Why UK retirees may prefer dividend income – putting the personal into finance

There was a spirited discussion over at Monevator as to why on earth retirees focus on dividend income – in a rational world investors wouldn’t give a damn about where their return comes from – an appreciation in the share price or dividend income or some mix of the two. Total return is where it’s at. The Greybeard was advocating a shift towards companies with a tendency towards stable dividend payments like income investment trusts and met with some resistance to the idea from people who I would hazard were largely in the accumulation phase. I’m one of the greybeards favouring income too.

Bogleheadism is a comforting creed. Take the return the putatively efficient market gives you for your particular asset mix of choice. Adopt your previously determined safe withdrawal rate (SWR) – typically 4 to 5% though mistersquirrel and RIT advocate lower levels, then sell off accumulation index fund units to realise your SWR.

How many years do you have to average out the market noise to detect true value?

Benjamin Graham said that in the short term the market is a voting machine, in the long term it is a weighing machine. It’s a pity the old boy didn’t give us an integration time to average out the noise signal from the voting machine bit, but we can get a feel for it by two bits of indirect evidence. One is the boom-bust cycle, and the other is the integration time of the Shiller CAPE index.

The BBC counted 25 bear markets in the 20th century, with typical drawdowns of up to 40%.

The Shiller CAPE index takes an integration time of about 10 years. That’s a bastard. It means if you start your retirement, say in 2007, you could have to wait a long time – over five years – to start to observe whether the engine of industrial capitalism was misfiring and trending towards secular stagnation, in which case you want to rack back your 5% SWR assumption and follow RIT down the 2.5% rat-hole. Trouble is, you’ve been overdrawing your retirement capital at twice the safe withdrawal rate for the last five years.

So you decide to be a bit more jumpy and respond more quickly to the headline value of your networth. That’s now going to be feast or famine – one year you’re on caviar and flying First Class, the next year you’re on Pot Noodle and taking the Megabus to Blackpool.

The working saver can take a nonchalant approach to market crashes. They are either getting a lot more shares for their money, or if industrial capitalism is doomed anyway then they are hosed like everyone else. If it turns out the 5% real return on investment was a quirk of the postwar period then they can defer retirement and save more money, unwelcome as it may be.

If you lose or give up a job in your late 40s or 50s you often find it hard to match your previous salary, so once you pull the big red ejector handle you better be sure your plan is workable. Both in terms of academic correctness and in terms of being something that you can actually do without being stressed out into daft moves should the market throw a hissy fit on you.

Dividend income is less volatile than the capital value of shares

You can go get historical data for the FTSE 100 (UKX) index price and the UKX Total return from the FTSE here.  Unfortunately it only goes back to 2012; I munged the data to rebase both to a value of 100 on 1 Nov 2012. Then I took the quarterly change in the UKX from the previous period and calculated the dividend [ref]dividends are paid less frequently than quarterly so I will pick up sampling error, but this will come good in the 4Q/yearly boxcar average as quarterly shortfalls will be carried forward[/ref] (from the difference between UKX and the UKX-TR, bearing in mind the TR accumulates the dividend over time which needs to be compensated for).

The chart shows a 4-point moving average of quarterly change in networth based on 100, ie each point is averaged over the previous year. You’re taking the piss if you live off dividend income and don’t have at least a year’s worth of buffer. The smoothed quarterly variation is +2.5% to -1% so the range sweeps a good portion of a typical +1.25% SWR[ref]one quarter’s worth of a typical 5% annual safe withdrawal rate[/ref], and it doesn’t even cover a particularly exciting period in the market. It’s a bumpy ride – about half the quarterly values are below the nominal steady SWR

The dividend value varies less over the periods than the capital value. It’s also always a positive number (even in the pits of the recession some of the FTSE100 paid a dividend). It isn’t as much as the typical 1.25%/qtr SWR but the FTSE100 does generally increase capital value over decades, if you exclude the irrational exuberance of the dotcom boom.

Passive investing is still a set of axioms – you are modelling the behaviour of a chaotic system subject to known random stimuli as well as human frailty and the madness of crowds. It may well be the best game in town for a host of good reasons, but you must live with that rough ride and the long and unspecified delay of filtering the voting from the weighing, to decide what your SWR is. What exactly is the value of your portfolio on which you base that SWR? It’s not like you can stop investing 10 years before retiring and do a Shiller CAPE on it.

