The most important question that investors ask themselves is how much money do they need to retire. There are several things to consider, in order to answer this question. I will share those questions, and also share a rule of thumb that I have found helpful in my personal retirement planning.
1) How much money are you spending
In general, I have found that traditional rules of thumb that focused on salary income to be misleading. I prefer to focus on the spending levels in retirement. The more you save, the more you will be able to invest, and the faster you will reach financial independence. In order to get there, you need to compile a list of annual expenses from credit cards, checking accounts and other sources in order to get a reasonable gauge of past expenses. Putting everything in one place really helps in this direction.
The next step involves determining what your retirement may look like. Perhaps you will not be commuting one or two hours per day to work, and you won’t be needing professional business attire. So certain expenses would be taken out from the budget. However, if you expect to be doing more travelling, you may need to incorporate those numbers. If you are able to downsize your home, or plan to move to another location, this should also be taken into consideration.
If you expect to spend more in retirement, this means you may need a larger nest egg to support you. However, if you expect to spend less in retirement, you may get by on a smaller nest egg.
2) Other sources of income in retirement – Social security, pensions
Now that you have determined what your expenses will be in retirement, you also need to determine if you will have any other reliable sources of income in retirement. If you are planning on retiring in your 60s, you will be eligible for Social Security benefits. Some employees are eligible to receive benefits from their company pension plans as early as their mid 50s. All of those amounts need to be put into consideration.
Some retirees expect to work part-time. It is always helpful to defer spending from your investments for as long as possible. However, retirement is a time in life where you do not want to be trading your valuable time for dollars, unless you really want to. If you retire in order to follow your passions however, that would be a worthwhile endeavor for you, even if this occupation doesn’t produce much income.
For those that want to call it quits in their 30s or 40s, Social Security and Company Pensions are decades away. Therefore, you will need to rely on investment income, and possibly income from side ventures or part-time/consulting gigs.
3) This is the amount you need
After you subtract your estimated retirement income from your estimated expenses in retirement, you come up with the amount of money you need to generate from your investments.
I usually look at the average yield on a portfolio of attractive dividend growth stocks in order to determine the size of the nest egg needed to cover the expenses in retirement. For example if you need to generate $30,000 in annual income, you need to have a portfolio worth $1 million invested in companies yielding 3% today. If you manage to find companies with safe dividends yielding 4% on average today, this reduces the amounts to invest to $750,000. In the current environment, I find it easier to build a defensive dividend portfolio that will pay dividends for decades using a 3% yield. Therefore, in order to come up with amounts you need to retire, simply divide the amount of dividend income you need by the average dividend yield you are finding. Alternatively, you can multiply the amount of annual expenses times 33 for dividend yields of 3%. If you rely on a 4% dividend yield, simply multiply annual expenses by 25. Multiplying your annual expenses by 25 or 33 is a very neat and helpful rule of thumb to help you determine the amount you need to retire.
I have found that dividend income is more stable than capital gains, which is why it is an ideal source of income for retirees. I have a higher level of confidence that a company like Johnson & Johnson (JNJ) will pay me $3.20/share in dividends over the course of the next year. On the other hand, I have no idea whether the stock price will fall to $75/share or rise to $125/share. I have also found that a diversified portfolio of dividend champions and contenders purchased at attractive valuations can generate a rising stream of income for me, which generally increases purchasing power over time. This is why I expect to live off dividends in retirement.
The traditional retirement advice has been to withdraw 4% from your portfolio every year. I think that given the low bond and stock yields today, this traditional advice needs to be modified. Therefore, it is unlikely that a retiree who spends only income generated from their portfolio that yields 3% on average today, will run out of money in retirement.
4) How to get there
It is “relatively easy” to see how your investments (3) can generate the income to pay for your expenses (1). However, it may take time, effort and sacrifice to reach the amounts you need at point (3). Only a small portion of US households ever reach the millionaire status. This is why most individuals retire when they are eligible for Social Security or Pension benefits. After all, a $12,000 annual social security check is equivalent to having $400,000 invested in a dividend portfolio with an average yield of 3%. So there is clear value to income in retirement.
In order to get to the target income, you need to take full advantage of saving, investing and the power of compounding. In a previous article on how to retire in a decade with dividend stocks, I shared a spreadsheet with some assumptions on how to get to your target dividend income in ten years.
I used the following inputs:
- Monthly contribution of $2,000
- Average dividend yield of 4%
- Average annual dividend growth of 6%
- Tax-free reinvestment of dividends
After approximately 97 months ( 8 years), the portfolio generates $1,000 in monthly dividend income. After 154 months ( approximately 13 years), the portfolio generates $2,000 in monthly dividend income. It takes a total of 192 months (16 years) to reach $3,000 in monthly dividend income. You can see how it takes fewer and fewer additional months to go from $1,000/month in dividend income, to $2000/month to $3,000/month etc.
If you manage to save more money every month, you will get to your dividend crossover point much faster. However, if you have trouble finding appropriate investments, you may have to spend more time on your journey towards financial independence.
How long it takes you to reach the dividend crossover point will be dependent on your assumptions, savings rates, and curve balls that life throws at you. Unfortunately, when modeling behavior, we are limited in using linear assumptions. We all know that real life doesn’t work that way unfortunately.
Going back to our model, we can see that it would take our retiree 170 months in order to reach $30,000 in annual dividend income using the inputs set above. At a 4% dividend yield, the portfolio will be worth roughly $750,000.
Today we learned how to determine the income needs in retirement, and how to get there. We also learned a few simple shortcuts, that will allow us to quickly calculate a nest egg using a dividend yield of 3% or 4%. The more important step is to actually get down to business, and work our way towards financial independence.
Full Disclosure: I am on track to reach my dividend crossover point by 2018. As a family unit, we will reach this by the early 2020s.
- How much money do you really need to achieve financial independence?
- The Simple Math Behind Early Retirement
- Building my dividend snowball to $30,000 in annual dividend income
- Front Loading Savings for a Successful Dividend Retirement
- How to never run out of money in retirement
Article by Dividend Growth Investor