Archives For Retirement

Quiz!

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio.
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Your Financial Health in a Single Number

People use various numbers to measure their financial health. Let’s review some common ones, and see where they fail, through examples:

 

Measure Person 1 Person 2 Person 2 has better financial health
even though… because…
Net worth (total assets minus total liabilities) Net worth: $10M

Annual spending: $1M

Net worth: $1M

Annual spending: $50k

His net worth is x10 smaller His money can support double the years of living expenses
Income Income: $1M per year

Savings: $0 per year

Total saved: $0

Income: $100k per year

Savings: $20k per year

Total saved: $200k

Her income is x10 lower She has some financial security in case she loses her job
Annual savings Income: $1M per year

Income taxes: $400k

Annual spending: $500k Annual savings: $100k

Liquid assets: $200k stocks

Income: $100k per year

Income taxes: $20k

Annual spending: $50k

Annual savings: $30k

Liquid assets: $60k stocks

His annual savings is x3.3 smaller He is building security faster, saving 60% of annual spending vs. only 20%. His savings in stocks are also greater relative to spending.
Withdrawal rate from stock portfolio (annual withdrawals from the stock portfolio divided by its value) Expenses: $1M per year

Stocks: $1M

Annual withdrawals: $0k

Expenses: $40k per year

Stocks: $1M

Annual withdrawals: $20k

Her withdrawal rate is infinitely greater Her total spending (4%) can be sustained with no work, while the other has only 1 year of expenses saved
Spending rate from liquid assets (total annual spending divided by the value of all liquid assets) Liquid assets: $1M cash

Spending: $40k per year

Liquid assets: $1M stocks

Spending: $44k per year

His spending rate is 10% greater Stocks provide growth, and are more likely to sustain a 4.4% withdrawal rate than 4% from cash

Is there a single number that can give some indication of your financial health? Yes! It is the spending rate from your stock portfolio: total annual spending divided by the value of your stock portfolio. This assumes that the stock portfolio is diversified, and held for the long run, with no market timing, and no panic sales during stock declines. Also, you can reduce your spending measure by any amount that is guaranteed for life by an inflation-adjusted source, such as social security.

Why does this measure work?

  1. It shows progress towards financial freedom / financial security / retirement. Once your spending rate is below 3%-4%, depending on the specific portfolio allocation, the portfolio is likely to sustain the spending for as long as you live. If your spending rate is 6%-8%, you know that, between savings and investment growth, 100% increase will make you independent of work.
  2. It is not sensitive to a loss of job. It ignores income from work, that can be lost in various ways. In addition, if you want to ever be independent of the need to work, you want to measure your position assuming no income.
  3. It can withstand high inflation, given the focus on stocks.
  4. It does not suffer from liquidity concerns related to real estate, private equity and small businesses. Exception: If you have a diversified collection of properties, you can consider their income, after accounting for vacancies and repairs, if they are diverse geographically (and ideally enjoy country diversification, same as with stocks).
  5. It focuses on current health instead of potential. Even if you save a large amount every year, the saving can stop completely if you lose your job. What matters is money on hand (prior savings).

What are the implications? How can you improve your financial health?

  1. Maximize your allocation to stocks, but not beyond the point of risking getting into trouble during stock declines, either through large withdrawals, or panic sales. This requires a careful risk analysis.
  2. Keep your spending under control. A 10% reduction in spending provides an instant 10% gain in your financial health – this is powerful.
  3. Maximize your savings, either through lower spending or higher earnings. Note that higher earnings will not have any immediate impact, but the saved money from your increased earnings will build up gradually.

Quiz Answer

What is the most useful measure of a person’s financial health?

  1. Net worth (total assets minus total liabilities).
  2. Income.
  3. Annual savings: income minus expenses.
  4. Spending rate from stock portfolio: total annual spending divided by the value of the stock portfolio. [The Correct Answer]
  5. Spending rate from liquid assets: total annual spending divided by the value of all liquid assets (e.g. stocks, bonds & cash).
  6. Withdrawal rate from stock portfolio: annual withdrawals from the stock portfolio divided by its value.
  7. Withdrawal rate from liquid assets: annual withdrawals from all liquid assets divided by their total value.

