The investing for a living retirement model

Well, its finally time to put it out there. Since I started blogging I’ve been trying to build a base of background posts to get me to this point. Today, I want to share with you the retirement model that I am using to fund my retirement. I think I have posted enough background information that explains the reasons for this model. And to be frank, the writing process since I started blogging has helped tremendously to refine my thinking and the model. The model is an attempt to have your cake and eat it too. I think a retiree can achieve a good level of income that more than keeps up with inflation AND have a portfolio that compounds wealth significantly over time. That is the goal of the model. So, without further ado, here is the Investing For a Living Retirement Model.

  1. A dividend portfolio that represents 70%-80% of the overall portfolio: the model is built around the core of dividend investing. I’ve covered the many reasons for investing in dividend payers, from higher returns to bear market protection. The portfolio is built to yield enough in dividends to cover retirement expenses. I recommend starting out with a 4% yield target as given by the historical safe withdrawal rates (swr) in the standard retirement model. The key difference in my model is in the way dividends are used. As opposed to simply living off the dividends, as I discuss here, ideally I would like the enhanced return that comes from the reinvestment of dividends. However, I don’t want the risk of having to sell off a portion of my portfolio to fund my expenses particularly in a down market. So, in this portion of the portfolio I look for enhanced returns from reinvestment of dividends and manage the risk in another part of the model. My personal preference is to build a dividend portfolio with individual dividend paying stocks but the model can also be used with ETFs and even mutual funds if the appropriate yields can be found.
  2. Maintain 20-30% of the overall portfolio in cash and use that cash in a trading strategy that generates enough income to cover retirement expenses. Success in this part of the strategy allows the reinvestment of dividends in step 1. The goal here is to take an aggressive approach to income investing, with a 1 year time frame, and generate enough income to cover expenses. The strategies employed here can be quite varied. For me the primary strategy is option selling. Sometimes I delve into discount or high yielding bonds but most of the time I limit myself to selling options. See here for previous posts on options.
  3. Maintain flexibility. On a year to year basis steps 1 and 2 may not work out as planned. Or a big bear market may ensue or the risks of step 2 outweigh the potential rewards. Thus I always try to maintain enough flexibility in my retirement lifestyle to reduce my living expenses in any given year by 20%. 20% maybe a an extreme for of flexibility but even 5-10% flexibility helps a lot. Such flexibility allows me to ride out a bad year for step 2 of the model or even a series of dividend cuts in part 1 of the model. Alternatively, I could only reinvest a portion of the dividends in part 1 to cover any gaps in part 2.

That’s it. That’s the model. Lets look at an example of how this model can be constructed and what the yields and return requirements are for it. Lets take a $1M retirement portfolio and use a safe withdrawal rate of 4%. I use the SWR from the traditional retirement model as a safe starting point to analyze the model. That means we need to target a starting retirement income of $40,000 per year. In my model that means that the dividend portfolio in step 1 needs to be constructed to generate $40K a year in dividends and that the trading strategy in step 2 needs to generate $40K a year in income. That allows the $40K in dividends to be reinvested and compound into the future. The chart below shows the model with two different allocations to cash. 20% and 30%.

In the dividend portfolio, in order to generate the 4% yield on the overall $1M portfolio requires a higher yield if less than 100% is allocated to it. With a 70% allocation to the dividend portfolio, the portfolio needs to yield 5.71% to generate the $40K in income. With an 80% allocation, the portfolio needs to yield 5% to generate the $40K. While a lower yield is always easier to achieve in any market, these levels of required yields are not unreasonable. This is particularly true if the investor builds to this model over several years. With dividend growth, initial investments in the 4% yield range can easily build to 5%+ yields in relatively short order. A dividend portfolio with an initial yield of 4% and a 5% dividend growth rate grows to a 5% yield on the original investment in 5 years. Personally, I run a very concentrated portfolio of dividends stocks, less than 20 stocks. My largest holdings are in the MLP space, companies like EPD, KMP, and ETP. I own some foreign dividend payers, NGG and FRFHF.PK (Fairfax). Also, I own a couple of mortgage REITs, NLY and CIM that enhance portfolio yield with not much risk.

The cash portion of the portfolio needs to generate the same level of income as the dividend portfolio which means with a 20% to 30% allocation to cash and an income requirement of $40K the return requirement on the cash is between 13% and 20%. How realistic is this? From my personal experience returns of 10%-15% on cash via option strategies is reasonably achievable without taking undue risk. 20% is a much larger hurdle, requires a lot more trading experience and I think not always achievable year in an year out but represents a good upside goal for such a strategy. I think a good starting point is a 30% allocation to cash.

