I plan to live off my dividends…and you can too.
Recently, I discussed the logic behind the Dri Dividend Growth Strategy. If you are still not sure how we buy and sell stocks, click here for a quick tutorial.
This week, I want to explain how it’s possible to live off dividend income and how much is needed to accomplish this goal.
First, a bit of background…
It’s generally recommended in financial planning that retirees save a pool of money/assets sufficient to fund annual withdrawals until their expected age of death (say, 90 years old).
The theory is based on the famous saying, “I want my last cheque to bounce.” Which really means that a retiree spends their last dollar more or less on their deathbed.
Sounds like a great plan. However, it’s seldom that easy.
My experience shows that most people die with money in the bank. I believe this happens because no one knows exactly when they will die nor do they know how much money will be required to fund their later years especially if a severe and prolonged illness arrives. Hence, they reduce spending and conserve savings).
For example –
If Mr. Anxious plans to retire at age 65 and has an annual lifestyle expenditure of $100,000, he will need to save approximately $2M to fund his retirement.
Here are some assumptions: average rate of return is 4%, inflation is 2%, expected death is at 90, and monthly withdrawals are approximately $8,500 before tax.
In short, he can withdraw approximately $8,500 monthly, increase withdrawals annually by 2%, and run out of money at 90.
Obviously, there are problems with this method:
- How does anyone know how long they will live? What happens if they live to 100? Will they need to find a job at age 90?
- No one can accurately estimate their lifestyle expenditure 25 years into the future. What happens if inflation is higher than 2%? Or if they need special medical care which comes with much higher daily costs?
- How can anyone predict the long-term average of their investment portfolio? What happens if the average rate of return is lower than the projected 4%? Or the actual returns are low in the first years of retirement and higher in the later years?
Personally, I find this approach plagued with problems, rendering the projections almost useless. Hence, we must develop a better method to estimate the amount of money needed at retirement, and the approach must be adaptable enough to handle anything that happens in the future.
Here’s my alternative solution. I call it the Dri solution!
Forget the retirement calculator. Instead, take out a sharp pencil and clean sheet of paper. I’ll show you how anyone can quickly and simply calculate how much is needed to fund a retirement lifestyle.
For this illustration, I’ll use the XIU.T (iShares S&P/TSX 60 Index Exchange Traded Fund) to prove that anyone can structure a plan to live completely or partially off dividend income.
I selected XIU.T because the ETF is very liquid (i.e. it can be bought/sold very quickly without affecting the price), represents the 60 largest Canadian companies, most of those companies pay a dividend, and it’s rebalanced regularly by iShares.
At the time of writing (February 24th, 2021) , the yield paid by the 60 largest Canadian companies, as represented by the ETF XIU is approximately 2.8%, to simplify the math, I will round up the dividend yield to 3% and assume I can earn a 3% dividend on my stock portfolio for the foreseeable future ( lets ignore capital gains for the moment)
My financial independence approach involves investing my savings in dividend-paying stocks until the dividend income from the investment portfolio equals my lifestyle expenditure. Once this milestone is achieved, I consider myself financially independent for life.
Getting back to Mr. Anxious, remember he needs $100,000 annually to fund his lifestyle. Assuming he invests his savings in the XIU.T, and that he doesn’t want to encroach on the capital during his retirement, he will need to set aside approximately $3.4M of savings in XIU.T to achieve his income requirement.
Here’s the math: $100,000/3%= $3,333,333
Let me rephrase this point: If Mr. Anxious invests $3.4M in XIU.T, his investment portfolio will earn approximately $100,000 of annual dividend income (before tax) without touching the capital (as of February 24, 2021).
But wait, not so fast Richard! What about…
1. Inflation
Many readers wonder if the dividend stream will keep up with inflation.
For example, to cover an inflation rate of 2%, Mr. Anxious needs $100,000 in 2021, $102,000 in 2022, $104,040 in 2023, $106,120 in 2024, and so on until his death.
From its inception on September, 28th 1999 to March 30, 2021, the cumulative distribution paid by XIU.T was $11.75 on an initial price of $10.00 per unit. The simple math represents an annual distribution of approximately 5.6% against an annual inflation rate of approximately 2.1%(https://www.statista.com/statistics/271247/inflation-rate-in-canada/ )
In short, distributions outpaced the inflation rate ( from inception to end March 2021).
