Building on Success

The traditional methodology claimed a 4.0% (plus inflation) Safe Withdrawal Rate at today’s valuations. It was actually 3.6% (using a 50% stock allocation, not 80%). We lifted it to 4.4% by switching, where we vary the stock allocation with valuations (P/E10).

We lifted the bar to 5.4% (plus inflation) by combining switching with a dividend strategy.

We lifted that level to 5.5% by managing the income stream of a blended income portfolio.

We raise the bar once again, combining switching with a blended income portfolio.

Safe Withdrawal Rates with Switching
What Do I Really Think About Dividends?
Taken At Face Value

The Baseline Income Portfolio

I use the portfolios of the Morningstar Dividend Investor newsletter. I use the current yields of its two portfolios with their minimal dividend growth rate goals.

This is what happens at today’s valuations:

Taking the Morningstar Dividend Investor at face value, I assign Investment A an initial dividend yield of 3.5% per year and a dividend growth rate of 8% per year. I assign Investment B an initial dividend yield of 6.1% and a growth rate of 2%.

I assume 3% inflation and 2% (real) interest for the TIPS.

Scaling for Valuations

Valuations affect the initial dividend yield of the two investments, but not their growth rates. The dividend growth rate is independent of prices.

I assumed that the price of high dividend investments will not fall as much as the market as a whole.

I assume that valuations will become favorable enough within the next decade to double the initial dividend yields. This corresponds to valuations falling below typical levels (P/E10=13 or 14) but not to a bottom (P/E10=7 or lower).

At that time, Investment A will have an initial dividend yield of 7.0% and a dividend growth rate of 8% per year. Investment B will have an initial dividend yield of 12.2% and a growth rate of 2% per year.

I continue to use 3% inflation and 2% (real) interest for the TIPS.

Expanded Allocator Results

Using a 40% allocation for Investment A, 40% for Investment B and 20% for TIPS, the continuing withdrawal rate was 10.0%.

The optimal allocations were 15% Investment A, 85% Investment B and 0% TIPS. The continuing withdrawal rate was 11.18%.

Delayed Purchases

The TIPS Equivalent Safe Withdrawal Rate (TESWR) of 2% TIPS at Year 10 is 11.13%. If the withdrawal amount is 6.0%, the remaining principal at Year 10 is 56% of the original balance.

If we put 56% of our original balance into an investment that returns 11.18%, we receive an income that is 6.26% of our original balance.

If we withdraw 6.1% from 2% TIPS for a decade, the remaining principal is 55% of our original balance. If we invest this amount at 11.18%, our income stream is 6.15%.

If we withdraw 6.2% from 2% TIPS for a decade, the remaining principal is 54% of our original balance. If we invest this amount at 11.18%, our income stream is 6.04%.

From this, I conclude that the continuing withdrawal rate is 6.1% of the original balance (plus inflation).

Conclusions

Combining intermediate term timing based on valuations (i.e., delayed purchases) with an income blend approach lifts the continuing withdrawal rate to 6.1% (plus inflation).

Keep in mind that there is a (small) risk that the market will not become attractive enough to implement this strategy.

Have fun.

John Walter Russell
April 19, 2007