Imagine this kind of ride on a intercontinental flight

You’re the pilot of an aircraft taking off from LAX. You observe your plane has massive fuel tanks, about 10x your fuel consumption, but they start off low. After a bumpy takeoff they seem to fill steadily from nowhere. For five thousand miles you overfly land, at a steady speed, sometimes you have outages in the fuel income but the increasingly full tanks help you ride these. Halfway through your journey, you reach the East Coast and the open sea, the tanks are almost full, and your flight engineer says let’s switch to the alternative powertrain.

All of the sudden the power approximately halves, and gets rough, not only have you lost 50% of power but of what is left you’re facing a 2:1 variation in the inflow. The tanks never refill and the fuel gauge is going nuts – much of the time is shows a gradual and manageable decrease with sudden plunges to half of the previous level and back.

It’s gonna make you jumpy and fearful. Particularly bearing in mind that people retiring now often had an experience of a steadier work income than is common in a less secure employment environment now. I have left five jobs (discounting crappy university infill stuff) but four of the leaving dos were in the first seven years of my working life. These people are going to be ill-suited to managing such a variable income compared to many people working now. They’re just not used to it.

capital value/networth is a bad metric for people with high equity exposure – it’s feast or famine

This is an ermine’s networth, as it was in numerical form at the instance of the time on the x-axis. It shows cash and equity investments I can get hold of, and excludes things like my house value, main pension and AVC savings. If I can’t sell it in 30 days Quicken[ref]Quicken is the 10 year old program I use to track money. Unlike young pups like theFIrestarter or even mistersquirrel I don’t do cloud, I’ve taken the shaft too many times by providers closing business, and there’s the whole ‘if you’re not paying for the service then you are the product‘ problem.[/ref] may track it but it doesn’t show it. So at the end of the graph I have a 70% equity exposure. At the start I had very little, and obviously I was earning. I was a salaryman – there was no variability in my earnings, which you can see in the steady and monotonic climb at the left-hand side. All the variability was in my spending, and I had driven that down as much as possible.

I left work in 2012 – the jump reflects two things, one is the redundancy money but for tax reasons I tossed a lot of that into my pension AVCs, not shown. There was a bunch of Sharesave shares vesting and therefore coming onto my books.  Quicken is able to update equity prices with a whole load of scripting fun and games, this chart therefore shows what the liquidation potential of my financial assets at any point in time. I stopped earning in 2012 – you can see this because the slope of the chart falls off. But also look at the increasing random variation on my networth, which is the result of the increasing equity exposure. In May 2012 I could have given a reasonably accurate answer to “what is your networth”. Whereas now it would be, well, search me, guv. There’s a 10% random noise figure on it as it is, and if the Greeks pick a fight with the Germans then that 70% equity networth could easily be marked to market at half its previous value, ie my networth would be hammered to 65% of the current value on the right-hand side[ref]computed at 70%÷2+30%[/ref]. The month on month change is more than I was saving when earning, it is more than my monthly running costs, and this is the normal variation of a market that I have moaned about for two successive years that it is boring and tedious. I suspect we are due some excitement soon 😉 My ISA is more diversified than the UKX in terms of sector, size and geography, but that doesn’t eliminate volatility, just reduces it.

So if you’re spending x% of your annually evaluated networth, you could be eating a 50% variation in income year on year. If you want to see what that looks like check out the bellyaching about the GAD rules in 2011 as people in drawdown had to cut their spending for very similar reasons – and that was only 8% because the GAD window time spanned several years. Now retirees have usually got shot of the children and paid down most of their mortgage, so their fixed costs can be less of their income proportionally to their working selves. That’s a good position to be in, because they can then adjust their spending to suit. Still not going to be fun!

The age-old choice – speed or comfort, Sir?

In my view you need to hold about three years worth of running costs as a cash float to live off dividend income anyway. It seems many people think that’s too much – so they may be prepared to pay a bit more to have someone do that smoothing for them. Which is where the investment trusts come in – although valuations make it harder to do this now than when this article was written the time will come again. To wit –

The pick of these trusts have paid regular dividends for decades, with the income rising annually for well over 20 years. The very best have grown their payouts for more than 40 years

You are paying for the smoothing – in risk as well as slightly higher fees. The efficient market hypothesis says so. Nevertheless, if they have a track record of growing their payouts for decades then if you determine the amount of payout you get now is good enough, you may feel better about relying on it more than that SWR% of your net worth.

You can do the smoothing yourself – just how much cash do you hold? There are other ways of smoothing – you can shift your portfolio towards bonds. How much? It really helps to know how long you will live for. You can take the Logan’s Run approach to putting an upper bound on that, for for some reason this isn’t a particularly popular option.

