Living off Dividends vs the Four Percent Rule – Part 2

According to Wikipedia, financial independence is defined as “the status of having enough income to pay for one’s reasonable living expenses for the rest of one’s life without having to rely on formal employment.”

Financial independence does not mean you have e.g. a late-model luxury car, an expensive house, a nice watch, or even a paid-off house. If you have to work, you’re not financially independent because you are dependent on your job.

So how do you live off your investments forever? There are two main ways to achieve this: (1) live off dividends and (2) sell assets according to the “four percent rule.”

In a post I made back in 2018 titled 4% Safe Withdrawal Rate vs Living off Dividends, I claim that it is better to live off dividends because it is easier:

 [It] is better in my opinion to simply live off your investment income (dividends, rent, interest, etc) as there is no calculation involved and no work. Everything is on autopilot. That being said when living off dividends there is a trade off between income and growth (see The Problem with HVST) and this is where I think the four percent rule can be used as a guide. If your dividend income is more than 4% of your net worth, invest more in growth assets whereas if your dividend income is less than 4% of your net worth, invest in income-producing assets.

Living off dividends is indeed simple. Suppose you have $1 million. You invest it in a high dividend ETF (e.g. IHD, SYI or VHY) and that is it. The dividends will be paid to your bank account, which you live off.

However, there are many problems with relying on dividends. Typically Australian investors have relied on blue chip Australian stocks for dividends because of favourable tax treatment (due to franking credits). The problem is that these stocks tend to be concentrated among a handful of companies and historically Australian high dividend payers have performed poorly. It makes sense that high dividend paying stocks underperform because each dollar paid out in dividends is a dollar not reinvested in the company. Because the company pays out the profit as dividends, it is not able to use that money to further grow the company. The chart below demonstrates the underperformance of high dividend paying stocks by comparing an Australian high dividend ETF (black) with the broader Australian equity market (orange). For the sake of comparison, the Nasdaq 100 is represented in blue, which is the NDQ ETF tracking an index that consists mostly of technology companies that historically pay low dividends but instead reinvest profits for growth. Major companies in NDQ are Amazon, Microsoft, Apple, Google, Facebook, etc.

High dividend ETF IHD (in black) underperforms the broader Australian stock market (represented by STW in orange) and significantly underperforms the tech-heavy Nasdaq 100 index (represented by NDQ in blue). Source: Bloomberg

In contrast to the simplicity of dividends, implementing the four percent rule is more difficult, but there is considerable evidence that this approach is better, not only due to it being more tax efficient but also because the assets you invest in tend to earn more (as demonstrated in the above chart comparing the Nasdaq 100 ETF vs an Australian high dividend index ETF). Suppose you have $1 million. Rather than invest this in high dividend stocks or ETFs, you invest it in high growth stocks or ETFs that focus more on capital gains rather than dividends. You can choose NDQ, a Nasdaq 100 ETF, but if you want more diversification across countries and sectors, a good high growth ETF is VDHG, which invests in 90% global equities and 10% bonds. (Another ETF similar to VDHG but with slightly lower fees is DHHF.)

How to implement the 4% rule

When you retire, rather than rely on dividends, you simply sell off 4% of the value of the investments each year, so if you have $1 million you sell off $40k and then live off that for the first year. The expectation is that after you sell $40k then you will have $960k, but if we assume 7% annual growth then the next year your net worth will grow to $1.027 million and then you withdraw 4% of this, which is $41,088. This higher withdrawal in the next year accounts for inflation. (Note there is some uncertainty about whether, in this example of retiring with $1 million, you simply withdraw $40k each year or if you withdraw 4% of the new balance each year. I believe the latter option is safer because it explicitly accounts for inflation.)

The “four percent rule” is controversial with many arguing that it is only designed to last you thirty years. However, a simple fix to this problem is to withdraw 3% of your portfolio each year rather than 4% and, in my opinion, anything below 3% is far too conservative. Based on FireCalc.com, although the 4% rule fails with 95% probability after 30 years, the 3% rule is highly likely to last you forever. Basically if you are retiring in your 60s or 70s, you should be able to get away with the 4% rule, but if you retire any earlier, you should use the 3% rule instead.

The chart below made using FireCalc.com provides a simulation of historic stock market returns using the 4% rule and shows that over 70 years there is a good change you will not run out of money after 70 years but there is approximately a 10% probaility that you will (represented by lines going down below the horizontal red line).

