exactly. With the capital drawdown approach the more you try to smooth capital with greater quantities of bonds and cash the lesser the overall return.
Hence the beauty of dividends. They allow one to ignore capital volatility by focusing on the naturally more stable dividend income. Then of course this removes the need for bonds, only requiring a cash buffer for 2 – 3 years living expenses. A portfolio over the long term dominated by stocks (minus the bonds) not only results in greater returns but much higher income.
Oh and not advice:-).
Yeah, I didn’t like that idea either – having large amounts of bonds. Ideally, we want as little as possible in lower-returning assets.
Fully agree with your points there. Once someone moves from focusing on fluctuating share prices, to looking at the steadily rising income – it’s a real game changer. And when I learned that, it was a bit of a light bulb moment 🙂
Always appreciate you stopping by mate!
As Austing touched on the relationship between bonds and stocks being inverse is spot on.
Most people try not to over do it with the bongs though because as you suggest it’s a huge drag on your wealth building.
Typically it’s suggested that a good mix of stocks and bonds is around 70-30 or 80-20 or 90-10 for those happy with ththe higher risk. The aim is to keep whatever ratio you have decided on in check. So if shares go up you sell some high and buy bonds cheap and then when the market has a downturn you sell your bonds when they are high and buy stocks for bargain prices.
This is typically when your approaching or in your wealth preservation stage of life which depends on when you have enough to retire. It’s suggested to have 100% shares while in the wealth building stages while your still working as having a paid job covers the risk here. So whether it’s having dividend producing shares or growth shares is up to the individual investor imo. I believe both strategies compliment each other. Just my opinion.
Not advice
Thanks for that Ben. Both strategies are certainly valid and work – most of us tend to lean one way or the other I think.
Personally, I’ll just be holding cash rather than bonds, but for a similar purpose. Rather than smoothing out the price volatility, it’s for smoothing out the income.
hello there.
i would add alternative incomes: ebay, blogging, renting a room in your place, consulting, etc etc… opportunities are endless, but not always “passive”.
In Australia, we have pension. I have invested and diversified overseas, etc etc..
Thanks grogounet.
I was gonna add hobby/work related stuff, but the post was already too long!
And I thought I’d leave it with just the investment income streams.
You make a great point, there are unlimited options. I think many people could semi-retire with less than they think and be just fine.
Dividends also usually include those sweet sweet franking credits. If the dividend payments are enough to live on comfortably then (without any other decent income) one would also be getting a tax return.
Yes, very important. I always include franking credits in my calculations – they’re real cash with your name on it, after all!
Great article mate.
Am tossing up between the 4%WR and pure dividends as a FIRE strategy.
Pure dividends certainly nice from an emotional point of view.
Have you crunched the numbers to see which one may require more capital invested/take longer to be FI though?
Thanks a lot!
Yes dividends certainly provide a strong psychological advantage, and helps to focus on the company performance as opposed to market prices.
If we take the Oz market, then living on dividends will allow shorter time frame to retirement due to higher yields – so less capital needed to generate the income needed. Outside Oz though, then you’ll be forced to go the 4% route, as dividend yields are much lower so shares will need to be sold to generate the same income.
Also focusing on dividends – it makes for a more ‘certain’ return. With a large portion of the return coming from dividends, which are more stable, your depending less on market growth to reach your goals. I think this is a neat aspect too.
Personally, I think a good strategy is to build Oz focused dividend income first, reach FI sooner, then any extra cash after that can be used to add international for extra diversification if desired.
I much prefer to rely on the cashflow from shares, rather than market growth. This goes for in retirement AND on the way to retirement.
Cheers for the reply.
Well thought out argument.
I’m sure you’ve heard it all before, but you’re obviously comfortable with a large percentage in Oz shares.
Whereas the “normal” argument is Oz is 2% of the World Market and as such would be “foolish” not to have Intl > Oz.
Are you that confident in the Aussie market or just your personal risk tolerance?
Yeah, I’ve read arguments against over-weighting Oz shares. But at the end of the day, I do feel ok having such a large percentage in oz. I’ve seen varying opinions from different investors on it, anywhere from zero to 98% international, as you say.
I can’t be that confident of the aussie market, because I don’t know the future. I just think it’s very likely that the Oz economy does just fine over the next 50 years. Basically, we only really need the economy to slowly chug along and for company profits and dividends to grow with inflation. So if we’re expecting just 2% growth per year, I don’t think that’s expecting too much.
