Why you should stop using dividend yield to calculate your retirement sum

The question everyone avoids

Most people want to retire. Even more want to retire early. But, not many know they can retire. Like running a race, the most important thing to know is where is the endpoint, and how long more you have before reaching the endpoint.

Two ways of calculating the retirement sum

There are basically two ways of calculating your retirement sum. The first is the savings method. In this method, you basically set aside a sum of money, and withdraw it till it depletes. The rule of thumb is to plan for age 100, whereby your retirement sum will be this formula: monthly expenses x 12 x (100 - your age when you choose to retire).



I do not support this method because your monthly expenses will always increase, and you might be in a situation whereby your needs become more than the savings that you have. This is also why many retirees end up turning to their children for income. On a side note, this is also what many insurance agents use for retirement planning for their clients.

The second method is to have an investment sum that never depletes, and you will draw out a sum of money every month that does not deplete this investment sum. The correct way to do it is using the withdrawal rate. The withdrawal rate is the rate of taking out money from the investment that does not deplete the investment. In this case, retirement sum = monthly expenses x 12 / withdrawal rate.

The wrong withdrawal rate

I have seen people say that the withdrawal rate is simply the dividend yield of your investments, or the average yield of your REITs. This is absolutely wrong. Let me explain.

When you take the dividend yield of your investments, you are ignoring the capital appreciation potential of your investments. In a growth portfolio, the dividend yield is likely to be small, and you end up overestimating your investment sum. In other words, you could have retired much earlier.

In a dividend portfolio, your dividend yield is likely to be high. In this case, the total amount of your investments is likely to stay the same or grow very little, even though inflation is eroding their value. If you use this, you will end up with a retirement sum that is underestimated. Putting it in another way, you have retired much earlier than you should.

Since taking the dividend yield of your investments is not accurate, taking the average yield of your REITs as the withdrawal rate is even more absurd. REITs have a high dividend yield, and doing so grossly underestimates your investment sum. You might find yourself going back to work after you have retired but realised you don't have enough money.

The right withdrawal rate

Theoretically speaking, there isn't a right withdrawal rate. From this point on, I would like to quote from my book, Building your Financial Skyscraper.


The withdrawal rate is deemed as a rate of taking out money from the total sum that does not deplete the total sum. A safe withdrawal rate is 4%. Research has shown that by withdrawing 4% of an investment portfolio yearly, the investment sum can remain intact through various stock market peaks and troughs. This withdrawal can be done through receiving dividends, or selling off shares.

As with all research, they suffer from hindsight bias. The exact same conditions in the past might not be present in the future. The research that was done was conducted in a period of 7% real return, and might not be so in the future.

To be very sure that your investment sum would not be depleted, the withdrawal rate can be more conservatively lowered to 3%.

Conclusion

Using this withdrawal rate, it will ensure that I have enough income to retire on, as well as maintain the investment sum. Because there is still growth in the investment sum, the monthly income rises when the investment sum rises, thus mitigating the effects of inflation to both the monthly income and the investment sum itself.

For instance, if I estimate that my monthly living expenses would be $2,000 when I just retired, then I would need around $800,000 when I retire ($2,000 x 12 / 3% = $800,000). $800,000 when you retire is entirely possible, and you can do this while still keeping your day job.

For further reading, read this post on how to invest (link), where you do not need any investing knowledge. Or, you can get a copy of my book (link), where I take your through step by step on how to achieve financial freedom.

Regardless, remember to sign up for my email list, where I send you special, hidden goodies that are not available anywhere else!
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8 comments

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Cory
AUTHOR
15 August 2016 at 22:55 delete

There are stocks which can provide 4%-8% returns with long term capital gains.
I think it still boils down to stock selection.

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15 August 2016 at 23:46 delete

Hi Cory, does the 4-8% include dividend yield and capital appreciation?

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RayNg
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16 August 2016 at 10:22 delete

You don't need $800K for $2K monthly living expenses.

You can do it with CPF retirement account (RA) with enhance retirement scheme (ERS). Current ERS of $241K yield ~$1.8K.

The only downside is this cash flow comes after age 65.

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17 August 2016 at 00:22 delete

Hi Cory,

If you can get 4-8% in dividends, and still have capital growth, then you wouldn't need to do index investing. I think you are probably an expert. Congratulations to you!

My strategy is more for people who are not experts, but still want to invest. Stock selection harms the average investor because of natural human biases and irrationality.

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17 August 2016 at 00:23 delete

Hi Ray,

You are absolutely correct. CPF ERS is a very good option for many people. However, as you have also correctly pointed out, it is hard to utilise for people who want early retirement before age 65.

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Cory
AUTHOR
17 August 2016 at 21:51 delete

I am quite certain me not reach expert. :)
I know that ST Index long term is 7%.If remember correctly includes roughly 3.5% dividends. That's mean 3.5% growth.

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18 August 2016 at 14:59 delete

Hi Cory,

Yes, it is around 7%, but that is before inflation. The US market had a post-inflation return of 7%, and the withdrawal rate recommended was still 4%. Considering this, a 3% withdrawal rate would be more conservative considering that the future performance of markets might not be as good.

So, you do stock selection? You can always consider index investing :)

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