Explanations: See article above. Note that the last option “withdrawal rate from liquid assets” is not addressed by the article, since it suffers from the combination of flaws of the two options above it (5 & 6).

Disclosures Including Backtested Performance Data

Quiz!

Which of the following should be elements of a plan to provide lifelong income through all market cycles? (Multiple correct answers)

1. Hold a rainy day fund.

2. Maximize diversification, and include at least the following: stocks, bonds, real estate.

3. Commit to low spending relative to your assets.

4. Diversify your stock allocation across companies and countries.

5. Start a profitable business.

6. Dedicate your money to high growth investments.

7. Limit your mortgage(s).

How Does the Book “The High-Beta Rich” Apply to You?

This article discusses an issue raised by the book “The High-Beta Rich” by Robert Frank, and explains how QAM’s plans address it.

Historically, wealthy families were more immune to market cycles than the general population. The book shows that starting in 1982, the income of the top 1% earners became more volatile than the income of the overall population. While they enjoyed high growth, their income declined further during economic downturns. This is due to more of their income depending on volatile investments, including leveraged real estate, individual companies and concentrated stock investments.

The book presents stories of people that amassed substantial wealth, and later lost most or all of it. A common strategy to avoid losing it all, is to hold some money in stable investments. While this solves one problem, it introduces another one – it slows down the overall growth, which increases the risk of outliving your money.

Is there a solution that lets you enjoy the high growth without taking excessive risks?

Such a solution exists in certain cases. Here is a list of goals with details of how to achieve them:

1. Having your money last: Dedicate your money to high growth investments – stocks of profitable companies that are priced low (value stocks).

2. Recover from declines: Diversify across thousands of stocks in many countries.

3. Provide stable income through the declines: Commit to low spending relative to your assets, with a clear trend towards 3%-4%.

The beauty of this solution is that it doesn’t require lifelong financial sacrifices. What it does require is:

1. Disciplined spending, even as you see your savings reach high levels, or when your income is much higher than 3%-4% of your savings. Lack of this discipline is a big reason some wealthy people get into trouble during downturns.

2. Strength in the face of downturns, and commitment to the investment plan.

3. Permanent diversification at all times; avoiding the temptation to put a substantial portion of the money in a single company or real estate investment.

Does the list of these requirements seem too easy to follow? During over 11 years of service, QAM learned that many people find these requirements to be very difficult to adhere to. If you are able to adhere to them, you have a good chance at sustaining lifelong (and multigenerational) growing income. In addition, successive downturns are likely to become easier to handle, if you limit the growth in spending.

Quiz Answer

Which of the following are key elements of a plan to provide lifelong income through all market cycle? (Multiple correct answers.)

1. Hold a rainy day fund. Sometimes correct: A rainy day fund, such as 3-6 months of living expenses in cash, is necessary for surviving declines early in your saving years, especially if you have low job security. Once you build meaningful savings, the benefit of such an allocation gradually becomes outweighed by the benefit of maximizing the growth of your investments, for lifelong income.

2. Maximize diversification, and include at least the following: stocks, bonds, real estate. Incorrect: While maximal diversification helps survive declines, including slower growing investments hurts the necessary growth for lifelong income that grows with inflation.

3. Commit to low spending relative to your assets. Correct: This is a key element. There are a number of benefits to low spending relative to your assets: (1) It helps handle declines combined with lack of work without depleting your money; (2) It helps build your savings faster, to provide the nest egg needed for lifelong income.

4. Diversify your stock allocation across companies and countries. Correct: Diversification helps avoid total loss during declines.

5. Start a profitable business. Sometimes correct: Running a business combines pay from work and profits of the business ownership. As a small business, it has the potential of outperforming stock investments. The benefit of higher growth comes at a price of liquidity constraints and the risk of a total loss. Therefore, for the goal of lifelong income, it is best to limit your investment in your business to a small portion of your savings.

6. Dedicate your money to high growth investments. Correct: As long as you stick with high-growth investments, diversification provides a benefit of higher low points during declines, without the price of hurting your average returns.

