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Last week I argued that, for investors with a long term view, the most desirable market direction was anything but up, at least for the time being. Of course the longer prices remain depressed, the greater the opportunity to buy at discounted prices, and as such the greater total return potential. Short term pain for long term gain.
While all well and good, retirees no doubt struggle to see the relevance for their situation. Nevertheless the potential for a protracted period of market stagnation does not necessarily spell disaster for those looking to support themselves after work. Let’s start at the beginning.
Now the goal for retirement is to have built up sufficient capital to provide you with enough of an income to support your desired lifestyle after work: an obvious fact but one often neglected until it’s too late.
For those in retirement or about to retire, your current circumstance is largely fixed. Unless you are prepared to resume paid work, you have only so much capital available to you and you will fall into one of two broad groups. The first are those that have enough capital such that the income it generates (rent, interest, dividends, realised capital gains) will be sufficient to sustain their desired standard of living and match inflation. Clearly this is a very desirable scenario because you are in a position to leave your capital base untouched. Because you consume only the income returns from your assets, you will essentially never run out of money, ever. And of course you are able to provide a generous inheritance to your loved ones.
To see if you belong to this group, divide your desired annual income by a realistic and dependable rate of return minus inflation. Studies suggest 6% is a good approximate, but of course you can use what figures you like. So for the sake of argument, if you wanted to live off $80,000 per year you would need about $1.33 million when you retire. (For the sake of simplicity and due to differences in rules between Australia and the US I have not included taxation effects).
If the sums come out in your favour then good for you. And congratulations if you got there through careful saving and investment, rather than just dumb luck. Those still a distance away from retirement take note: if you want to be in this position later in life it will generally take planning and commitment. You’ve been warned.
Those that belong to the second group are less fortunate, and this regrettably includes most of us. Because the capital they have is insufficient to generate their required income, they are required to draw down their capital to make up the difference. This means there will be some point in the future when you will become penniless.
Now that’s not necessarily a tragedy. Your capital doesn’t have to last forever, only long enough until you depart this earthly realm. What surprises most people is that we actually live quite a long time after retirement. In the developed world, those aged 65 can expect to live close to another 20 years, on average of course.
For starters this fact alone puts lie to the claim that retirees cannot afford a long term view with the market. Indeed, it is critical that they do. Secondly, it’s probably a good idea you take a moment to consider your own circumstances.
A protracted period of market weakness will mean you do not have the capital growth component of total return to rely on. Realistically the assumed rate of return for the market nears something like 3 or 4% because dividends are really the only source of return. Again, that’s not necessarily a disaster, but it does mean one of two things. Either you must be able to cope with the fall in income, or you must draw down on your capital at a greater rate to compensate for the lower return.
This second option, although largely unavoidable for many, is not an attractive proposition. In effect, you are forced into selling in a depressed market and crystallising capital losses. Worse, you are in a sense dollar cost averaging in reverse. The depletion of your capital base means you do not fully participate in any eventual recovery. In fact the whole affair greatly diminishes the longevity of your capital.
As such, for those that require access to a significant portion of their capital within the next few years, the share market is not an appropriate place to invest. Despite all the potential benefits it is simply too volatile a place to risk your precious capital reserves for a short period of time. Better to go with something more secure like a term deposit or a bond; you won’t get spectacular returns, but then you can be confident that you won’t lose any money either. That’s a very good compromise given the circumstances.
If however, you think that you will only require access to a small part of your capital, you can be far more relaxed. You certainly need a focus on dividend paying stocks though. For starters, dividend income is far more dependable (i.e. less volatile) than share prices; during the GFC, Blue Chip Australian shares saw dividends decline by only 15% on average, and have since largely recovered. Secondly, you are less reliant on selling stock; which is a good thing when prices are depressed.
That means that for many retired investors in Australia, the GFC was barely noticed as a modest and temporary drop in income. While the market price of their portfolio at one point halved ‘on paper’, it has since significantly recovered and is still exposed to any further pick up in the market, even if that is potentially a number of years away.
Ongoing weakness in the corporate world will of course rule out any significant rises to dividend payouts, but the defensive nature of many of the better income stocks will at least provide you with an income and therefore time to wait things out.
If you want to learn more about what a dividends can do for you, visit www.dividendkey.com
Make the markets work for you
Andrew Page
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