Building multi-generational wealth means keeping what you save and investing it well. Doing this means minimizing how much of the principal you withdraw to fund your lifestyle, at least once you’re living off of your investments. In an ideal world, not only do you have enough capital saved to only use the income and never use the principal for living expenses, but you have enough left over to continually reinvest and grow your portfolio as well. Once you have reached that point, and assuming your family doesn’t screw it up down the road, then your family will be well setup for the future. Your principal is the beginning of your orchard or your garden. From it, all else grows.
There is much discussion in the financial planning and personal finance industry around safe withdrawal rates (SWR). Frankly, the safe withdrawal rate depends a great deal on how much money you have, the size of your living expenses, when you start your retirement, and how the sequence of returns works out. Most people will be forced to dip into their principal balance in order to pay living expenses in retirement. The safe withdrawal discussion for those folks is one that is far more complicated and will be addressed in another post. For those of us earning above average incomes, saving at above average rates, and very interested in the concept of financial independence and F-You money, our safe withdrawal rate is something else entirely.
Problem with Safe Withdrawal Rates
Let’s take a brief look at the typical SWR of 4-4.5%. Each year, the market (bonds, stock, or any other market) returns a combination of income and price return. Income, by definition, is always positive, while price return is highly variable and can turn very negative. Below is a chart of the S&P 500 dividend yield (12 months of dividends divided by last year’s beginning index price) and the 10 year US Treasury bond yield. Since 1970, the S&P dividend yield has averaged 3.1% and the 10yr US Treasury yield has averaged 6.5%. A 60% US stock/40% 10yr Treasury bond portfolio would have yielded an average of 4.45% in income, enough to cover the SWR without touching the principal.
This is obviously a highly simplistic example, and an incorrect one at that, since you don’t earn the “average” yield on a portfolio through time. You earn the actual yield, which is highly variable and in this case, declining. Add to that the fact that the 1970s and into the early 1980s was a time of high inflation, and correspondingly high bond yields. From 1990 on, however, the S&P 500 has yielded an average of 2.3% in dividends and the 10yr Treasury has averaged 4.6%, for a 60/40 portfolio yield of 3.2%. Again, highly simplistic, but if your portfolio did this throughout your retirement, a 4% SWR starting out would be 3.2% in income, with a small portfolio sale of 0.8%. As you deplete your principal, more and more of the annual income would need to come from the sale of assets in your portfolio. This is what people mean when they talk about eating their seed corn.
Today, however, the S&P 500 is yielding 2.2% and the 10 year Treasury is yielding 2.4%, for a 60/40 portfolio yield of 2.3%. Bond yields are dramatically lower than they have been historically and dividend yields are on the lower end. Hence, the biggest problem with historical SWR analysis is that it doesn’t fit with today’s world. The world we live in is one of exceptionally low yields. If you bought a 10 year Treasury today, and held it for 10 years, your return would be 2.4%. Before inflation. If inflation was 2.5% over these 10 years, you’d actually lose money in real terms.
Much of the historical analysis for SWR is done looking backwards, sometimes as far back as the early 1900s. But herein lies the problem. Not only are 10 year Treasury rates some of the lowest they’ve ever been, but the three most expensive stock markets (as measured by the price/earnings ratio) were in 1999, 2007, and…. today! There is no 30 or 40 year period in history that would approximate this market. Using historical analysis may prove accurate, especially over very long periods. On the other hand, it may not.
Withdrawal rates and the risk of running out of money are driven largely by sequence of returns risk. Sequence of returns just measures how the cumulative return played out over time. For example, given any cumulative return over time, it’s far better to have the market increase and then decrease after you retire as opposed to having the market decrease then increase. If you’re drawing on the principal balance for life expenses, each year that the market increases provides you with more of a margin of safety. With today’s expensive markets, the odds of the market decreasing first from here are higher than the markets continuing higher (although that doesn’t mean it can’t and won’t happen).
Getting more of your withdrawal from income buffers you against this risk, as you need to sell less of the actual underlying portfolio at variable prices. As mentioned above, here’s our risk with today’s market. A 4% SWR based on portfolio income of only 2.3% means that you need to get nearly half of your withdrawal from selling down the assets in your portfolio. When the market generated income of 4.45%, or even 3.2%, you were in a much better position to handle market declines than you are today. The risk of drawdown is far larger today if you need to sell down your principal than it has been in a long time, maybe ever.
Don’t Touch It!
So long as you never touch the principal and can live off of the income generated by your portfolio, you will never run out of money and drawdowns will matter far less to you (they always matter though!). Never needing the principal is the ultimate margin of safety. In fact, since your drawdown risk is less, you can invest in riskier assets that have a better chance of growing through time. This is how the wealthy stay wealthy, and it’s primarily how they grow their wealth through time. You’ll want your income to grow faster than the rate of inflation, which can be done either by selecting investments with solid growth potential or by reinvesting some of your income. With your income growing faster than the rate of inflation, your margin of safety will increase each year as well. If you so choose, you’ll be able to sustain a different or higher standard of living in the future.
