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Living Off the Dividends and Interest

A reader writes in, asking:

“What do you think about just living off my portfolio’s interest + dividends each year in retirement instead of using the 4% rule? Seems safer to me.”

Frankly, I’m not a big fan of live-off-the-income strategies for stock/bond portfolios. (This is in contrast to fixed annuities, where living off the income is the only choice, because you no longer have access to the principal.) In many cases, following such a strategy leads to one of two mistakes:

  1. Choosing a poorly-diversified asset allocation, or
  2. Restricting your spending to an unnecessarily low level.

Causing Asset Allocation Mistakes

Regardless of the rate at which you plan to spend from your portfolio, there’s a benefit to being broadly diversified. Unfortunately, many people seeking to “live off the income” make asset allocation decisions that focus too heavily on the yield of each investment, as opposed to its risk level and expected total return.

As a recent brief published by the Center for Retirement Research put it:

“The retiree then runs the danger that the tail (the desire to consume) may begin to wag the dog (investments), resulting in a portfolio allocation that does not minimize the risk for any given level of expected return on the portfolio. That is, the retiree may over-invest in dividend-yielding stocks, losing the benefits of portfolio diversification.”

And the same goes for bonds: Basing your spending on yield makes it tempting to load up on higher-yielding (i.e., higher-risk) bonds.

Shifting your portfolio toward high-yield investments, and spending more because of the change, is simply increasing your withdrawal rate at the same time that you increase the riskiness of your holdings — not exactly a recipe for success.

Setting Spending Too Low

Unfortunately, if you avoid the above mistake and instead opt for an appropriately diversified portfolio, you’d probably have a yield of less than 2% in today’s environment, which, if you’re following a live-off-the-income strategy, would lead to a spending less than 2% of your portfolio balance each year.

For most retirees, there’s no need to restrict spending to such an extreme degree — which is fortunate because most investors obviously won’t come anywhere close to saving 50-times the annual level of income they need from their portfolio. It’s OK to spend down your principal over time, provided that you do it slowly enough.

Live-off-the-income strategies require a heck of a lot of money and leave behind a large portfolio to your heirs rather than allowing you to make full use of your savings during your lifetime. If leaving behind an inheritance is not one of your primary goals, such a strategy usually doesn’t make much sense.

In short, rather than using a live-off-the-income strategy and therefore a) loading up on high-risk, high-yield investments in order to achieve a suitable spending level or b) restricting your spending to an extremely low portion of your portfolio, I think it’s generally preferable to use a widely diversified portfolio and slowly tap into principal throughout retirement. (Or if you’re really looking for safety, delay Social Security and annuitize enough of your portfolio to know that your needs will be met from safe sources of income.)

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Comments

  1. Great article. You should also link to Vanguard’s whitepaper contrasting income vs total return distribution styles.

  2. This one?

    https://personal.vanguard.com/pdf/s557.pdf

    “Under the income approach, the investor typically spends only the income generated by the portfolio, which often is not sufficient to meet spending needs. To make up for the shortfall, many investors elect to either increase their allocation to bonds, tilt their bond holdings toward high-yield bonds, or tilt their equity holdings toward higher-dividend-paying stocks—none of which are preferred strategies for maintaining inflation-adjusted spending over long periods.”

    That sounds a lot like what I was trying to say here. :)

  3. it's a-me, mario! says:

    Bingo. That’s the one. It is similar to what you were saying, and I’ve heard Larry Swedroe say something similar too.

    Due to low yields, I am frequently hearing essentially ignore asset allocation – or deemphasize it – and instead talk about investing in high-yielding securities: high dividend / dividend growth stocks, reits and high yield bonds.

    articles like this really emphasize the importance of staying the course.

  4. Good answer Mike!

  5. Luigi, Mario's fireball-wielding friend says:

    Mike,

    How does this strategy fare for longer periods of time? For example, suppose a 50/50 portfolio where the investor limits withdrawals to investment income. At the end of the period, how does the account value compare to the starting value in real terms? Obviously it varies; but what’s been the range?

    Most of the withdrawal research that I’ve seen focuses on retirement. There is the platonic accumulator and the platonic retiree. But I think that reality is more nuanced, and I’d like to see research that addresses it. For example, as the boomers pass their retirement savings are passing to their children. What does it mean for these children to prudently manage these savings? Their options are the same as everyone else’s: spend, save and invest. But it is a larger problem to have this money completely disappear at the end of 30 years (ie just as they are entering retirement). And it doesn’t make sense to accumulate in excess either.

    Might this “spend only the income” strategy be appropriate for situations like this? Are there any other established strategies?

  6. I haven’t seen any research into that question. (Perhaps Wade is aware of something?)

    Just as far as common sense things I can say off the top of my head though, I think it would depend markedly on the asset allocation the investor chooses.

    To consider a few extreme examples…

    With a 100% nominal bond portfolio, if you spend all of the income (interest) every year, over time the real value of the income and the principal will be declining.

    With a 100% TIPS portfolio, if you spend just the interest, the portfolio value and income level should keep up with inflation over time. Of course, right now, the downside there is that, even if you went all the way out to 30-year maturities, you’d only be spending 0.36% of the portfolio’s value per year.

    With 100% stocks, who knows?

    Of course, most people wouldn’t choose 100% of anything. But it might be able to piece together a very, very rough guess for a diversified portfolio by looking at expectations for each of the pieces.

  7. Coming at this from a UK perspective, if you’re happy to have a lot of home bias (and let’s face it most investors do, whether they know it or not) then a UK investor at least doesn’t have to take the yield hit following this strategy.

    The UK’s FTSE 100 for instance has yielded around 4% on a forward basis for much of the past few years. I think that makes the strategy much more palatable (though in reality I’d be likely to go for closed-ended income funds that have a superb record in the UK market for generating annual payouts ahead of inflation here, and annuitizing a portion).

    I currently have no heirs, and no real plans to get any imminently. But nevertheless, I think I’d find it very difficult indeed psychologically to slowly run down my capital, after spending 3-4 decades getting it — even if I knew for sure when I’d die, and very few of us. At the worst, I’d go for the annuity option.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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