Sometimes dividends are not enough to fund your retirement aspirations.
Recent events have re-inforced the old mantra that income from shares (dividends) can fall as well as rise. In fact, in the last month, barely a week goes by without news of a major company reducing, or eliminating, its dividend payment. If you depend on dividends that's distinctly unpleasant. I therefore thought it might be useful to look at how much capital you could withdraw without depleting your portfolio.
Dividend dilemmas
Stock market history shows there are long periods when dividends do not increase in line with the cost of living. In the 64 years starting 1945, dividends endured a real decrease in value (i.e. adjusted for inflation) 27 times, or 42% of the time.
The single worst year was 1998 when real dividends decreased by 16.1%. the worst sequence of years was 1966 to 1976 when real dividends rose on only two occasions. The second worst sequence was 1997 to 2003, when real dividends rose in only one year (and then by a measly 1%).
Let's be crystal clear; income (dividends) has to rise at least in line with inflation to maintain your standard of living. Anything less and you're getting poorer.
Since there is a reasonable chance of dividends not performing in this respect, I decided to look at how much capital it was safe to withdraw from a share based portfolio. Using data from the Barclays Gilt Equity Study 2009, I analysed all twenty- and thirty-year periods since 1945 and made the following assumptions:
- the portfolio was 100% invested in UK shares
- the annual portfolio value included re-invested dividends
- the retiree withdrew an initial 4%, 5%, 6% or 7% in the first year
- that initial amount was increased each year in line with the cost of living (a proxy for RPI) for the next twenty or thirty years; and
- no allowance was made for transaction, management or other charges.
From 1945 to 2008 there were 35 sequential periods of 30 years, the final one ending in 2008. In three cases the portfolio was depleted before the retiree breathed his final breath, but in many cases the retiree left a very decent inheritance.
Let's look at two of the successful and unsuccessful retirement periods to draw some general conclusions.
Meet Mr Lucky...
Mr Lucky, assuming his starting portfolio was £100,000, made his first withdrawal of £4,000 (4% of starting capital) in 1974. He index linked each subsequent withdrawal so that in his final year of retirement, thirty years later, he withdrew nearly £25,000. Now, to maintain your annual purchasing power over 30 years is remarkable. However, even more remarkable is that even allowing for all those inflation-adjusted withdrawals, Mr Lucky left his heirs with an astonishing £8.4m in 2003.
Mr Lucky timed his retirement to perfection, leaving work just after the worst stock market collapse in UK history and just six years before the best bull market in UK history.
...and Mr Unlucky
Mr Unlucky had the misfortune to be two years older and retired in 1972, just before the largest UK market crash. Big mistake. By 1974 his initial £100,000 had been reduced to £32,000 and by 1995, using the same assumptions as Mr Lucky, he was broke.
This is not a problem just associated with the 1970s. Applying identical assumptions to a person who retired in 2000 would mean his £100,000 is now worth about £45,000.
The table below shows the results for withdrawal rates from 4% to 7%. I have calculated the 20-year success rates and these are also included. Success means still having money in the final year.
| Initial withdrawal rate | Success rate (30 years) | Success rate (20 years) |
|---|
| 4% | 91% | 98% |
| 5% | 74% | 91% |
| 6% | 60% | 80% |
| 7% | 37% | 64% |
These results surprised me. I thought a 4% initial withdrawal, annually increased by RPI, would have a better survival rate than 91% over 30 years. In fact, 4% is only marginally higher than an indexed-linked annuity would provide to a 60 year old man (the best rates were 3.6%-3.7% at the time of writing).
And remember these are investment returns before charges. Anyone paying an annual 1.5% to 2% to fund managers would be well advised to adopt a more conservative withdrawal strategy.
What about just relying on dividends?
Of course, the conservative investor would just respond, why not rely on dividends and never touch the capital? The big advantage of a dividend-only policy is that, by definition, you never run out of capital. The disadvantage is that you are constrained by the level of dividend yield in the year you commence withdrawals. For instance, in the examples above the dividend yield was 3.2% in 1972, but 11.7% in 1974. You are also vulnerable to the not infrequent years when dividends do not keep pace with inflation.
By 1985, thirteen years after his retirement, the 1972 retiree's annual dividend income had increased from £3,200 to £12,800. Unfortunately, to keep up with inflation and therefore maintain the standard of living an annual income of £13,600 was required.
How to avoid portfolio depletion
The best method to avoid portfolio depletion is to avoid portfolio withdrawals immediately before a savage bear market. The second best way is to have an investment approach which beats the index and its dividend flow. For the rest of us there are three ways of mitigating financial disaster in retirement:
1. Adopt a sensible asset allocation, including commodities, index linked securities and bonds as well as shares.
2. Build in an adequate margin of safety, whether relying on capital drawdown or dividends.
3. Downshift your lifestyle in times of market declines, and withdraw less.
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