Live exclusively on dividends or eat up your capital?

When we are finally able to be financially independent, a fundamental question arises. Are we going to live the rest of our lives by gradually eating away at our capital? By leaving our heirs almost just enough to pay for our funeral? Or are we going to live exclusively on our income (dividends) and leave our capital intact? This question is very important. The way we answer it influences a priori our way of life once we reach retirement. It determines the wealth that we pass on to our heirs and the time needed to achieve financial independence.

Eat your capital

The study Trinity published in 1998, focused on studying the impact of capital withdrawal rates ranging from 3% to 12% per year on several portfolios composed of different weightings of US stocks and long-term US government bonds. The backtest was carried out from 1926 to 1995. This covers in principle all possible and imaginable events to which an investor and a retiree may be subjected. An update was carried out in 2011, taking into account data up to 2009.

The Trinity authors analyzed varying withdrawal rates, across portfolios with different allocations. They also looked at them in terms of their expected lifespan.

The Teachings of Trinity

In short, here are some interesting elements that emerge from this study:

- The negative impact of inflation on the purchasing power of retirees should not be underestimated. This is all the more true since retirement is taken very early. The data given below all take this variable into account.

- The longer the expected life of the portfolio, the greater the share of shares should be (greater than 75% beyond 40 years).

- A withdrawal rate of 3.5% per year on any balanced portfolio (stocks/bonds) has a life expectancy of 40 years.

- A 75% stock / 25% bond portfolio has a 98% chance of surviving for 30 years with a withdrawal of 4% per year.

- Withdrawals lasting more than 15 years with withdrawals greater than 5% per year show low probabilities of success.

- Equity-dominated portfolios using a withdrawal rate of 3 to 4% can create wealthy heirs at the expense of the retiree's current standard of living.

The website Retire Early conducted a similar study at Trinity using an alternative database covering the years 1871 to 1998. It broadly confirms the results of the first analysis. 

Big differences between markets

It is necessary to note fairly significant differences depending on the markets in which one is invested. According to Wade Pfau (2010), the American markets (USA & Canada) were the safest during the 20th century to live off one's retirement via withdrawals from capital. The Canadian market even allowed one to live without risk for 30 years with a withdrawal rate of 4.4% per year thanks to a "simple" portfolio of 50% stocks / 50 % bonds. Conversely, the situation was much less rosy elsewhere. In Europe (Belgium, France, Italy, Germany), the safe withdrawal rate was only between 1% and 1.5%. These countries were indeed affected by the world wars during the period analyzed by W. Pfau.

We also find exactly the same phenomenon in Japan, with an even worse situation, since the safe withdrawal rate did not even exceed 0.5%. This can be explained, in addition to the wars, by the bursting of the Japanese bubble in 1990. The Swiss market, on the other hand, spared by the conflicts, did much better, since the safe withdrawal rate amounted to 3.5% per year over a period of 30 years. But in the latter case, it would surprisingly have been necessary to bet on an allocation of 80% bonds / 20% shares. This can be explained by the very high interest rates that prevailed at the beginning of the last century as well as during the 1970s-1990s. Great Britain experienced a safe withdrawal rate identical to Switzerland, but for a classic 50/50 allocation.

Living off your income rather than drawing on your capital

With a rate of 3.5 % of capital levies per year, we are therefore ensuring a very long retirement. 3.5% is also a rate that can be very easily achieved with quality and sustainable growing dividends (as long as we buy them at a good price or keep them a small number of years).

The advantage of dividends is that not only do they avoid withdrawal but they also grow, if you bet on the right horses, like the aristocrats for example. Thanks to them, one can thus receive a comfortable income while creating rich heirs. On the contrary, the strategy of eating one's savings does not a priori allow one to conserve the capital, as an ultimate safety cushion or as an inheritance for one's descendants.

A question of probabilities

However, the reality is not that simple. It depends on the withdrawal rate used and also on a factor over which we have very little control: luck! Indeed, according to the Trinity study and that of Retire Early, with a "safe" withdrawal rate of 100%, there is a strong probability that the portfolio will still be significant at the end of our existence. Let's take the case of a very early retiree starting his new life at 35 with $1 million. He has a one in two chance using a risk-free withdrawal rate that his portfolio will amount to more than $16 million by the time he turns 85, even by correcting for inflation and of course debiting all withdrawals.

This is very surprising at first glance, but it can be explained by the fact that to be certain that the portfolio lasts even in the worst possible scenario, we de facto agree to remain extremely cautious and we therefore have a good chance in fact that the capital will last and even grow.

Annuity / capital: a similar approach

If you think about it, the growing dividends in the Trinity study look like a 100% portfolio in stocks with a withdrawal rate of just over 3% (in fact the dividends). In this case, the capital never dies. Better yet, it grows, along with the distributions. This is exactly what we often see with a safe 100% portfolio.

We note in the end that living off one's income (dividends) or nibbling away at one's capital is quite similar, provided of course that the rate of debiting the capital remains prudent according to the expected duration of retirement. This is quite logical since dividends are a "fruit" of capital.

Since living off dividends is a 'withdrawal' that is more than 100% safe, nothing prevents you from indulging in little pleasures from time to time, by eating into your savings. Once again, the boundary between the two approaches (income or capital) is quite permeable.

The Limits of Trinity and Asset Allocation

That being said, the Trinity study is limited to classic static portfolios, weighted only between stocks and bonds. The problem is that either the share in stocks is insufficient, and therefore we have a priori a problem of profitability in the long term, or their share is too large, and we have a problem of volatility.