7. Limit your mortgage(s). Usually incorrect, but read further: Real estate with no (or limited) mortgages tends to grow more slowly than diversified stocks, and is less liquid. If you are going to limit your mortgage for any reason (can’t qualify for high mortgage, short-term risk is too high, don’t like volatile investments along with the mortgage obligation), you are better off investing in diversified stocks instead of owning a home, for the purpose of lifelong income. There are non-financial benefits to owning your home, which may lead to accepting a lower mortgage along with less optimal lifelong income.

Disclosures Including Backtested Performance Data

Quiz!

What is the financially optimal way to handle stock dividends for a retiree?

  1. Automatically reinvest the dividends and sell from the principal for income.
  2. Keep the dividends in cash and use them for income.

Look for the answer below and read this month’s article for a discussion.

2 Reasons to Reinvest Dividends

In recent years, it has become tougher to automatically reinvestment dividends. Despite this difficulty, it is still beneficial.

What is the difficulty with automatically reinvesting dividends? When reinvesting dividends (as with any other “buy” trade), there is a 61-day window (30 days before and after the reinvestment) in which selling and recognizing tax-losses is disallowed. This is called the “Wash Sale Rule”, and is established to prevent people from selling and buying for the pure sake of getting a tax deduction. Complying with the wash sale rule, requires knowing the date of upcoming dividends at least 31 days in advance, to avoid sales in that window.

How has it become more difficult to automatically reinvest dividends? Brokers & custodians are required to report the cost basis of mutual fund purchases on form 1099-B, in order to shed light on wash sales, and discourage them. By not reinvesting dividends, you reduce the number of buys, including the number of wash-sale windows, and retain more freedom to sell without violating the wash sale rule.

What are the benefits of reinvesting dividends?

1. Full participation in gains: Reinvested dividends never stay in cash, allowing you to get the investment returns at all times, and avoid missing returns while money sits in cash. For every 1% that you avoid keeping in cash in the account, and instead keep in an investment that averages 10% per year, you get a benefit of 0.1% per year (1% of 10%). This is a material portion of the investment performance.

2. Tax deduction: When there is a need for cash (e.g. retirement income) or a rebalance, you can sell the most appealing mutual fund shares (outside the 61-day wash-sale window), allowing to realize tax losses.

How can you avoid wash sales? To avoid wash sales, you need to be strategic, and sell away from the time of dividend reinvestments. Dividends are often given quarterly. After excluding the month before and after the dividend, you are left with one month per quarter to sell while realizing tax losses. One strategy is to sell once per quarter (whether for rebalancing or for withdrawals). If you need cash throughout the quarter, you can choose between keeping it on margin (borrowed against the brokerage account) if the amount is small, or selling in advance for large amounts.

Quiz Answer:

What is the financially optimal way to handle stock dividends for a retiree?

  1. Automatically reinvest the dividends and sell from the principal for income.  [The Correct Answer]
  2. Keep the dividends in cash and use them for income.

Explanation:  While keeping the dividends in cash is the easiest thing to do mechanically, there are many benefits to reinvesting them. The article above explains the benefits.

Disclosures Including Backtested Performance Data

Money can buy many things that give happiness in life.  But, once you cross a moderate standard of living, more money leads mostly to temporary increases in happiness until you get used to the new normal (e.g. new car, private jet).

One thing that can stick is the ability to stop worrying about money.  This happens when you save money, and have enough available for surprise needs, beyond the routine expenses, such as a major repair or unexpected health care expenses.

The key factor that makes this work is the extra unused money.  $1M invested in Quality Asset Management’s portfolio Long-Term Component is likely to provide perpetual annual income of $40k, growing with inflation.  Any unexpected expenses up to this amount can be handled with great piece of mind.

The ultimate worry-free life (financially) is reached when your investments can cover all of your ongoing + unexpected expenses perpetually (e.g., $5M providing $150k for routine expenses + $50k for surprise expenses, at 4% annual withdrawals).  At that point, you can avoid worrying about money, and feel the lasting happiness.

