Simple Path to 5%

Even in today’s market, it is simple and straightforward to obtain a 5% withdrawal rate that keeps up with inflation. Here are the requirements.

Investigation

Recently, I have determined that an investment with a higher yield and slow growth does better than an investment with lower yield and fast growth, subject to certain conditions.

[The conditions are that the sum of the dividend yield and growth rate is constant and that the timeframe is limited to two decades.]

In this investigation, I examined several simple portfolios on my TIPS Income Stream Allocator B. The portfolios consisted of a high yield, slow growing asset with TIPS to manage the cash flow.

My high yielding asset had an initial yield of 6.0% and a dividend growth rate of 2.0% per year (annualized). I used TIPS with a 2% interest rate for the cash management account. I assumed an inflation rate of 3%. I did not buy or sell any shares of stock.

Results

Allocations:
Stock A: 80%
Investment B: 0%
TIPS: 20%
Inflation: 3.0%
Initial dividend yield: 6%
Stock A dividend growth rate: 2% per year (annualized).
Withdrawal Rate: 5.0% (plus inflation) through Year 32.

Allocations:
Stock A: 90%
Investment B: 0%
TIPS: 10%
Inflation: 3.0%
Initial dividend yield: 6%
Stock A dividend growth rate: 2% per year (annualized).
Withdrawal Rate: 5.0% (plus inflation) through Year 36.

Allocations:
Stock A: 100%
Investment B: 0%
TIPS: 0%
Inflation: 3.0%
Initial dividend yield: 6%
Stock A dividend growth rate: 2% per year (annualized).
Withdrawal Rate: 5.0% (plus inflation) through Year 40. $5391 real TIPS balance at Year 40. ($17074 nominal TIPS balance at Year 40.)

Allocations:
Stock A: 100%
Investment B: 0%
TIPS: 0%
Inflation: 3.0%
Initial dividend yield: 6%
Stock A dividend growth rate: 1% per year (annualized).
Withdrawal Rate: 5.0% (plus inflation) through Year 21.

Data Analysis

The best initial TIPS allocation turns out to be zero. You should use the excessive returns of the high yielding investment to buy TIPS in the early years. Supplement the income in the later years by drawing from the TIPS account.

An investment with a yield of 6.0% and a dividend growth rate of 2% is sufficient to fund 5% (plus inflation) withdrawals for an extended period of time, roughly 45 years. It continues to deliver close to 4% of the buying power of the original balance at that time.

The withdrawal rate should be reduced below 5% per year (plus inflation) if the dividend growth rate is only 1% per year.

Remarks

Finding suitable investments in today’s market is straightforward. For example, Morningstar’s Dividend Investor’s existing Harvest Portfolio exceeds these requirements.

Have fun.

John Walter Russell
February 26, 2007