That’s the trouble with retirement planning. You have to make a judgement call on your own death, it’s not something a living system really likes to do. The Cyclopes of ancient Greek mythology traded one eye for knowledge of the future. They weren’t that chuffed to get in return the foreknowledge of the date of their own death 😉

That’s why this retiree likes dividend income. Taking the efficient market hypothesis as an article of faith is a lot easier when you are young and retirement is far away. When I was looking for a way to top up my pension to allow for the fact that I was going to work for shorter than the original time I had expected, I started in the teeth of the recession. While this indicated to me I was starting at a good time[ref]market timing is deprecated by the cognoscenti, for reasons I confess I don’t really get, valuation is one of the few signals that does seem to have a correlation with future returns. Even the Boglehead gurus at Vanguard say so.[/ref], I didn’t want that rough ride on income that a fixed SWR would represent, even though the income was for wants, not needs. It’s very easy to imagine future bear markets when you are in one 😉

When I read “there’s a way of profiting from holding shares that requires no selling at all, by receiving the (generally) twice-a-year dividend” I figured this was a good way to go to match my requirements and temperament. It’s got harder to do that, and I have given some nod to the EMH and diversification by using index funds for non-UK equity investments. I have seen my target yield fall as a result, though not my unitised portfolio value. At the moment because I reinvest dividends I am converting dividend income to ISA capital gain. I accept that I eat about 1% costs on the dividend in trading costs to invest it again.

If I had 30 years of accumulation I would use continuous drip feeding. But I just don’t have that long. And I’m prepared to accept the consequences, because my risk profile is abnormal – this is not the main part of my retirement savings.

Adjusting spending upwards is easy. Adjusting it down is hard

I’ve had experience of trying to reduce spending incrementally. I read this book by Guardianista Polly Ghazi, probably in ’97. At the time I was looking to move from the first two-up-two down I stupidly bought in Ipswich for vastly more than it was worth in 1989 to the current place. The only small problem was icing the negative equity first, which meant kissing goodbye to roughly half the interest only (endowment backed) mortgage. There’s only one way to do that, every month you take a shitload of money you’ve earned by selling a load of your time to The Man and you throw it into a black hole of debt, money which you could be spending it on holidays, meals out, or even another house.

Let me save you that £11 book price. You don’t downshift in any meaningful way by switching to value brands at Tesco. You don’t do it by switching to ecologically favourable washing up liquid – because it doesn’t work as well as the sort of thing that says ‘kills fish’ on it[ref]I jest. Slightly. There is no point in using things like Ecover toilet cleaner. If you are going to be less environmentally hostile use vinegar for glass and vitreous surfaces and baking powder (NaHCO3) as a degreaser/deodouriser. Neither of them work as well as Unilever’s finest but they are cheap. Bleach is not particularly bad as it breaks up as it gets diluted.  MMM can help you address the supply side of this problem[/ref]. If you need Ms Ghazi to tell you it’s cheaper to hang your washing outside rather than use the dryer you need a check up from the neck up. You don’t save money by going part-time. In short, you very definitely don’t go about it in the way described by these two Guardian journalists, I didn’t realise journalism had already been taken over by aristocratic interns that early. They had no bloody idea. Yes, if you’re spewing money away on John Lewis housewares and shop at Waitrose then maybe you can save enough money to matter. But if you’ve already put some brain cells to work in cutting down you need revolution, not evolution in your spending habits. Keeping hens in the back garden of your Islington pad ain’t gonna cut it.

“Do or do not. There is no try”.

It sounds outrageous, but if one is trying to jump across a chasm, it makes no sense to focus on first jumping half way across and then on jumping the rest of the way. Aim to jump all the way or don’t jump at all.

Yoda and ERE

Adjusting spending downwards is like running into a brick wall. Then getting up and bashing your head against it until it doesn’t hurt any more. Best done all in one go and you have at least six months of hell where you go “Why can’t I do [insert piece of stupid consumerism that you used to do but was vaguely enjoyable, though not as much as the hours of sucking up to the Man to be able to pay for it]?” The trouble is if you don’t go cold turkey the losses you feel in one piece of consumerism denied will simply go into jacking up some other piece of consumerism. If you try and nail that you now had two areas where you feel mildly pissed off but you still haven’t saved a useful amount of money. The meek shall not inherit the earth in this fight. Consumerism delivers the message every day “buy this. It will make you feel better ‘because you’re worth it'”. Lots of really clever people are paid lots of money to pound that message into your skull, and there are many of them and only one of you. This is not a question of balance, it is a case of terminate with extreme prejudice or go home and enjoy the consumer lifestyle and suck up to The Man. Incrementalism works a treat on upshifting but really blows on downshifting. Humans are loss averse – the downshift hurts way more than the upshift delighted. You’re just built that way.

