My recent article on the Financial Independence, Retire Early (“FIRE”) movement and some of the unrealistic assumptions baked into the model elicited a great deal of comment. The original article is available here but the basic premise was that applying the 4% rule or 25 times annual living expenses to an extended retirement period could be problematic.

One of the most common queries was what I thought about an extended retirement on the income generated by a portfolio. The basic premise is building a portfolio of income producing shares, living off the dividends and never selling the shares. This eliminates the risk of running out of money. That risk – called longevity risk – is outliving your money during a retirement of an indeterminate length.

My plan to retire at 50

Before getting into the pros and cons of this approach a quick story. This was my plan when I was younger. From the outset I was intrigued by dividends when I started investing. It seemed amazing that I could own part of a company and get paid part of the profits. And I loved the fact that if you found the right company the dividend would continue to grow over the years.

My plan was straightforward. I wanted to be able to retire at 50 by building an income stream that would continue to grow through dividend increases even after I started living off the dividends. I was going to do this by saving as much as possible, buying dividend paying shares and reinvesting the dividends.

I created a spreadsheet and tracked the growth of my income meticulously. I analysed the dividend history of countless companies. I projected my income growth and the influence of the three sources of that growth: investing new savings, dividend reinvestment and dividend increases.

I spent a great deal of time thinking about the risks I faced and how to address them. I would build a large cash buffer by turning off the dividend reinvestment three years before I retired and keeping that money in cash. This was essentially the bucket method where my buffer of 3 years of spending would protect me from dividend cuts and act as a larger emergency fund.

I also hid all of this from friends as even I was embarrassed about how obsessively I took it. Years later I am 44 and have no desire or plan to retire at 50. Changing my course was a result of the challenges of building an income portfolio that could support my lifestyle and a change of perspective.

I started to imagine an extended retirement and wondered how I would stay engaged and fulfilled. I started liking my job more as my responsibilities increased and felt more challenged. And most of all I got sick of living a frugal lifestyle to increase the amount I could save and invest.

Does early retirement on investment income work?

Despite abandoning my own attempt at funding an early retirement through investment income I still believe it is a sound strategy. There are some challenges in getting to that point which I will outline. Nevertheless, I think it works and does eliminate the risk of outliving your money.

The biggest challenge is accounting for fluctuations in the income generated from your portfolio, the risk of unexpected large expenses and the necessity of keeping up with inflation. Each of these can be addressed but all add to the challenge of getting to the point where this is a feasible approach.

A dividend is not a guarantee. They can be cut or eliminated. I always envisioned most of my income coming from dividends. Highly rated bonds would have been a safer way to ensure my income wasn’t cut. But interest payments never increase. There would also be significant reinvestment risk when the bond matured if interest rates had fallen. Dividends can be increased as the profit of the company grows.

My assumption was that dividends would grow faster then inflation over time. And over the long-term that is reasonable. Over the past 35 years the S&P 500 index has grown dividends by 6.19% which far outpaced inflation.

Dividends do get cut and I wanted to protect myself in case my income dropped. One way to address this risk is through the bucket method. In the most basic sense this means that cash is kept that can be used to make up for a shortfall in income. If a dividend was cut, I would just take that amount from my cash account. The more cash, the bigger the buffer.

I settled on three years. To raise that from my portfolio essentially meant ending the reinvestment of dividends three years prior to my target retirement date. This cash buffer could also protect me from large expenses.

The other way to protect yourself from dividend cuts is diversification. I built a portfolio that was widely diversified across sectors and geographics. I also limited the percentage of my total income that came from one holding. This would limit the impact of a dividend cut or elimination that did occur.

The challenges I faced in growing investment income

I found several challenges in trying to grow my investment income to a level where it could support my expenses. And the magnitude of this challenge should not be underestimated. Australia has some of the highest dividend yields in the world. But a portfolio only invested in Australian shares does not offer the diversification that I believe is needed to protect an investor.

Investing outside of Australia means lower yields than the ~4.5% yield of the ASX 200. For example, the S&P 500 is currently yielding only 1.5%. To support a pre-tax income of $50,000 from a portfolio evenly split between Australia and the US would require $1.6m. That is a challenge.

1. The law of big numbers

My quest to grow my investment income got off to a good start. I didn’t have a big portfolio and I was able to grow my income at a high rate simply by saving and investing more money. This got increasingly challenging I tracked my income growth per month for over 15 years which provides data to back my assertion.

The first 9 years I grew my investment income by an average of 16.66% a year. And this included the GFC when many dividends were cut. The next 6 years the growth dipped to 9.52% which was below my target of 10%.

The issue was the growth in my income. There are three ways to grow investment income. Dividend increases, reinvesting dividends and new saving. As a portfolio grows in value the impact of new savings drops.

A $10,000 portfolio generating $300 in income mean saving and investing $5,000 in a year will grow total income by 50% before accounting for any dividend increases or reinvestment. When the portfolio reaches $100,000 and generates $3,000 in income you would need to save and invest $50,000 for the same impact. Most people can’t keep up their savings with a growing portfolio.

2. Taxes

Governments provide tax advantages to encourage retirement savings. In Australia superannuation lowers tax rates on income and capital gains during working years and eliminates taxes during the pension stage.

Building an income portfolio for an early retirement must be done in non-tax advantaged accounts. The inability to access retirement accounts until the government mandated retirement age doesn’t support early retirement.

When my investment income was low, I simply paid the taxes I owed on my dividends out of my income. This lowered the amount I could save but it allowed me to keep reinvesting all my dividends.

This became unsustainable when my investment income grew. I now had to forgo dividend reinvestment to pay tax. This lowered the rate I was able to grow my income.

The tax advantages bestowed on retirement accounts also create a bit of quandary. How do retirement savings fit into a plan for an early retirement. My plan was to simply increase my lifestyle once I reached retirement age.

The other sensible approach is to move into part-time work and / or lower paid work until retirement age. The income generated in non-retirement accounts can supplement the lower earnings until full retirement.

3. Lifestyle creep

Accomplishing my goal meant being disciplined with my spending so I could save and invest more. I was at the beginning of my career and as I furthered my education and started to gain more credentials and experience my salary grew.

I dedicated 50% of each pay rise to savings and increased my spending by the other half. This slowed lifestyle creep but didn’t eliminate it. I was getting used to spending more money.

I knew that as my spending grew it was impacting my ability to retire early. My target for investment income had to grow to keep up with a more expensive lifestyle. A more disciplined approach would mean saving all or most of my raises. I just didn’t have the will power to do it.

There were many things I wanted to experience from life and those things cost money. I was still saving a significantly higher percentage of my salary than the average person but not to the degree that would make up for my income target increasing. I was falling further behind and didn’t have the desire to do anything about it.

Where to from here

I don’t regret dedicating so much effort to a goal that I abandoned. Goals continually shift over the course of a lifetime. My savings gave me the opportunity for more flexibility and I’m using my investment income to supplement my life. Plus I gained first hand insights into the different factors that impact an income investing strategy which I’ve shared in the following resources:

I would love to hear your story about retiring early. Please email me at mark.lamonica1@morningstar.com

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