One caveat of the 4% withdrawal rule

Dieters experience a great deal of joy when they are able to tighten their belts an extra notch.

But financial belt tightening isn’t much fun. It’s something that came to mind when reading Andrew Hallam’s article called “Retirement Fortunes That You Can’t Control.”

He looked at the experience of two unfortunate retirees. One retired at the peak of the market in 2000 and the other at the peak in 2007. Both invested in a low-fee balanced index fund from Vanguard and withdrew 4% per year to live on.

Given their poor timing, the results weren’t entirely discouraging. While both investors suffered from an initial dip, they also enjoyed a subsequent recovery.

But—and it’s a pretty big ‘but’—the income produced by their portfolios fell when the market declined. For instance, 4% of a $1 million portfolio is $40,000. Should the portfolio fall to $500,000 then the 4% withdrawal only produces a payment of $20,000.

In addition, even after the portfolios recovered, the payments didn’t keep up with inflation. You’ll recall that inflation is the propensity for the purchasing power of the dollar to erode over time. Put alternately, it is the tendency for the price of goods and services to increase over time.

The 4% withdrawal rate, as Mr. Hallam points out, is a commonly used rule of thumb for retirees who don’t want to run out of money. The original incarnation of the rule suggests starting with a 4% withdrawal rate on retirement and then adjusting the payments to account for inflation thereafter. The idea being to fund a particular lifestyle and then maintain it over time.

Simply taking 4% out of a portfolio annually, and not adjusting for inflation, can boost a portfolio’s longevity and the payments it produces during bull markets. But it comes with the risk that the payments will shrink during down periods.

In other words, investors following this approach have to be willing to tighten their belts when the market is depressed. Retirees who are already counting every penny during good times, and are not able to cut back during bad times, will be forced to boost withdrawals near market lows and therefore run a greater risk of exhausting their savings quickly.

While there are many ways to bolster a retirement plan, they all come down to saving more and spending less. Much like the ants of yore, if you spend less during happy times, you’ll be able to weather bad ones more easily.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of June 14. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.

Source: Bloomberg, June 14, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)

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