Simulation showing the 4% withdrawal rate has an approximately 10% probability of failure over 70 years. Source: FireCalc.com

However, using the 3% rule, there are no probability where you lose your money (based on historic stock market performance), even under the assumption that you retire in your 30s and live for 70 years.

Simulation showing a 3% withdrawl rate being highly likely to last you forever. Source: FireCalc.com

The reason why selling off assets is more tax efficient is because capital gains are not realised until you sell the assets, which means you can sell them when you retire. By selling off assets when you retire, you do so when your income is low, which exposes more of your capital gains to low (or zero) income tax brackets. However, dividends are taxed once they are paid, which means that while you are working and accumulating assets, you’ll pay taxes on dividend income while your income is relatively high.

Capital gains are subject to Australian income tax rates once the capital gains are realised.

What will I do?

Early in my journey towards financial independence, I focused mainly on accumulating high dividend ETFs e.g. IHD and even HVST (see The Problem with HVST). When investing in purely Australian equities, I discovered that not only did my investments underperform but I also needed to pay taxes every year. To address this problem, I used a margin loan to borrow against my ETFs and diversify into international and emerging market equities more (e.g. I made some good bets on technology ETFs). Having a margin loan has its pros and cons, but one of the pros is that the interest on the margin loan is tax deductible, which helps to offset the tax paid on the dividends from Australian equities. Today Australian equities make up approximately half of my equities with the other half in international equities and a small amount of emerging market equities. Although I have a margin loan, I have started dabbling in NAB Equity Builder. NAB EB allows you to borrow at a lower rate compared to a margin loan.

While I am moving towards growth rather than dividends, I am still holding onto my high dividend ETFs. My plan is, rather than choose between dividends or growth, I will simply aim for both. There are many benefits of dividend investing e.g. franking credits. Furhermore, even though Australian high dividend stocks have underperformed in the last decade, there may be hope in the future as these companies enter the post-COVID future. If I sell Australian dividend stocks and use the proceeds to purchase global tech stocks, there is a very real risk that I will sell low and buy high, so rather than sell, I prefer to simply leave my Australian dividend stocks and ETFs. It should also be noted that there are other ETFs on the ASX that pay high dividends but do not invest in Australian equities e.g. UMAX uses options against the S&P500 to generate income; EBND invests in emerging market bonds and pays approximately 5% monthly; and TECH focuses on global tech stocks that have strong moats, and surprisingly this ETF has a dividend yield of approximately 9% paid yearly. I will discuss these non-Australian high-yield ETFs in a separate future blog post.

Property vs shares

Although it is clear that I have a bias towards shares over property, the strategy of selling down high growth ETFs exposes yet another benefit of shares vs property, which is the ability of ETFs to be sold in small chunks. If you have a $1 million property, you cannot sell half of it because no one will want half a property. You must sell it all in one go. Suppose you make $500k capital gains. Then $18200 of that will be exempt from tax while the rest of it is subject to tax, so you’ve managed to avoid tax on $18200. Now suppose you have $1 million in ETFs, which we will assume is $1 million all in VDHG. Rather then being forced to sell all of it in one go, you sell half of it in one year and the other half the next year. By doing this you realise $250k in each year. This exposes $36400 to the tax free threshold. By being able to sell smaller portions, you make the most of the tax free threshold.

Thanks to ETFs being highly divisible, I can sell off small amounts of ETFs each year thereby spreading capital gains across multiple years and exposing more capital gains to low tax brackets. Furthermore, any capital gains on assets held over one year receive a 50% CGT discount.

Another benefit of investing in ETFs rather than property is that you can sell ETFs cheaply e.g. selling one property will cost you about $20k to $30k in real estate agent commissions, but with ETFs you will pay about $20 or $30 to sell (or even $9.50 for discount online broker SelfWealth).

Other benefits of ETFs vs property is you avoid stamp duty and land tax. You also have access to franking credits.

