Living off your income or consuming your capital – presentation of possible scenarios

This article follows on from Jérôme's excellent article "Live exclusively dividends or eat up capital?" and to the very pertinent question recently asked by Laurent Martin:

"When you consider that the time has come to become a rentier (and therefore to give up paid employment), when you judge the investments made so far sufficient, do you expect to live only on the income from these investments (dividends) or also on the capital by starting it? This second hypothesis is undoubtedly more delicate to manage, but allows one to consider oneself as financially independent sooner.”

This fascinating question has occupied my mind a lot in recent days and has prompted me to develop my thoughts here based on different possible scenarios.

For illustration purposes, I will base my examples on the deliberately simplified basic situation and the following assumptions:

• A person (or couple) who has long been accustomed to a frugal lifestyle and who only needs 5,000 francs per month (60,000 francs per year).
• The children no longer live at home.
• The stock portfolio offers an average dividend yield of 4% (a high but achievable value, especially with stocks acquired several years ago and which regularly increase their distributions).

“Late” version and living solely on dividends

For example, we stop working at 58. For tax reasons, the 2nd and 3rd pillars are withdrawn entirely in the form of capital over 3 years (each time approximately a third at 58, 59 and 60) and invested in shares.

At this time, the savings (750,000 francs) + the pension fund capital (500,000 francs) + the 3rd pillar (250,000 francs) give a total fortune (portfolio) of 1.5 million.

All the wealth is invested in shares, representing an annual income of 60,000 francs.

Comment: This version is very attractive in terms of income and security, but it involves working until quite an old age. In addition, In the end, it offers too much income "unnecessarily", because after a few years the dividends will have inexorably increased and the AVS pension will soon be added to this passive income which has already become too high!

In fact, from the age of 65, the AVS pension of 2,370 francs (for a single person) or 3,555 francs per month (for a couple) is added.

Softer version

From the same starting point, for example, 1.3 million is invested in shares (annual income 52,000 francs). The remaining 200,000 francs are kept in a much more liquid manner (cash, money market funds, cash bonds, etc.) and are used to supplement the "salary" if necessary or occasionally cover large expenses (purchase of a new car, major medical expenses, etc.).

The "liquid" portion of the portfolio serves as a safety cushion, an airbag against financial unforeseen events.

“Living only from the consumption of one’s capital” version

Typical operation: consumption of 4% of its capital each year, over a period of 25 years (for example, an initial capital of 1.5 million allows you to withdraw 60,000 francs per year for 25 years).

This is the version that many financial advisors offer and which I will not use here, not only because it may not work if you live beyond 25 years. ("longevity risk"), but also because it does not use the fantastic possibilities offered by the stock market and dividends.

“Reduce your working hours” version

There are many possible variations here, for example reducing your working time to 50% once the passive income from your dividends has managed to cover this shortfall, or reducing your professional activity little by little, for example in tranches of 20% every 5 years.

Mixed version

Like investing half of your fortune in shares and taking the rest from your capital each year.

Semi-retirement version at 50 with a small additional lucrative activity

Our man declares himself independent and withdraws his 2nd and 3rd pillar. He then has: savings 500,000 francs, 2nd pillar 325,000 francs, 3rd pillar 175,000 francs, i.e. a total fortune of 1 million. This capital is invested in shares and offers an annual income of 40,000 francs.

From 50 to 65 years old, this person works a few hours per week in order to earn what he lacks (around 1,700 francs per month in our example).

Ideally, it is a small activity that he enjoys and that does not occupy him more than 2 days a week (for example, helping with sales in a bakery on Saturdays, selling his homemade jams on the Internet, etc.).

At age 65, the AVS pension is added (I do not recommend taking it in advance: the reduction is in fact 13.6% if you take it in advance by 2 years).

Riskier version but allowing you to achieve financial independence earlier

This scenario could for example consist of leaving one's job at 50 years old with a fortune of 1.1 million. 1 million is placed at 4% (annual income is 40,000 francs), the rest is kept in cash.

The missing 20,000 francs per year are obtained by selling a few shares from time to time in the event of good stock market performance. If necessary (in bad stock market years), by taking this amount from the cash reserve.

After a few years already, the annual increase in dividends should make it possible to compensate for the negative influence of the sale of this small part of the portfolio and to live solely on its dividends.

In summary, in this scenario:

• In bad stock market years, we live off our dividends and by drawing on our cash.
• In years when our portfolio gains 2 or 5%, we sell 2 or 5% of its shares.

And finally, from time to time, we will have an exceptional stock market year, during which our portfolio will gain, for example, 20%. These 200,000 francs can be used to pad our cash cushion for many years. They can also be reinvested in stocks distributing dividends of 4%, increasing our annual income from 40,000 to 48,000 francs.

What I want to illustrate with this example is that the starting figures should not be taken too literally. Stocks are not static entities and stock market history teaches us that both our portfolio and our dividends are doomed to increase over time..

Conclusion

Wanting at all costs to wait until having reached passive income necessary (60,000 francs per year in my example) to live your dream of financial independence, we condemn ourselves to wait longer than necessary to embark on this magnificent adventure.

What's more, after a few years we will find ourselves with a much higher pension than we need to live (increase in dividends, AVS pension). In other words, we will have worked all these extra years for nothing.

By daring to embark on the adventure early enough (for example at 50 years old) before having reached the income necessary to live (for example already once we receive 40,000 francs in dividends) and by putting a little cash aside to supplement our income in the first years (in the event of poor stock market performance), history shows us that we have every chance of doing very well.

After 5 or 10 years, the increase in the size of the portfolio and dividends should allow us to live well without having to draw on our cash reserves (or by selling a fraction of our portfolio). Not to mention that the AVS pension will be added to our dividends from the age of 65.

The stock market is unpredictable in the short term, but its trend is clearly bullish over a longer time horizon. Let's not let its short-term hormonal imbalances put a spoke in the wheels of our long-term goals and dreams.

Why kill yourself working until you're 60, when by planning things carefully and accepting, if necessary, not to live from the first day of your financial independence only on its dividends (i.e. by drawing on your capital or cash reserve in the first years if necessary), you can regain this freedom that was priceless even 10 years earlier?