The good news is that you don’t need to wait for decades to reach the ultimate goal, to start reaping the benefits.  With every bit of increased savings (relative to spending), you get reduced stress and increased happiness.

Disclosures Including Backtested Performance Data

In the article  6 Problems with Dividends for Income [December 2013] you saw a long list of disadvantages of dividends when compared to selling from your investments to generate any required income.  Yet, retirees still like dividends.  Why is that?  The reasons are psychological, and several are listed below:

  1. Disciplined spending:  By limiting spending to dividends, you can resist the temptation to spend the principal.  It gives structure.
  2. Avoiding selling at a loss:  Dividends are given whether the investments are up or down.  A dividend withdrawal at a decline doesn’t require actual selling at a loss.
  3. Avoiding regrets over missed gains:  If you spent dividends, it feels like you spent cash.  But, if you sold from your investments, and they gained substantially, you may regret the sale.  People tend to regret action more than inaction.

Since income can be generated by selling from the portfolio instead of dividends, it is best to avoid focusing on high-dividend investments just for the sake of income generation.  By sticking with selling, you gain control over the amount, timing and regularity of income, as well as investment choice and improved tax-loss harvesting.

The missing piece is the psychological comfort.  That can be obtained by sticking to a conservative cap on withdrawals from the portfolio (typically 3%-4% of the peak value of the investments).  Having an outsider (investment advisor, family member, close friend) track the withdrawals can strengthen the discipline.  As a Quality Asset Management client, you receive the available withdrawal amount in your quarterly email, so you can view your investments very clearly as a sustainable income stream.

Disclosures Including Backtested Performance Data

If you own a company with a $1 share price, and it pays a 5c per share dividend, you get 5% in investment income.  While this is a natural solution for retirement income, it has problems.  Some of them stem from the way dividends work:  The share value goes down to 95c (reflecting the cash that the company paid out and no longer has) + you get 5c in cash, leaving you with an unchanged total of $1.  That is, until tax time.  You have to pay taxes on the 5c, reducing the value of your investments.  Below is a list of problems, created by this effect among other factors:

  1. Amount:  More dividends than needed result in unnecessary taxes.
  2. Timing:  The dividend is in cash, not invested, until using the money (called “cash drag”).
  3. Irregularity:  Dividends can be increased or decreased unpredictably – too much creates cash drag & too little creates income stress.
  4. Tax Loss:  If your stock is down, you use dividends for income instead of selling losing shares for income.  Selling losing shares can provide a reduction in taxes.
  5. Limited Growth:  Companies tend to pay dividends when they have limited growth prospects (e.g. utility companies).  Some of the fastest growing companies pay no dividends.
  6. Rebalancing:  By using the dividends for income, you miss out on selling from the biggest gainers in your portfolio to rebalance while generating cash.

Selling from stock investments is far superior:  you can sell from your fast-growing companies, the exact amount needed, when needed, combined with rebalancing & tax-loss harvesting.

Advisors often avoid this optimal solution, since it requires more work and careful planning.  Specifically, it requires setting dividends to reinvest, while carefully planning when to sell to avoid wash sales (i.e. selling at a loss within 30-days of the automatic dividend reinvestment).

Disclosures Including Backtested Performance Data

The combination of the 2008 stock market crash and the wave of retirees brought volatility to the spotlight, and many are looking for any way to reduce it. This article questions the idea of sacrificing returns to reduce volatility, and suggests ways to be happy in retirement while investing in a volatile portfolio.

The article is aimed towards retirees who want income for as long as they live. To achieve that, a limited annual withdrawal from the investments is assumed (e.g. 4% of Long-Term Component by QAM, and 3% of Extended-Term Component). With higher withdrawal rates, you take a real chance of outliving your money.

Volatility is the movement of the portfolio price up and down around its average growth. The greater the volatility, the further the returns tend to go below and above the average. A simple way to reduce volatility is to combine multiple investments that don’t all move in the same direction at all times. Ownership of one fast growing company can provide substantial returns, or a total loss. By adding many companies from various industries and countries, you virtually eliminate the risk of total loss.