Of course, in all fairness, there are some downsides of ETFs vs property e.g. the interest rate on NAB EB and margin loans are higher than those on mortgages, and although you can achieve leverage of about 70% using NAB EB or margin loans, you are able to achieve leverage of 80% up to 95% with property. In my opinion, even if you are able to achieve more leverage against property, it doesn’t necessarily mean you should. Leverage can magnify gains but also magnifies losses should the market go through a downturn. When leveraging into ETFs, you are able to diversify within the portfolio defensive assets such as bond ETFs (e.g. VDCO), hybrid ETFs (e.g. HBRD) or even gold mining ETFs (e.g. GDX), which reduces volatility. When you leverage into a property, you are all in one property in one place, exposed to an universified asset in one location. Many believe that property is safe compared to the volatility of the stock market, but if you invest in a highly diversified ETF, it is safer than investing in one property. The lack of volatility in property is actually the result of poor price discovery mechanisms rather than because property is inherently safer than shares. Once property is listed and exposed to the same price discovery mechanism of shares, property is highly volatile as evidenced by the price charts of residential REITs.

Disclosure: I own IHD, SYI, HVST, NDQ, UMAX, EBND, TECH, HBRD, and GDX.

Property Prices Decline in Melbourne and Sydney – Should I Buy?

After property prices have been going up for quite some time, there seems to be a considerable amount of anxiety in Australia as house prices start to fall. According to Corelogic, so far there have been price declines of about 10% in Sydney and Melbourne. However, this is an average and masks the finding that top-end properties have been declining much more than affordable properties e.g. the average Broadmeadows house in 2017 is $540k and in 2018 it is $560k, a slight increase. However, in Toorak house prices went from $5 million 2017 to $3.4 million in 2018, which is a 30% decline and $1.6 million wiped out of the average Toorak house.

Toorak house and unit prices as of February 2019, source: realestate.com.au

If you own a home, does this mean it is a good time to sell it? Alternatively, is it a good time to buy?

My answer is that I don’t know. In my opinion, it is rarely a good idea to try to time the market as studies show that most people fail to pick the bottoms and the tops. The better strategy is diversification. One form of diversification is diversification into different types of assets e.g. splitting your wealth across e.g. stocks, bonds, property, gold and cryptocurrency. However, with property there is little opportunity to diversify because each house is very expensive. The average family home in Melbourne costs about $800k. If you save up a 20% deposit of $160k and right after you buy there is a price decline of 30%, then you’ve lost $240k. Another major problem with expensive property is limited ability to dollar cost average. In a volatile market, you can invest a small amount every fortnight to smooth out the bumps, but this is clearly not possible if you’re borrowing to buy a house.

Will I buy a property?

I have been anti-property for a long time, preferring instead to live at my parents and invest in ETFs. My plan was to live off dividends and eventually use the dividend income to rent a place. When my dividend grew high enough, I’d retire early and travel the world forever, living in Southeast Asia. This plan was hatched during a time when I hated my job.

However, as my salary and dividend income rise, I am having mixed feelings about gallivanting in Southeast Asia for the rest of my life, especially when I am starting to enjoy my work, and I’ve realised that although renting can be cheaper in some suburbs, this does not apply to all suburbs. In many suburbs, it is cheaper to rent, but there are some suburbs where it is cheaper to buy. This depends on a number of factors e.g. rental yield but also how much you earn. The more you earn, the more likely it is that it is cheaper to buy rather than rent. This is because you rent with after-tax income. For example, if you paid zero tax, then if you had a choice between buying a $1 million apartment or renting it for $40k per year then it is preferable to rent because you could invest $1 million in an Australian equity ETF or LIC (e.g. A200, VAS, BKI, or ARG) and earn about 5% dividend yield of $50k per year, use the $40k to rent and have $10k leftover. However, if you were earning enough salary such that you are taxed at 40% (if you earn over $80k then you pay 37% in income tax in addition to a 2% medicare levy so it is approximately 40%) then rather than getting $50k in dividends you’d only be getting $30k after-tax (ignoring franking credits), which is not enough to pay the rent of $40k per year. In this case, it is cheaper to buy.

Although this may vary across different cities, as a simple generalisation, within Melbourne family homes tend to be cheaper to rent whereas units and apartments tend to be cheaper to buy. For example, using Toorak again as an example, the average Toorak house costs $3.43 million whereas it costs $965 per week (about $50k per year) to rent. If you had $3.43 million to afford a home, you’d be better off putting this in an ETF earning say 5% dividend yield of $171k per year. Even after tax and ignoring franking credits you’d have about $16k per year in dividend income. You’d then pay the rent of $50k and have $66k per year extra if you rented.