A key point of the model is that it is not all or nothing. A super conservative version of the model can be implemented by never trading the cash portion of the portfolio. In such a version the investor would not be able to reinvest the dividends of part 1, they are needed to live, but the cash in this version reduces the risk of the overall portfolio and provides great opportunity to enhance returns when the market sells off. In between such a version of the model and one where an investor seeks to generate 20% returns of cash there are many in-between versions. In any given year, the portion of living expenses that is not generated in the cash part of the portfolio can be taken from the dividend portfolio by not reinvesting a portion of the dividend stream. Any part of the dividend stream that is reinvested will enhance returns. An investor in retirement can have the best of both worlds.

That’s the introduction to the Investing For A Living Retirement Model. The model takes the best parts of several retirement strategies and tries to compensate for their drawbacks. The model is definitely a work in progress. I am a living experiment I guess. I built toward this model over a period of about 4 years and have been living the model for about 2 years. I am always looking to improve the model so any suggestions are more than welcome. I’ll keep posting on individual portions of the model but hopefully this post outlines the framework I am using which will allow a better understanding of my individual posts.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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19 Responses to The investing for a living retirement model

  1. J Carroll says:

    Paul, thank you very much for posting your retirement model. I like your choice of stocks for the dividend portion (MLPs, REITS, some foreign); I also include a few blue chip high-yielders (ex: GE, MO [and, yes, GE has had a tough couple years]) and high-yield bond ETFs and closed-end funds. I am new to the options arena (for generating income), but find myself seeking a minimum 1% option premium (relative to the price per share of the underlying stock) for an option that expires in 30 days, and preferably 1.5% or more option premium for the 30 day option; as a 1% premium over a 30 day period produces an annualized yield of only 12.87% (minimally acceptable, given the risks), and a 1.5% premium over a 30 day period produces an annualized yield of 19.86% (a more reasonable risk premium, in my opinion). The option premium XX-day yield can be less if there are less than 30 days until option expiration, but must be more if there are more than 30 days until expiration. Low volatility stocks frequently do not have sufficient option premiums to, in my opinion, justify the risks (I may change my mind here if I get burned a time or two, but that is my opinion for now.). An area of the market that seems to have decent options premiums is mining (ex: BHP, CCJ, XME), and I am searching for other areas of the market with an acceptable risk-options premium balance.

    Note: The formula I use for determining Annualized Percentage Yield (APY) (easy to program in Excel and it pops out an answer instantaneously):

    APY = ((principal + gain)/principal)^(365/days) – 1

    where principal = price per share, gain = option premium, and days = days until option expiration. In practice, I modify principal and gain to allow for commissions and fees, and I add 3 to the number of days until expiration to allow time for me to respond to an exercise or expiration.

    Feedback welcome (if critical, please be gentle).

    • libertatemamo says:

      J, your approach looks fine. I tend to focus on options 3 months out, 2 months minimum if premiums are really high (VIX above 30 for example). The issue I have with 1 month options is that fees can overwhelm the gain on the trade. I always assume I need to enter and exit the trade. A great deal of the time the options expire worthless but sometimes I also close the position by buying back the options. Also, I like to have some more time for the trade to play out particularly if it goes against me early on.

      What is your risk management strategy? Do you always plan on letting the options expire? Or do you have a max loss point where you get out?


  2. heyduke says:

    it is scary how similar our approaches are but I invest in individual stocks rather than options mostly because of my lack of experience with options.

  3. J Carroll says:

    Paul, still pretty new at options and my strategy is evolving. However, at this time, I plan on my write options either expiring worthless of being exercised. I write 5%-10% out-of-the-money covered calls, so my return increases beyond the premium on the option if it is exercised and I, accordingly, sell the shares for more than I purchased them for. If an option expires worthless, I will then write another covered call on the underlying stocks. Good point, by the way, on extending the options beyond a month to lessen the impact of commissions.

  4. Pete D says:

    Paul, any options books you would recommend for an options rookie?


    • libertatemamo says:

      Hey Pete. I think the options books by Mark Wolfinger are the best to start out with. Even better, you can start with his website Options For Rookies where you can get a ton of information for free. If you like what you see then you can get the books. Also, the CBOE has some great options education for free on-line.


  5. libertatemamo says:

    For those interested in the options strategy there is a very relevant post today at Options for Rookies,


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