Dear ex-girlfriend and I never managed to save money the Ghazi way. We stopped going out for meals. Stopped going abroad for holidays. We decided what mattered to us and what didn’t. and I poured endless money down an endless circling drain to go fix the most monumental personal finance error I have ever made. There is absolutely no fun it that at all.

Buy to Let = early retirement?

You see the scars from that cock-up in all the grousing about residential property on here. It is in the value of my house[ref]most UK PF readers are from London. In the provinces houses are a tenth of the sort of prices you are used to[/ref] being less than a third of the networth chart of a subset of my total assets. It is in the fact I am not a BTL investor. The Ermine Does. Not. Do. Res. Property. Everybody else in the UK thinks residential property = money tree.

I look at this pair of blessed tossers asking “Will income from a £750k buy-to-let empire pay for our three babies?” The ermine stares into the crystal ball and as it shatters with the intense flow of the clients’ emotion of Greed and he walks away with a cynical baring of the teeth and a note to charge these dudes for the trashed glassware. “There is nothing I can do for you in the face of such folly”. The Guardian tells you the cost of raising a child × 3 is over half a million pounds, and you both want to retire[ref]sorry, both “focus on their creative careers without worrying about paying the bills”.[/ref] by 40, live in London, raise those kids on an asset base of £750k while servicing a mortgage of £430k? He was lucky enough to make £300k on his house so he believes in BTL, like 99.99999999% of British people – I am the sole exception to that in this benighted country it seems. Let’s see – three kids FFS – you already have to be rich to be able to afford to have three kids in Britain these days. Props to them for ambition, wanting to retire before having children. Good luck with that. Hope it works, because the taxpayer is underwriting the downside of this triumph of hope over experience. BTL can be money tree. In the right hands. These are not the right hands IMO:

“Property makes the most sense to me as an investment – I’ve spent a lot of time trying to understand stocks and shares, and it feels quite counterintuitive, although I bought shares in Royal Mail and Gap and I did all right.”

Horizontal and vertical diversification, asset classes, risk management, all that tosh… Even though I hate on the asset class I have some property in REITs and HHP index crap.

What you don’t want to do is upshift and downshift repeatedly

So the second time in my life when I had to save a load of money was to quit work eight years early I knew what to do. Cold Turkey. It’s the only way IMO. When you are looking at downshifting for the rest of your life you’d like to at least qualify the option, and for that you need an answer to ‘how much income will I have in retirement’, and preferably not one that flaps about 50% down in a rough year or few.

Take a look at the Ermine’s networth. Why am I still standing on the brake of spending, indeed have done for 5 years now – after all that networth is actually creeping up, and it represents less than half the much less volatile resources I do have? I am standing on the brakes because I know how hard it is to reduce spending, and I don’t want to have to do it again, or – shudder-  go work for The Man again. I’ve done with that for one lifetime. That’s why, when I look to win an income from an equity portfolio I favour dividend income like The Greybeard. It’s why when you go on TMF-UK you see people talking about high yield portfolios so much. It’s worth smoothing the income because if you’re going to have to downshift because you upshifted in the good times it’s probably going to feel better to not upshift in the first place, because the hurt of the down is more than the joy of the up. A smoothed income lets you minimise these changes. It’s between business class and economy, rather than business class and Megabus.

The Boglehead way is probably great, but the ride absolutely sucks because of the unknowability of the true value of your portfolio. It’s for the young ‘uns with decades of investment ahead of them, and they will probably do very well out of it. Those of us with more aged bones prefer the gentler ride, and are often prepared to surrender performance for smoothness.

Once you’ve had the experience of downshifting a couple of times, you really don’t want to do it on somebody else’s terms. It’s tough enough to do to achieve a positive goal like freedom from The Man[ref]I’m not sure if freedom from something is positive. But it feels good[/ref]. So I’ll favour conservatism, and inflate when I feel far enough away from the brick wall to have some space from it. Yeah, I could go to work, but I don’t have the taste for it, because I have gotten used to owning my own time. They still aren’t making any more of it.