Earn 6% Income With 40% Lower Risk And Drawdowns (Retirement Series) (2024)

In spite of the high volatility and the wild ride in 2019, the markets are only about 6% below their new all-time high achieved back in July. In fact, it's already the longest bull market in history. Still, there are plenty of risks on the horizon. Trade wars on multiple fronts are keeping the market on edge. On top of that, there's this nagging worry of a slowing global economy and decelerating corporate earnings. The more recent scare has been the rate-curve inversion, which many believe to be a forewarning for incoming recession. Besides, sooner or later, the economic cycle will turn back, and market sentiment will turn sour. When exactly will that happen? No one knows. It may be two years away or six months away, but it's a question of when and not if. How can we avoid the extreme risks while still be invested and generate regular and high enough income?

If you have recently retired or a near retiree, the question becomes even more relevant. Recessions or ugly corrections can cause havoc with retirement funds. More importantly, if you are invested entirely in broad index funds, the retirement timing can be an important factor as well. To avoid the risk of retirement timing as well as the risk of market volatility, one needs to adopt a diversified income method. We cannot possibly predict the market direction, but we can ensure the security of the income stream to a large extent, even during recessions and market panics.

Why A Dividend and Income Strategy Is Superior (especially during the income withdrawal phase)?

There are folks who would argue that dividend harvesting is not important and one can simply sell shares to create an income stream. Without a doubt, there's some value to that argument. Especially for younger folks, who do not need income for a long time, investing in growth stocks could do wonders as long as they know what they are doing. But for retirees or near retirees, who need to withdraw income for living expenses, to depend solely on capital gains is a recipe for disaster. In addition, to know when to sell in itself is not an easy task.

To illustrate the significant impact of retirement timing and the importance of dividend income, let's consider a hypothetical example of two friends, John and Jim. John happens to be three years older than Jim. Both of them retire at the age of 62, with one million dollars of financial assets invested in the S&P 500. However, John retired at the end of the year 1999, whereas Jim retired at the end of the year 2002. Both of them assumed, at the time, that a million dollars was sufficient to take care of their retirement needs. Even though Jim’s portfolio took a significant hit during 2001-2003, but since he was still working, he was still making regular contributions at low prices. He even made extra catch-up contributions at great low prices. However, John who retired at the peak of the economic cycle and internet bubble did not have that luxury since he was already retired. We assume that they both withdrew the traditional 4% of their initial capital with a yearly raise accounting for official inflation every year. So, essentially, we would think that they would be in a somewhat similar situation after 20 years. After all, they retired with the same amount of savings and lived a similar standard of life. At the beginning of 2019, their futures looked quite different, mainly due to the timing of retirement.

Table 1: John's Portfolio (retired Dec. 1999):

Table 1B: Jim's Portfolio (retired Dec. 2002):

Jim’s portfolio has grown very well, and in spite of the regular 4% withdrawals, it stood at more than $2.3 million while John has depleted the portfolio by more than half by the end of 2018. John’s financial future does not look bright at age 81.

Now let’s consider that instead of investing in the S&P 500 index, John had adopted the DGI Income model, which depended on dividend income and dividend growth. Let’s assume that he invested in “Dividend Aristocrats” starting in January 2000. Please note that there was no official ETF available to represent the Aristocrats Index at the time, however, today you could invest in ProShares S&P 500 Dividend Aristocrats ETF (NOBL).

There were 54 stocks in the year 1999 Aristocrat’s list, while 34 of them still exist today. The rest may have been merged or acquired by other companies, while few of them may have been de-listed as public companies or even went bankrupt. So, there's no easy way of knowing the average dividend yield of all the 54 companies, but we can certainly calculate the dividend yield based on the yield of 34 companies that exist today. The average yield of these 34 companies was roughly 3.0% (at the end of 1999). However, if we dig deeper, the average yield of the index was more like 2.40%. The dividend yield of the Aristocrat index has hovered between 2% and 4% over the years. We could not find a precise way of knowing the average yearly yields going back to 1999, but we were able to get rough estimates. Let’s look at the revised table (table-3) for John with the assumption that he invested in the stocks in the Aristocrat’s index starting 1999 (instead of the S&P 500). The income generated fell short of 4% yield that was needed for retirement expenses, but growth in dividends and capital over the years more than compensated for the shortfall. In fact, John would have done very well with this strategy compared to investing in the S&P 500.