Home prices vs rent prices in Toorak as of February 2019, source: realestate.com.au

However, this does not apply if you are buying or renting a Melbourne CBD unit (which is where I’d rather live). A unit in the CBD is $484k to buy and $530 per week ($28k per year) to rent. Putting $484k into an ETF earning 5% dividend yield would only give you $24k before tax, which is not enough to afford the $28k rent. Given that it is cheaper to buy ignoring tax, it will definitely be cheaper to buy after tax. The higher your marginal tax rate, the more likely it would be that buying is cheaper. However, this analysis ignores the high body corporate fees that apartment owners typically pay. Furthermore, an argument can also be made that Toorak homes are better investments vs CBD apartments. Therefore, it may be worth buying a Toorak home vs an ASX200 ETF as there is some hope that the Toorak home will outperform the ASX200 whereas there is little chance a CBD unit will outperform the ASX200, and this may explain the differences in rental yields.

Melbourne CBD buy vs rent prices as of February 2019, source: realestate.com.au

Arguments for home ownership

As I said, I am considering buying a place of my own. One of the reasons is that I am starting to dislike commuting and would rather walk to work. Another reason is that over time I am starting to dislike living with my parents. Furthermore, buying a place is not that inflexible. Even if I move, retire early, or even dislike the place I live in, I can arrange for a real estate agent to rent it out the apartment and forward any leftover rental income to me, so I can still retire early and live off rental income, although rental income will likely be lower compared to dividend income because the real estate agent will take a cut of the rental income as a fee for managing the property. Furthermore, rental yields are typically lower than dividend yields.

Another concern with buying a property is debt. I believe that it is important to always be ready to retire because you never know when you’ll be fired or if you’ll hate your job. Buying a property usually incurs significant debt, and many people are tied to their jobs because of the mortgage. However, even though I own ETFs now, I still have a small amount of debt via a margin loan. I rationalise this by telling myself that the interest expenses is tax deductible and also in the event of a need to retire early I can easily sell off ETFs to pay off all the debt. This idea can be applied to property as well. If you buy an affordable property (e.g. $300k to $400k) and save up a large deposit (e.g. 50%) before you buy, even if you are fired you can sell the property and invest the proceeds into high dividend ETFs. Another alternative if you have enough equity in the property is to simply rent it out. If the equity is high in the property, the rental income should be higher than the interest cost as well as property management fee, which makes this a passive income stream similar to dividend ETFs.

Another option is to sell all my ETFs and buy a place outright, but I’ve decided against this idea because then I’d forego dividend income as well as trigger capital gains tax. When I buy ETFs, my plan is to hold it forever. Ideally, I’d like to hold any asset I buy forever and live off investment income (with the obvious exceptions being gold and cryptocurrency).

Conclusion

In my opinion, the best test of financial independence is to ask yourself how long will you survive if you have no job. If the answer is “forever” then you are financially independent.

Right now, in my thirties, I generate about $20k per year in dividend income, which in my opinion is enough to live a reasonable lifestyle in Southeast Asia e.g. Bangkok, Chiang Mai, Bali or Sihanoukville. If I really hated my job now or if I were fired, I could fly to Southeast Asia, live there for a few decades, and then come back to Australia to collect my superannuation.

However, even though I feel I could do it, I don’t feel comfortable relying solely on $20k per year in dividend income, and as I said, even though I hated my job many years back, I am starting to enjoy it more and more, so my plan is to stay in Australia and continue to invest and build more dividend income. However, if my plan is to stay in Australia for longer, I’ll need to consider my comfort, and two areas of discomfort in my life now are living with others and commuting. Basically being around other people bothers me. If I live with others, I have little privacy, and if I am on a packed train, it bothers me as well. Being at work with others bothers me if I am around the wrong people. The key is in having enough financial independence to allow you to have more say or control over the type of people you surround yourself with. Something I have learned about myself is that I am very much a people person. If I am around the wrong people, I feel extremely unhappy and depressed, but being around the right people can make a huge difference to your mood.

Buying a place in or close to the city will cut my commute, allowing me to walk to work, and it will also allow me to live by myself. If I save up enough cash deposit and buy a reasonably cheap place, even if I do decide to retire early, I’d still be able to “positively gear” the property by renting it out and generate passive rental income, which when coupled with my dividend income can boost my early retirement living standards.