Even without a total loss, substantial declines can be problematic for retirees. Retirees depend on their investments for immediate income. They cannot decide to stop eating because a 50% decline occurred. A withdrawal of $1 at a 50% decline costs $2, resulting in a substantial loss on the withdrawn amount. This leads retirees and financial professionals serving them to try to minimize volatility. It seems logical, at first.

If volatility were not a consideration, retirees could put all of their money in stocks and get nice long-term average returns. In order to reduce the volatility, most retirees put a meaningful portion of their money in less volatile investments such as bonds. This allocation indeed moderates the declines, and can significantly reduce the excess cost of withdrawals during deep declines of stocks.

Volatility Cost

Assume that you are a retiree living on 4% of your stock portfolio Long-Term Component, or 3% of Extended-Term Component. The total effect of declines on the annual withdrawals during the 3 most harmful declines as simulated since 1970 is:

Cost of Retirement Withdrawals from Stock Portfolios During Severe Declines

4% annually from Long-Term Component

3% annually from Extended-Term Component

Decline to New Peak Cost 1 Decline to New Peak Cost 1
4/1973 – 12/1975 2.5% 7/1973 – 12/1976 2.7%
4/2000 – 5/2003 1.4% 1/2000 – 11/2003 4.8%
11/2007 – 6/2013 2 7.3% 11/2007 – 6/2013 2 6.5%

Even severe declines resulted in very small losses to a retiree thanks to limited withdrawals and global stock diversification.

Volatility Tradeoff

The next table shows the long-term average cost of withdrawals during declines, and impact on the returns:

Cost of Retirement Withdrawals from Stock Portfolios During Declines

Annual Average 1/1970 – 6/2013

Portfolio & Annual Withdrawal Rate Returns Cost 1 Net Returns 3
4% from Long-Term Component 16.4% 0.35% 16.1%
3% from Extended-Term Component 19.2% 0.46% 18.7%

The withdrawals during declines reduced the returns only minimally. The net returns above are the returns achieved with a portfolio that never experienced a decline.

Solutions that reduce the volatility of stock portfolios (only partially), cost far more than the costs above (<0.5%), and result in far lower average returns, erasing the entire financial benefit of volatility reduction. As an example, bonds don’t provide annual returns much higher than 5%-8%. 

Happy Retirement with Volatility

So far, we saw that reducing volatility is likely to hurt the retiree’s financial security. Yet, living through the decline periods can be tough psychologically. How can you stay happy while going through deep and prolonged declines?

  1. Remember that the impact of severe declines on your limited withdrawals is very small.
  2. When investing in a globally diversified stock portfolio, declines don’t sustain. The declines are like pressing a spring very tight – at some point it is released and there is a surge. While the well-publicized concentrated investment – the S&P 500 – had extended downturns, the returns for the globally diversified portfolios were much better in all 10-year periods as simulated since 1970.

     

    Range of 10-year annualized returns 1/1970-6/2013

    Portfolio Worst Average Best
    S&P 500 -3.4% 10.2% 19.5%
    Long-Term Component 6.3% 16.4% 28.3%
    Extended-Term Component 4.4% 19.2% 40.5%

    If your average returns in recent years were on the low end of this scale, or even below it, you can be optimistic that your chances are for better than usual returns (no guarantees).

  3. Supporting the point above is a simple view of valuations (price/book, or liquidation value) of your portfolio. Typically, after extended periods of poor performance, the valuations of the portfolios become much lower than typical. They reflect the fact that people tend to over-sell investments when there is bad news or uncertainty. Supporting the “over-selling” theory is the fact that deep and long declines don’t start with low valuations – they start with high valuations. So, when valuations are low you can be much more optimistic than usual.
  4. The expectation for returns to be meaningfully positive over time is logical. Companies use materials, labor and capital to generate added value. While a number of companies can fail, the whole system of efficient production is likely to stay with us, since people typically want things done for them in the cheapest and most efficient way possible.
  5. If you listen to the economic news frequently enough, you are likely to expect every large decline to be “the new normal”, where returns don’t revert back to the typical. This has been predicted many times before, and always turned out to be wrong. In addition, the news typically focuses on concentrated portfolios in just one or a few countries.