Table 3: John’s portfolio and income, based on Dividend Aristocrats, starting in Jan. 2000.

As you can see (from table 1 and 3), John’s financial future would have been very secure if he had invested in Dividend Aristocrats instead of the S&P 500 (similar amounts were withdrawn each year, in two scenarios).

How to Avoid The Wild Ride and Invest With Peace of Mind?

As we saw in the above example, investment in an ETF like NOBL would be a good way of growing capital over the long term and generate modest income. That said, the method falls short on current income, especially in the first 10 years. If you are at least 10 years away from retirement, this could be a reasonably good strategy for you. However, it would be wise to diversify in more than one ETF or strategy. Moreover, this may not work very well if you need that income today.

We do not know what the markets are going to do tomorrow or in the next three months or three years. While most folks can't afford to lose a sizable chunk of their hard-earned savings in a future correction, recession or any other crisis, whenever that shows up, but it does not mean that they should sell all their stocks and move to cash. There's no doubt that retirees who may have 30 years or more in retirement do need the market gains to stay ahead of inflation.

The first thing that every retiree or a near retiree should do is to keep a certain amount of cash reserve, whether it's 10% or much more, would depend on the personal situation. Some folks simply like to keep enough cash to cover the spending expenses for the next one to two years. It also ensures that you do not have to sell stocks at the worst time to withdraw cash. It's important not to overdo it since cash does not earn much, especially now when interest rates are likely to fall.

Once you have taken care of the cash bucket, you should divide your investible cash into two or three parts or buckets, as we like to call it. We recommend having a three-bucket system as follows.

• DGI Bucket (35-40% of the capital)
• Risk-Adjusted 6% Income Bucket (35-40% of the capital)
• High Income 8% Income Bucket (20-25% of the capital).

The First Bucket (35-40% of the capital): A DGI Bucket

For this bucket, the more active do-it-yourself type investors should invest in individual dividend-paying blue-chip stocks. You could follow any DGI (dividend growth investing) model, and there are several great models available on SA.

For a sample of a DGI portfolio, you could take a look at our "Passive DGI Core Portfolio." This DGI portfolio invests in about 35 solid, blue-chip stocks, which have a history of raising their dividend payouts year after year.

Though there are plenty of advantages of owning individual stocks over ETFs (or mutual funds), however, for folks who may like to keep it simple, a basket of good dividend-focused ETFs would do a respectable job. You would want to diversify among various ETFs, even if many of their holdings would overlap. This will not tie our fortunes with one particular fund or fund manager. For the vast majority of investors, diversification is one of the most important tenets of investing.

Table-4:

The Second Bucket: Risk-Adjusted 6% Income (35-40% of the capital)

This will be our risk-adjusted bucket and a sort of hedge against any future market downturns. Besides the risk hedge, it also will provide a respectable 6% income. In a way, it's the most important bucket because it will help us remain on the course and not deviate from our strategy during times of crisis or a recession. This is even more important now that the bull market is in its 11th year and shows signs of aging. In the meantime, we will keep earning about 5-6% income and at least 8-10% total returns.

There can be several approaches and variations to this, but we will provide one example of a risk-adjusted portfolio.

• 6% Risk-Adjusted Portfolio (based on QQQX, HYG, and IEF)

This portfolio can earn roughly 5-6% income in dividends and distributions, with nearly 40% less volatility and drawdowns, when compared to the S&P 500.

Note: We also offer variations of these portfolios as part of our Premium SA Marketplace service. Please see details at the end of this article.

6% RA Portfolio:

(Based on QQQX/HYG/IEF)

Portfolio Structure:

In this portfolio, we will hold only one asset at a time out of three chosen assets, which have a relatively low correlation with each other. Two of the assets have a relatively high yield as well:

• Nuveen Nasdaq 100 Dynamic Fund ( QQQX)

This is the asset our system will hold for a majority of the time. In other words, the system will hold QQQX when the stock market is doing relatively well. In our back testing, QQQX was held for the longest duration (about 56%) out of our 139 months test duration. QQQX has a positive correlation of about 80% with the S&P 500 and provides a quarterly dividend of 7.14%.

