A reader writes in, asking:
“What do you think about just living off my portfolio’s interest + dividends each year in retirement instead of using the 4% rule? Seems safer to me.”
Frankly, I’m not a big fan of live-off-the-income strategies for stock/bond portfolios. (This is in contrast to fixed annuities, where living off the income is the only choice, because you no longer have access to the principal.) In many cases, following such a strategy leads to one of two mistakes:
- Choosing a poorly-diversified asset allocation, or
- Restricting your spending to an unnecessarily low level.
Causing Asset Allocation Mistakes
Regardless of the rate at which you plan to spend from your portfolio, there’s a benefit to being broadly diversified. Unfortunately, many people seeking to “live off the income” make asset allocation decisions that focus too heavily on the yield of each investment, as opposed to its risk level and expected total return.
As a recent brief published by the Center for Retirement Research put it:
“The retiree then runs the danger that the tail (the desire to consume) may begin to wag the dog (investments), resulting in a portfolio allocation that does not minimize the risk for any given level of expected return on the portfolio. That is, the retiree may over-invest in dividend-yielding stocks, losing the benefits of portfolio diversification.”
And the same goes for bonds: Basing your spending on yield makes it tempting to load up on higher-yielding (i.e., higher-risk) bonds.
Shifting your portfolio toward high-yield investments, and spending more because of the change, is simply increasing your withdrawal rate at the same time that you increase the riskiness of your holdings — not exactly a recipe for success.
Setting Spending Too Low
Unfortunately, if you avoid the above mistake and instead opt for an appropriately diversified portfolio, you’d probably have a yield of less than 2% in today’s environment, which, if you’re following a live-off-the-income strategy, would lead to a spending less than 2% of your portfolio balance each year.
For most retirees, there’s no need to restrict spending to such an extreme degree — which is fortunate because most investors obviously won’t come anywhere close to saving 50-times the annual level of income they need from their portfolio. It’s OK to spend down your principal over time, provided that you do it slowly enough.
Live-off-the-income strategies require a heck of a lot of money and leave behind a large portfolio to your heirs rather than allowing you to make full use of your savings during your lifetime. If leaving behind an inheritance is not one of your primary goals, such a strategy usually doesn’t make much sense.
In short, rather than using a live-off-the-income strategy and therefore a) loading up on high-risk, high-yield investments in order to achieve a suitable spending level or b) restricting your spending to an extremely low portion of your portfolio, I think it’s generally preferable to use a widely diversified portfolio and slowly tap into principal throughout retirement. (Or if you’re really looking for safety, delay Social Security and annuitize enough of your portfolio to know that your needs will be met from safe sources of income.)