Pension: where can you get a safe income of 6%? (2024)

Last year the stock market rallied all year round, and the rally continues into the new year. Most investors like the idea of ​​rising markets, and for good reason. It makes everyone feel richer. However, it becomes a challenge when you have to deploy new money into the market. If you invest every paycheck into the 401(k) and have more than 10-15 years to retire, you'll get less trading each month. In fact, a rapidly rising market is quite a bad deal for young investors with a long time horizon, because they will get fewer shares for the same amount.

On the other hand, a rising or bull market for retirees or near-retirees is actually a very good thing because they aren't putting a lot of new money to work. On the other hand, a prolonged bear market for early retirement can be devastating.

However, most retirees do not invest for total returns, but for a regular income stream while preserving capital. So, the big question facing every retiree is how to get a secure income without sacrificing or losing principles. Of course, bank or CD deposits pay next to nothing. Bonds have been in a bull market for almost thirty years and are expected to lose value in an environment of rising interest rates. Still, there are several viable alternatives; however, none are without flaws or risks. For our examples, we will assume that our typical investor needs $40,000 in annual income from the investment portfolio. The rest of the spending needs will be covered by social security or other fixed income.

We will discuss three options; the first two offer only 4% income, while the third option aims to generate 6% incomewith less volatility and less resistance.

Option 1: Traditional 4% payout method

It's often said that as long as you have 25 times your annual expenses, that should be enough. The traditional advice is as follows:

• Keep 1 or 2 years worth of expenses insidecash as securities.
• Invest the balance in a 60:40 or 70:30 stock/bond portfolio (usually in mutual funds or ETFs) and rebalance it every year.
• Subtract the inflation-adjusted 4% each year to replenish the two-year checking account.

Here are some potential problems with the above advice:

• This is designed with an average pension of 25 years. However, every person is an individual and the term 'average' loses its relevance when we talk about an individual. In addition, average life expectancy has increased, meaning that people have to continue working much longer than the traditional retirement age.
• To live on 4% of the portfolio, you generally need a large portfolio size. However, this may vary from person to person depending on their expenses. For example, to earn $40,000 in annual income, the retiree would need an investment portfolio of $1 million. Anything less will result in an income gap. To make matters worse, the two-year cash component would be needed in addition to the $1 million portfolio. After adding the two-year cash component, investment capital should be approximately $1.1 million.
• This approach is especially risky if there is a prolonged bear market in the early retirement phase. A prolonged bear market at the beginning of the pullback phase can lead to major portfolio depletion, which can be difficult to recover from.
• Another potential problem would be a scenario where retirement takes much longer. For 35 or 40 years? Can you afford to run out of money at age 90? Money should be the last thing you should worry about at that age. In our opinion, to retire safely and worry-free (at least from a financial perspective), you should have a retirement fund that is approximately 35 times (instead of 25 times) your annual expenses.

Option 2: Conservative dividend stock portfolio - 4% return:

This option is nothing new, in fact, it is a very popular approach among DGI (Dividend Growth Investing) believers. If you still have a few years before you actually have to live off the income from your investments, and you buy and accumulate shares over a long period of time, that is a solid approach.

A DGI portfolio of solid, large, blue-chip companies will take about five years to produce 4-5% or more revenue. Typically, such a portfolio will start with an average return of 3% or less, and with dividend reinvestment and annual dividend increases, the annual return should be well over 4% within 5 to 7 years. Alternatively, if you combine a few REITs with higher-yielding but relatively safe stocks like AT&T (T) and Verizon (VZ), you can get a starting dividend of 4%. Nevertheless, it is generally advisable that you start a DGI portfolio a few years before you actually retire and reinvest the dividends until you actually retire, to take out 4 to 5% income in retirement. After that, we can safely assume that any inflation would be absorbed by dividend increases.

This option is solid and much safer than option 1 because we never withdraw or deplete the capital. Another benefit is that if for some reason dividend income does not grow sufficiently in line with inflation for a number of years, this would be a signal to temporarily tighten our belts and reduce spending for a number of years. The biggest mistake is that you need to have a large amount of capital to generate the income. Some people may also suggest that our investor will leave too much money behind. But in our opinion it's a good problem to have. They could leave it to their heir or their chosen charity or a combination thereof. There may also be RMD (required minimum distribution) issues if the money is in an IRA. RMD situations can vary greatly from person to person, which is why it is too big a topic to cover here in this article. But overall, a large portion of the RMD could be covered by the dividend income generated.

Below you will find a table with 25 examples of dividend shares that, if invested equally (based on prices as of January 23, 2018), would yield an initial yield of 4.12%. However, the most conservative investors should only aim for an initial yield of around 3%.

Option 3: Nearly 6% safe income with less drawdown

After all, the stock market is at an all-time high, and the run could continue for much longer. However, we know that the bull market won't last forever. The longer the bull run continues, the greater the risk of a major correction will be. This option is worth considering if you are constantly worried about a potential market downturn and what it will do to your portfolio. If your income needs are higher than 4% of your portfolio size and you can't tolerate very large drawdowns, this option is worth a look.

Is the income really safe?