Being able to invest in riskier assets is crucially important. The graph below lays out the growth in dividends in the S&P 500 relative to inflation.
There are a couple of things to notice here. One, dividends grow at a rate higher than inflation – this is an incredibly awesome part of investing in equities. Two, dividends occasionally decrease – this is the not so incredibly awesome part of investing in equities. This is on the index level; there are many companies that have never had a dividend reduction, and in fact have always grown, their dividend. However, company strengths can change and decline over time. Witness General Electric, which for decades had never decreased and always increased their dividend. They’ve now cut their dividend twice since 2009. This is why looking at the index for guidance is so important.
Dividends had noticeable declines in the 2008 Global Financial Crisis (declining by 28% over a year and a half time frame, before starting to recover) and in the 2000 Tech Bubble (declining about 8% before recovering). Companies tend to grow at a rate roughly equating to the broader economy, which tends to grow at a rate greater than inflation. This is why stock dividends continue to grow over time, but often decrease modestly during big financial recessions. Bond interest payments do not exhibit the same phenomenon, and there is no natural reason why bond coupons should keep pace with inflation. In fact, buying an individual bond and spending the income will ensure that you lose out through time to inflation (assuming the bond is a fixed rate coupon).
This discussion on growing income brings about an incredibly important point. Reinvesting some part of your current income allows your future income to grow, and buffers your money from any declines that occur through the years. How much is enough of a reinvestment? Based on history, you can spend up to 75% of all dividend income and be pretty safe. Even during the worst financial crisis in the last 100 years, dividends only declined by 28%. In this case, if you kept your income constant, you would have weathered the crisis pretty well. Your income would not have declined, you just would not have been able to reinvest as you had done historically. Once dividends started growing again, you would be able to begin to grow your income and start reinvesting.
Never Touch the Principal at 1.8%?
For an 80% stock/20% bond portfolio (an aggressive alternative to a 60/40 portfolio), a Never Touch the Principal Withdrawal Rate (the “NTP-WR”) is 1.8%. A global portfolio of stocks (MSCI ACWI Index) has a dividend yield of about 2.4% currently, with the 10 year US Treasury bond (as an ultra-safe bond proxy) currently yielding about the same. 75% of that portfolio in income totals 1.8%, which will allow some reinvestment of income to continue the growth of the portfolio.
How the heck can someone live off of 1.8%, when most struggle to save enough for a 4% safe withdrawal retirement? The goal of this blog is to help as many people be above average as possible and be able to do just that. Unfortunately, most people won’t even save enough to have a comfortable retirement at 4%. However, you can, by earning an above average income and saving at an above average level for years.
A few blog posts ago, I introduced you to a hypothetical 30 year old couple with two kids living near Atlanta. We’ll use real dollars (after inflation) to make the analysis easier to interpret. Combined, their income was $200,000, putting them solidly in the top 20-25% of income earners in the Atlanta metro. Their income will grow at 2% more than the rate of inflation, but they will have no “jump events” like a job switch or promotion that take them to a higher income level. They live a great life, spending 20% more than the average Atlanta resident, totaling nearly $64,000 per year. Their spending grows by 1% more than the rate of inflation. Up until this point, they have not saved a dime. However, they have now begun dutifully putting away the full $18,000 per person in their 401ks ($36,000 per year total), which will only grow at the rate of inflation (I know, going from zero savings to maxing out their 401ks is unlikely, but so is this couple saving nothing by the time they’re 30). They also pay $7,500 per year for health insurance, a number that will increase at 1% per year above inflation.
Their initial net pay is $8,200 per month (after taxes, 401k contributions, and health insurance) with expenses of $5,300 per month. They can save nearly $3,000 per month outside of their retirement accounts, illustrating the power of higher income. Assuming their portfolio grows at a real 4% return, they will have a combined 401k/taxable account balance of $4.7 million by the time they reach age 57. At that point, a 1.8% withdrawal rate is equivalent to $85,800 per year (again, in today’s dollars), which is greater than their annual expenses of $83,500. They will never need to touch the principal again.
Is this a highly simplistic example? Of course. I’ve also diminished how difficult this would be to do in real life, with a dedication to savings and building a portfolio over that time which is difficult to sustain. But more broadly, the point is that you can do it. This couple didn’t save a dime until age 30, were lucky and skilled enough to be in the top 20-25% of income earners, lived life with expenses that were 20% higher than the average family, and made it to a NTP-WR in 27 years. If you’re smart enough to begin saving earlier, or skilled enough to find yourself in the top 10% or higher of income earners, your path will be even more straightforward.
Find a Way
If you’re interested in building a multi-generational Great Family, you’ll need to find a way to build up a big enough portfolio to sustain a true Never Touch the Principal Withdrawal Rate. Today’s low yields, both in dividends and in bond interest rates, makes it more difficult, but still doable. Focus on building a portfolio that allows you to live off of the income and still reinvest a portion. At that point, your risk to the markets is minimized and you’ll be set for your life, as will the generations beyond you.
Keep building my friends.