Not sure I’d be too comfortable with 98% international, or even more than half! Our comfort zones change over time though. To be clear, I will probably add international later for further diversification. I see international as more of a growth play, and possible protection against Oz catastrophe.
And since I’m an income investor these days, I go where the income is. Oz investors get a huge free kick due to franking credits, as you know. International would likely provide higher dividend growth though, due to lower payouts, so they can compliment each other over time.
If one has plenty of capital, it’s probably a good idea. But we don’t have unlimited capital, and we need a certain level of income, now, in retirement. It’s really a personal decision… perhaps in my case, a foolish one 😉
I have been thinking a lot about retirement lately and I don’t know how I will get all the proper income I need to live well. That is great that there are so many different options for income and there isn’t a right or wrong way. I like how you mentioned that you shouldn’t follow a certain way of investing just because everyone else is doing it. There are many different ways and it’s best to find the one that works best for you! Thank you for the information!
Thanks for reading Deb!
You’re right, there’s lots to choose from. And each of us will feel more comfortable with certain investments.
I think many people are wondering the same thing as you. The best thing we can do, is save and invest as much as possible throughout our working lives.
Hello. First of all congratulations on an amazing journey and the great way you’re sharing it with others through the site. It’s a great show of altruism 🙂
I have a few questions after reading more than 10 or so of your articles:
Do all your calculations on how much is needed for retirement and the savings rate to get there mean you don’t have children or didn’t at the time of building your wealth?
You mentioned you had lots of investment properties purchased through equity in your partner’s property. How did you balance paying off the loans and offset accounts associated (I don’t suppose you were paying down the principals), and how much to invest in LICs?
To explain why I’m asking I’m 30 and my partner 32, we have a PPOR with 360k left to pay off (but through an IO loan and offset account so some cash to play with) and I’m on 170k gross a year and my partner 110k. So at this stage I’m seeing how we can retire early and deciding between investment properties and dividends from LICs (only after reading this blog). But trying to project how much we’d need in retirement and how long to get there is tricky and I’m not too inclined to go without a plan and simply buy dividend ASAP with any cash spare left without knowing my target.
Anyways that’s why I’d love to know a bit more about how you got there.
Hi Kriv. Thanks for your kind words!
Everyone’s situation is different. The amount of money you need to be able to retire is specific to you and how much you spend each year. You can roughly figure this out by multiplying your annual expenses by 25. If you spend $40k per year, you need around $1m. If you spend $60k per year, you need $1.5m.
As you can see, those with lower spending don’t need as much wealth to retire.
We didn’t pay any loans down during our journey, all interest only. Any left over cash was either put towards the next property or shares (once we decided to invest in shares).
It sounds like you’re on extremely good incomes, so all you need to do is find your level of annual spending and multiply that by 25. That’s how much wealth you’ll roughly need to provide enough dividends to retire on. $1m of Aussie shares would provide around $40k-$50k of annual dividends, for example.
What got us there is our high savings rate and the fact that we kept our spending low and were happy to retire on a modest level of annual spending.
Property is extremely hard to predict in terms of how it will perform and help you reach FI or not. Rental yields after costs are very low generally which means you’ll be putting cash in to keep the property and capital growth is very unpredictable from year to year. Going the dividend investing route is what I wish I did in the first place – your progress is achieved by simply saving money, buying shares and reinvesting your dividends to buy more shares. The income is very reliable from year to year, so you can see yourself getting closer to your goal with each purchase.
Hope that helps. Happy to answer any other questions you may have 🙂
Thanks for the thorough response. So form what I understand you simply paid the interest owned and never build up the offset accounts of your IPs instead using that cash to purchase more IPs or shares?
Yes that’s correct.
Hi Dave,
Thank you so much for your amazing article. Live off dividends sounds promising!
I can understand that I need around 1.5m dividends shares to spend 60k during my retirement. If that is the case, do I have to top up my superannuation to build that 1.5m dividend shares within my supper or do I have to buy dividend shares (worth 1.5) outside of supper?
Hi Gary. It can be a combination of both, but the place people invest usually depends on the age they hope to retire. If trying to retire much earlier than super age, then investing outside super is an effective way to create that passive income to live off. However, if someone is happy working part-time of full-time till super access age, then adding to their super can often be a simpler and more tax effective approach.
I got into this discussion in a podcast which you might find interesting: https://strongmoneyaustralia.com/podcast-superannuation-and-early-retirement/