1 For example, a year-long 20% decline combined with a 4% withdrawal, costs 1% calculated as: 4% of the remaining 80% = 4 / 80 = 5% = 4% of the peak + 1% penalty for selling during the decline.

Note: Investment taxes (taxes on dividends, capital gains distributions, and capital gains) are not accounted for, as they are dependent on the investor’s tax rate. They are not material enough to change the conclusions of this article.

2 A peak was reached, but the portfolio declined since then. While there are no guarantees, conservative assumptions lead to a small expected additional cost of 0%-2%.

3 Net Returns = Returns – Cost [of withdrawals during declines]

Disclosures Including Backtested Performance Data

Some people expect demand for stocks to decline given the large wave of Americans approaching age 65. This article questions this expectation.

Investment professionals often recommend that investors shift their investment allocation from stocks to bonds as they approach retirement age. The combination of the spike in people approaching retirement age, and growing longevity, may lead you to expect a big shift of demand from stocks to bonds. Below are several reasons why this big shift may never happen.

Bonds are too risky for the long run

While bonds reduce the short-term risk of stocks, they carry a risk of their own. The combination of inflation with increased longevity can erode the value of bonds, introducing the risk of running out of money, slowly and painfully. There are three ways to reduce this risk:

Work longer

People in good health, and with moderate assets, are likely to work longer. They may spend similar time in full retirement as retirees 50 years ago. They will do so by spending most of their increased longevity working, full time or part time.

Spend less

Those with health conditions that prevent them from working and without substantial assets will have to limit their spending to their social security income and whatever resources they have. Either they will reduce their spending early on in retirement, or they will gradually reduce their spending as they deplete their assets.

Invest in stocks, if you have the money

Those with substantial assets relative to their spending will benefit from the option to sustain a low withdrawal rate from their savings in retirement. When you can commit to a low withdrawal rate, stocks (globally diversified) are safer than bonds. Specifically, the risk of depleting the investments due to withdrawals during severe declines is very small. For those who happen to live long, the risk of stocks tends to keep declining, while the risk of bonds tends to grow.

Annuities do not solve the problem

Annuities are simply a window into bond investments (since insurance companies put money backing annuities in stable investments such as bonds), but with high administrative costs. They add the longevity protection and, in some instances, inflation protection, and reduce the income paid in order to finance these protections. Just as a retiree would not put substantial assets into bonds to finance increased longevity, he/she would not finance the bulk of retirement income using annuities.

Literature Support

A paper by the Congressional Budget Office (CBO), published in September 2009, provides evidence to support this article’s claims, with many interesting angles on the topic.

Summary

As people live longer, they have a choice between working longer, reducing spending, or investing more in stocks. Investment advisors and individuals are gradually realizing that bonds are too risky for financing the increased longevity. This realization may accelerate at times with elevated inflation.

http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/105xx/doc10526/09-08_baby-boomers.pdf

Disclosures Including Backtested Performance Data

Some people believe that the present is far more important to them than the future. This article argues that this is not true for most people.

Say you believe that the future, 5 years from now, is substantially less important to you than today. Please answer the following questions:

  1. Did you hold a similar belief 5 years ago? If yes, read further.
  2. Do you believe that the present is at least as important as 5 years ago?

If you answered “yes” to the last question (as most people would), there is a contradiction: 5 years ago you believed that the future 5 years away (i.e. today) will be substantially less important, yet, today, you disagree. This means that you had trouble accepting the importance of your future needs, and there is a good chance that you are acting the same way today.

More considerations:

  1. While the present is tangible and certain, you have to be sure that you will not be around in 5 years in order to ignore this future. I haven’t met any person aggressive enough to ignore the possibility of living beyond a certain age.
  2. Humans keep living longer. Please don’t underestimate this effect, and be wary of naming any age that you are certain to never reach.
  3. Future needs are easier to finance thanks to the likely growth of your investments over the years (twice as easy after 6 years with 12% real growth, and 4 times as easy after 12 years).