On a relative basis we think so, even though nothing in the investment world is 100% certain. Now we have seen that both option 1 and option 2 require high starting capital to generate a reasonable income. With this option we try to achieve a higher return with less capital and limit any additional risks by using multiple strategies. In fact, this option results in higher income, market-beating total returns, and smaller drawdowns. We will try to demonstrate this in a moment.

We will invest in three different portfolios, or we can call them baskets, buckets or whatever name you like. However, for younger people we recommend an additional fourth growth bucket.

As with options 1 and 2, let's assume we have a total investment capital of $1,000,000.

Emmer 1: DGI core portfolio (40%)

Invested Capital: $400,000 (40%)

Total return target: 10-12%

Dividend target: 4%

No retirement portfolio could ever be complete without a DGI bucket. This should form the basis or 'core' of our investments. Just like the foundation of a house, the foundation of our portfolio must be strong. You should select the strongest stocks available at a reasonable price using the following criteria:

• Large-scale, blue-chip company with a significant moat in its sector.
• Dividends at least equal to those of the S&P500, or preferably 3%.
• Must have increased dividends in the last 10 years. Even better 20-25 years. SA writer David Fish's CCC list is a good place to start.
• Maximum 3 or 4 names from the same sector. At least one company from each sector.
• Reasonable valuation at purchase. Alternatively, you can purchase using the DCA (Dollar Cost Averaging) method.

For the DGI portion, we can use the same stocks as mentioned under Option 2 (Conservative Dividend Portfolio) above in this article.

Here is the same 25-stock table as mentioned earlier, but with a total allocation of 40% (dividend as of 23.01.2018).

If you absolutely hate owning and managing individual stocks, your next best option is to hold some low-cost, dividend-focused ETFs.

Bucket 2: Risk-adjusted portfolio

Invested capital: $350,000 (35%)

Total return target: 10-12%

Income target: 6%

We will propose two different strategies here. As such, you can choose either or own both by dividing this capital between the two to ensure better diversification. Of course, there will be more work if you decide to choose both.

Strategy #1:

Sector rotation:

While the dividend yield with this strategy will be similar to the S&P500 (typically around 2%), we assume the remainder could come from pullbacks. The main benefit would be that we would invest in the two best-performing sectors of the economy at any given time, rather than investing in all ten sectors. If neither sector outperforms the risk-free assets, we will invest in 10-year government bonds and/or cash. Although the strategy can have so many variations, the backtest results of such a strategy are given below. The lookback period for measuring performance is three months with monthly rotation.

Strategy #2

Modified 6% income strategy:

We call it custom because it differs slightly from our original '6% revenue strategy' used in our marketplace service. However, the performance is comparable. This strategy invests in four CEFs (EVT, FFC, KYN, NMZ) along with TLT/IEF and uses SHY or CASH as the hedging asset. Investments are typically made in the four CEFs (25% each) as long as each of the CEFs has outperformed the risk-free assets with a three to four month look back period. The lookback period can vary from 3-6 months or a combination of more than one month. 50% weight each at 3 months and 6 months. If any of the CEFs have not performed well enough, that particular CEF will be replaced by the 10- or 20-year Treasury fund in the coming month. The rotation is monthly.

The main advantage of this strategy is that it would generate a consistent income of around 6% thanks to the high distribution from the CEFs. However, there is a caveat: this strategy may not work as well during a raging bull market as we are currently seeing. However, it must compensate for periods of stress or panic while preserving capital. To give a general idea, below are the backtest results of such a strategy, going back to the year 2006:

List of effects:

• Eaton Vance Tax-Advantaged Dividend Income Fund (EVT)
• Flaherty & Crumrine Preferred Securities Income Fund (FFC)
• Kayne Anderson MLP Investment Company (SIX)
• Municipal High Income Opportunities Fund Nuveen (NMZ)
• iShares 20+ year government bond ETF (TLT)
• iShares 7-10 year government bond ETF (IEF)

Bucket 3: CEF's portfolio - 8% income

Invested Capital: $250,000 (25%)

Total return target: 10%

Income target: 8%

This corresponds to our regular '8% Income CEF' portfolio. We recently provided an updateher.

Total income from combined portfolio:

Let's look at the risk and withdrawal potential:

One method is to look at how specific securities would behave during a crisis or recession, by looking at how they behaved during the 2008-2009 financial crisis. While there's no guarantee it will be exactly the same next time, it gives you an idea. The table below assumes the net declines of each security type based on their respective behavior in 2008-2009.

* This is the assumed net price decrease after deduction of the 8% benefits.

Conclusion:

We are not advocating that the high-income strategy is the best strategy for everyone. You have to look carefully at their personal situation, especially their risk tolerance. If someone has a $2 million portfolio and his or her income needs are only 2% of the portfolio size, we think a DGI strategy would be great and cover all the bases. However, with smaller portfolios it becomes difficult to generate sufficient income through index investing alone or even the DGI strategy. What we need in such situations is a slightly more diversified approach, as option 3 described above. It delivers much higher income, better diversification of strategy and assets, market-beating returns and a third less movements.

Disclaimer:The information in this article is for informational purposes only and should not be construed in any way as financial advice or a recommendation to buy or sell any stock. Always do additional research and do your own due diligence before investing. Every effort has been made to accurately represent data/information; however, the author does not claim 100% accuracy. The stock portfolio presented here is a model portfolio for demonstration purposes; however, the author has many of the same stocks in his personal portfolio.