2. Taxes
In Ontario, the 2021 combined federal and provincial tax rate on taxable income between $98,040 and $150,000 is 43.41% for interest income, 21.70% for capital gains, and 25.39% for eligible dividends.
So $100,000 of dividend income produces an after-tax cash flow of $74,610. However, if the same $100,000 was invested in a GIC, the after-tax cash flow would drop to $56,590 (because it’s considered interest income).
In short, if Mr. Anxious planned to fund his retirement with dividend-paying stocks, he would need to save approximately $3.4M. Alternatively, if he planned to use GICs to fund his retirement, he would need an additional 24% (approximately $4.13M) of savings to have the same after-tax cash flow…
3. The initial capital
Remember that the Dri retirement method recommends living off the stream of dividend income and not spending the initial capital invested (in our example, close to $3.4M).
You might be wondering: What happens to the initial capital over the retirement period?
Of course, no one has a crystal ball. But if Mr. Anxious invested $3.4M in XIU.T in September/1999, his capital would have increased to approximately $9,600,000 by the end of March 2021 ( not including dividend reinvestments).
In summary, since September 1999, that $3.4M in XIU.T would have produced a steady flow of distributions that increase most years and covered inflationary increases AND the initial capital continued to grow at the average rate of approximately 4.20% compounded annually.
Don’t forget, Mr. Anxious only spent the distributions.
It’s a win-win solution: a rising annual cash flow and increasing capital value.
4. Higher savings
The Dri retirement plan requires a lump sum at retirement of approximately $3.4M. But if we plan to draw down our capital during retirement (assume a 25-year retirement, inflation of 2.25% and an investment return of 5% average), the required savings would drop to approximately $2.2M.
In short, the Dri solution requires an additional savings of approximately $1.1M but provides protection from life events such as living beyond 90 years old, increased inflation, and higher living expenses.
I am not trying to under-emphasize the implications of saving an additional $1.1M during your working career, because we all know it’s not a simple achievement…
Instead, I’m suggesting that investors live off the dividend income that their retirement pool generates and not touch the capital forever (or at least until their late 70s). So, if Mr. Anxious saved $2.2M, he should adjust his living expense to match up with his dividend income.
If we make the same 3% dividend assumption (as used above), the investment pool generates $66,000 (pre-tax) without drawing down capital. By spending only the dividend income stream, Mr. Anxious reduces the risk of outliving his money or experiencing a large inflation erosion.
Other considerations:
Lets not forget that accumulating $2,000,000 or $3,300,000 requires deliberate savings over a long time frame and a successful investment strategy. I believe all Canadians can save and invest on their own but using an advisor has been documented to improve long term returns.
In a recent study by Morningstar, (entitled Alpha, Beta and Now), they estimate that investment returns improve by 1.82% for those who use professional advice to make their financial decisions. A similar report by Vanguard (entitled Advisor Alpha) estimated the advantage at 3%.
Lastly, investors must also “Know Thyself” which for investing means: if you panic when the market go down or become greedy when the markets go up, maybe a 100% dividend portfolio may not be appropriate.
So in short, carefully analyze thyself and select an appropriate asset allocation.
In summary, financial independence is achieved when dividend income equals lifestyle expenditures.
That’s how Mr. Anxious becomes Johnny Calm.
If you are struggling with your financial independence goal, call me and we can work on a plan.
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One of Canada’s most beloved comedians and actors, Catherine O’Hara is perhaps best known for her sketch comedy work and hilarious celebrity impressions as a member of Second City. Or perhaps for her roles in Home Alone, several Tim Burton movies, mockumentaries like Best in Show, her portrayal of Aunt Ann in Temple Grandin, or her recent stint as Moira Rose on the sitcom Schitt’s Creek (alongside Second City pal Eugene Levy). With a career extending back to 1974, O’Hara’s recent performance as Moira has earned her five Canadian Screen Awards for Best Lead Actress in a Comedy Series, a Primetime Emmy Award, and a Golden Globe Award, among many others. O’Hara is also a singer-songwriter, as is her sister Mary Margaret O’Hara, and continues to write, act and sing today. With more projects currently in the works, the 67-year-old Canadian icon exemplifies the Never Retire philosophy.
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