In theory, according to the Trinity study, retirees should accumulate unspent surpluses when markets are up and should face spending shortfalls when markets are underperforming. Based on historical data, a withdrawal rate of 3.5% allows a portfolio to withstand the worst market decline in 80 years and hold up for an exceptionally long life.

Living with 75% of shares?

Theory is one thing, but it is forgetting that volatility has very important psychological impacts on investors. It is not the same to invest in stocks with a paid job or to have to live off your investments only. Go tell a guy to withdraw even 3.5% from his portfolio, when he has just lost 25%, or more...

"I guess the only question left is how many of us nearing retirement are prepared to face the great unknown of retirement with 75% of stocks. To be honest, it scares the hell out of me (...). When I get my last paycheck, it's going to get harder, exponentially..." (source)

Caution and intelligence

Putting the cursor in the middle (50% shares / 50% bonds) therefore seems to be a good compromise, which is what Benjamin Graham had already taught us in his famous "Smart Investor". In 2010, Wade Pfau also demonstrated that between 1900 and 2008, on the US market, it was possible to vary the weighting of shares in a portfolio between 30% and 80% without impacting the safe withdrawal rate.

Similarly, in 1996, William Bengen showed that since 1926 the risk-free withdrawal rate over a 30-year period varied very little for equity allocations between 35% and 90%. The difference in the choice of data for the fixed-income component between William Bengen's work and the Trinity study requires explanation. William Bengen used intermediate-term government bonds, which allow a success rate of 100% for the inflation-adjusted 4% withdrawal rate rule. At the same time, the Trinity study uses more volatile long-term bonds, which caused the inflation-adjusted maximum withdrawal rate for new retirees in 1965 and 1966 to fall below 4%.

I had already mentioned this difference in volatility between medium and long term bonds in my series of articles devoted to portfolio diversification. Medium-maturity bonds (around 10 years) have a higher risk-return ratio than others.

Income/capital: the importance of volatility

The merit of the Trinity study, but also of the research of W. Pfau and W. Bengen, is to put the finger on the importance of volatility. We often tend to underestimate it when investing. Indeed, we often forget its impact on our emotions, which leads us to sell wrongly in panic or to buy, again wrongly, in euphoria. But when we no longer only invest, but must also live solely on our capital, volatility no longer has only a psychological impact. Its consequences have very real financial effects on the financial capacities of retirees who follow a capital withdrawal method.

This is why variations in the weightings between stocks and bonds in portfolios have only a marginal impact when following this strategy. The profitability of stocks compensates for their volatility. Bonds compensate for their lack of performance by their low nervousness. Let us add to this that the inverse correlation between stocks and long bonds allows a portfolio to increase its profitability/risk ratio.

The ideal would therefore be to have a profitability similar to shares, while having a volatility close to long-term bonds. The various studies that we have mentioned have always focused only on these two asset classes. In doing so, we have completely left aside real estate, gold and cash in particular. The work of Mebane Faber, through his famous Ivy Portfolio, have proven that it is possible to achieve slightly higher profitability than the stock market, with volatility that is similar to that of bonds. I was inspired by Meb Faber to create my own asset allocations.

So, should you live exclusively on your income or eat up your capital?

For a truly early retirement, capital levies must be limited to 3.5% per year. There are very significant disparities between countries. Those that have not experienced war on their territory are among the only ones to have achieved this objective. We will mention the USA, Canada, Great Britain and Switzerland. These countries are in fact those that have posted the best historical performances, in accordance with the conclusions of J. Siegel in his book "Investing in stocks for the long term".

However, nothing tells us that history will repeat itself identically in the future. Even if it does have an unfortunate tendency to repeat itself. We obviously do not hope this for our European neighbors. It is therefore important to continue betting on the winners. On the other hand, we will cover our backs by diversifying in countries where shares are cheap.

Withdrawal Rate and Dividend Yield

This advice also applies of course to those who only intend to live off their dividends. The risk-free withdrawal rate of 3.5% is very close to what can be expected from a dividend. To do this, you obviously have to buy cheap. Or wait a few years for the yield on purchase cost to climb to this level. Taking 3.5% of your capital, or receiving dividends with a similar yield, is therefore practically the same thing. In any case, it allows you to achieve the same goal.

There is a big difference between the two methods (annuity vs. capital). It is the impact of volatility on the physical and psychological well-being of the retiree. Those who follow a withdrawal strategy have every interest in diversifying their portfolio with bonds (at least). In theory, a 100% allocation to stocks works. However, it is very difficult to support from an emotional point of view. Not to mention that it does not provide better results. Those who intend to live solely on their dividends have less to worry about volatility. Even if it is never very pleasant to see your capital melt away. It is also obviously necessary to bet on high-quality dividend payers, such as aristocrats for example.

Income/capital: the importance of diversification

Generally speaking, the diversification has always been a valuable investment tip. This applies to currencies, countries, and asset classes. It also applies to strategies for living off your investments during retirement. It involves building a diversified group of quality dividend payers. These provide regular and growing income. Government bonds, real estate, a little gold and cash round out the package. We live largely off capital income (dividends, coupons, rents, interest, etc.). We supplement this with a withdrawal from capital, either occasionally or periodically.

A good system ofasset allocations is essential for a peaceful retirement, with solid income and a portfolio that is both efficient and not very volatile. It can even allow a safe withdrawal rate higher than 3.5%, as explained in my e-bookThis can substantially shorten the time it takes to become financially independent.

Income or capital, ultimately both approaches are necessary and complementary.