Conclusion

You can assess for yourself the importance of the present compared to the future, but be aware of a psychological bias that may lead you to prefer the present too much, simply because you discount future suffering compared to present suffering.

Disclosures Including Backtested Performance Data

You can achieve financial freedom using an investment that provides income for as long as you live. A globally diversified stock portfolio with limited withdrawals addresses this need well, and has the side effect of likely leaving your heirs with a large pot of money. While you may be happy to help them out, you may prefer to enjoy more of your money during your lifetime. The article explains why this is impossible, and why it should not bother you.

If you can save a large enough amount, to allow you to make very limited withdrawals from your investments (typically 3%-4% per year) and cover your expenses, a globally diversified stock portfolio may be your best solution for income for life. It provides a unique combination of benefits:

  1. Income for life . If you choose a low enough withdrawal rate, and keep the diversified portfolio with no individual stock selection or market timing, the portfolio may provide you with income forever, which, by definition, includes the rest of your life.
  2. Automatic inflation adjustments . Since inflation is the increase of the cost of goods and services, and you own the companies that provide these goods and services, their income and value ultimately grows with inflation. This allows for the portfolio to withstand growing withdrawals that are adjusted for inflation.
  3. Availability for unusual expenses . The entire investment is available to you at all times, and can support some level of unusual expenses, beyond the typical withdrawal rate. This flexibility can be very valuable if you want to move to a more expensive house, or face a large medical bill or any other extraordinary expense. (This applies to infrequent excess withdrawals – withdrawing a higher percentage for many years in a row will put you at risk of running out of money during your lifetime.)
  4. Growing income, beyond inflation . The investment is expected to grow over time, despite the ongoing withdrawals. During declines you can keep the income constant (with inflation adjustments). In all other times, as the portfolio reaches new peaks, withdrawing the same percentage of the peak value provides growing income.
  5. Money left for heirs or charities . A side effect of the money growth is that you get to leave a large pot of money to your heirs or charities of choice.

The problem : While most people are happy to take care of others through the money they leave, some may prefer to enjoy more of their money during their lifetime, while leaving behind a smaller amount.

No solution : Since you cannot know your lifespan in advance, you cannot plan to use up most of your money during your lifetime. Say you increase your withdrawal rate, with an aim to use up most of your money by age 95 (or pick any other specific age). There are problems with this approach:

  1. You may live to be 100 or longer, and end up bankrupt. Lifespans have grown at a rapid rate in the past century, and it is impossible to know whether you will live to be 80, 100, or 120.
  2. A major stock market crash early in your retirement can result in depletion of your money at a younger age.
  3. Instead of seeing your portfolio grow throughout life, you are planning to see it decline over time. This means that instead of having greater means to deal with unplanned expenses, your means decline.
  4. The difference between seeing your financial security increase over time and seeing it decline over time, is remarkable. Your choice will affect your feeling of financial security every day for the rest of your life.

Why it doesn’t matter : When comparing this lifelong income generating investment to the alternatives, even when ignoring the leftover money, this solution seems superior and pleasing. Let’s review two common alternatives:

  1. Annuity : This product is designed specifically to address the need for income for life. While it can work very well, it has several flaws: (1) no flexibility for large withdrawals; (2) income grows with inflation at best – you lose all the excess income growth obtained through stocks; (3) the income depends on the solvency of a single insurance company (compared to thousands of stocks around the world).
  2. Real Estate : Owning several properties can provide income for life, but does not allow easy access to the principal. In addition, it has no flexibility for large withdrawals. On the contrary – you may incur shortfalls in income through repairs and vacancies. There are some ways around these limitations, including selling a property to cover a large expense, or borrowing temporarily from a home equity line of credit, but they tend to be more difficult to implement and limited than the easy accessibility to a stock portfolio. Despite the limitations, this solution is legitimate, and many people swear by it.

Summary

Using a globally diversified stock portfolio for generating lifelong income has many benefits, and one of them may be seen as a downside by some people – a substantial pot of money left for your heirs. There is no way around this outcome, but when comparing this solution to common alternatives, the benefits clearly outweigh this negative (for those who see it as a negative).

Disclosures Including Backtested Performance Data