• iShares High Yield Corp Bond ETF ( HYG)

This is our bond proxy (high-yield corporate bond). Our backtesting model held this asset for about 19% of the total duration. HYG has a positive correlation of about 70% with the S&P 500. HYG currently provides a yield of about 5.28%.

• iShares 7-10 Year Treasury Bond ( IEF)

This is the mid-term Treasury and our risk-hedge asset. The system will switch to the Treasuries during the times of stress or corrections and recessions. For our test duration, IEF was held for about 28% of the time. IEF has a negative correlation of about -27% with the S&P 500. The yield for IEF has been going up in the rising rate environment and currently yields roughly 2.28%.

The Method and Back-Testing Results:

For back testing, we will assume that we invested $100,000 on Jan. 1, 2008, and stayed invested until July 31, 2019. We will be using the relative momentum method, which will consider the performance of the three securities in the last three months. Our model will pick the top-performing security (out of three) to invest for the next rotation period (monthly basis).

The rotation period will be for one month. That means we will check the performance of the assets on a monthly basis and rotate the assets as needed on a monthly basis. One could use a quarterly rotation, but the results may be slightly inferior.

We will provide back testing results since January 2008. The reason we picked up 2008 as the starting period is that this is how far back we can go with some of our investment picks. However, it does include the 2008-2009 recession period.

Performance of 6% QQQX Model vis-à-vis S&P500 - Without any withdrawals:

Table 5:

Performance of 6% QQQX Model vis-à-vis S&P500 - With inflation-adjusted 6% withdrawals:

The performance of the 6% Model becomes even more striking compared to the S&P 500 if we were to withdraw 6% income every year with 3% upward adjustment for inflation every year. An early loss in the S&P 500 fund in 2008 and the 6% (inflation adjusted) withdrawals every year gave no chance for it to recover. In fact, the S&P 500 fund ends up with only $87,000 assets at the end of July 2019, while the 6% QQQX model ends up with a balance of over $310,000 while providing inflation-adjusted 6% income all along.

Table 6:

As you would notice, the main advantage coming from this portfolio is that drawdowns will be much lower than the broader market in a crisis situation or a major correction. In our models, the maximum drawdown was only about -15% in comparison to -50% for the S&P 500. So, if you are a retiree, or you are someone who cannot stomach large drawdowns and likely to panic and sell at the worst time, these models definitely offer a unique advantage. It will provide most of the upside of the market but limit the downside.

The Third Bucket: High-Income (20-25% of the capital)

This is the high-income bucket. We will aim for roughly 8% income from this portfolio. Even though this bucket will only be 25% of the total investable assets but will produce over one third of the income. Obviously, this will be riskier than the DGI bucket, but it contains no more risk than the S&P 500 due to its diversification among various asset classes.

This basket will consist of high-income securities, mainly REITs, mREITs, BDCs, and some CEFs. Its main purpose is to generate high income, roughly 8%. This will help compensate for a lower level of income from other baskets.

Table 7:

The total income on a $250,000 portfolio would be roughly $20,000. The correlation factor of this portfolio with the broader market is less than 0.60.

Total Portfolio Income and Likely Drawdowns:

Table 8:

## These are just estimates based on limited data and back-testing by the author. Future outcomes can be different from the past and cannot be predicted.

Conclusion:

If we want to avoid the stress from ugly corrections or market panics from time to time, we need a systematic approach and something that has the in-built hedging mechanism. These three baskets, as described above, clearly attempt to address these needs. The broad market indexes like the the S&P 500 may provide reasonable returns in the long run but provide no safety net in case of corrections or during recessionary times.

In retirement, our goal is not to beat the market, because we don't need to. We don't have to compare our results with S&P 500 constantly, nor should we be concerned with day-to-day market gyrations. As long as the income is secure, reliable, and high enough to meet expenses, and the drawdowns are limited, we would just do fine. As the above models indicate, time will take care of the overall returns, which will, in all probability, be better than the market due to lower volatility and smaller drawdowns.