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.

The Simplicity of Living off Dividends

Some people have made comments that many of my posts on this blog are not finance related, so I will make an effort to post more about ETFs and other financial topics in the future. Perhaps the reason why there are few finance topics on this blog is because living off dividends is such a simple technique that I rarely think too much about finance. The whole point of making money is so you do not need to think about money. You do not need to stress about making ends meet when you have few obligations and multiple streams of dividends flowing into your bank account.

Budgeting, tracking net worth, trading, and rebalancing are not worth it

While most people maintain spreadsheets to track expenses and net worth, living off dividends only requires you to invest all your work salary and spend your dividends. If you end up spending more than dividend income, simply “borrow from yourself” by maintaining a few thousand dollars in cash in a separate savings account that you borrow from but pay back with dividend income. Either use a spreadsheet to keep track of how much you own to yourself or ensure that this savings account has a fixed amount e.g. you have $2000 in it, run out of dividends to spend, so you “borrow” $500 to have a balance of $1500 and then when your next dividend payment comes in, put $500 into this savings account to top it back up to $2000.

I don’t recommend tracking your expenses or tracking your net worth because it is time consuming and because the information you get out of it is not valuable. If you track expenses, you can see where all your spending goes, but what matters is not what you spend your money on but how much you spend. If you spend such that your expenses are equal to dividend income, this ensures you don’t spend too much, and one of the benefits of living off dividends is that dividends increase over time as you invest more and as companies become more profitable, so there is a gradual increase in standard of living, which I think helps overcome the feeling of deprivation many feel when they are frugal. If you only spend e.g. $10,000 per year for the rest of your life, you are stuck on that level and do not feel as if you are growing or making progress, but if you live off dividends and your dividends grow, you feel a sense of personal growth. As for tracking net worth, when you diversify across multiple areas (e.g. retirement accounts, managed funds, ETFs, cryptocurrency, etc) then it becomes a huge burden to log in to each of these accounts to check the balance. What matters to financial independence is not net worth per se but passive income. You live off passive income, not net worth, and if you live off passive income then you’ll be able to assess automatically whether you have enough based on whether you are satisfied or not with your standard of living.

Because living off dividends is simple, there are only two things you need to consider: how to spend your dividends and what to invest your work salary in. Most people have no issue with figuring out how to spend their money (e.g. holidays, books, smartphones, and coffee). What to invest in is more complicated, and generally I recommend buying broad and diversified ETFs with a slightly heavier allocation towards high dividend paying ETFs (or LICs). However, more important than what you invest in, in my opinion, is the “buy and hold” mentality. You should buy with the intention of holding these investments for a long time, if not forever. I also do not bother with rebalancing. For example, in recent years the Australian stock market has underperformed whereas foreign stocks (particularly US stocks) have done very well. There are those who rebalance by selling off US stocks to buy Australia stocks to maintain a certain amount to certain countries. This is far more effort than necessary, adds administrative burden by triggering capital gains tax, and does not add much value because if you feel you have too little Australian stock, rather than sell US stock, you can simply buy more Australian stocks. For example, in recent years, as US equities has gone up, I have purchased more high-dividend paying Australian stocks and ETFs e.g. CBA and IHD.

Age in VDCO

For most people who ask, I recommend Vanguard’s diversified ETFs. You cannot beat the simplicity of these ETFs. Whatever your age is, hold that amount in VDCO and the rest you hold in VDHG. For example, if you’re 30 then hold 30% VDCO and 70% VDHG. These Vanguard diversified ETFs diversify across just about all asset classes (e.g. Australian shares, international shares, emerging markets, small caps, property, bonds, etc) so you don’t need to worry about mixing and matching. The reason why you hold your age in VDCO is to broadly follow the “age in bonds” rule, which is insurance against retiring just after a huge market crash. There are many people who are anti-bond and claim that they are a drag on performance, that stocks always go up on the long run, etc, but this is not true. In fact, this is dangerous advice. There is no guarantee that stocks go up in the long run as the value of stocks merely represent company profits and there is no guarantee that company profits will go up in the long run. Even if stocks do go up in the long run, there are huge market crash (e.g. 50% decline) that emerge, not just normal business cycles but debt supercycles that can take centuries to materialize. You do not want to be in the position of being in 100% equities and then losing 50% just before you retire as this can really set you back and impact on the quality of your retirement. Broadly following “age in bonds” (government bonds, specifically) is insurance against such a scenario. In fact, of all the rules of personal finance, “age in bonds” is, in my opinion, the most important. You can pretty much invest in any exotic high-risk asset class (e.g. emerging markets, tech stocks, robotics ETFs, cryptocurrency, etc) but if you own your age in government bonds, you are safe.

When markets go up, it is very easy to rationalize why defensive asset classes are poor quality. It is when markets go up that people easily covert to the cult of equity, but when there is a market crash or when there is a prolonged economic depression that lasts many decades or centures, many will understand and appreciate the wisdom of “age in bonds.” The reality is that when markets are booming, it’s easy to convince yourself why 100% equities or high leverage is a good idea, and the opposite is true when there is a market crash. It goes back to Warren Buffet’s quote about being fearful when others are greedy but also thinking about Ray Dalio’s idea that you must stress test your ideas because you are never be too sure in yourself  because it is easy to be moved by your emotions as well as other psychological biases.

 

 

Vanguard Australia Diversified ETFs – The Only Investments You’ll Need?

Vanguard has always had diversified managed fund. I remember using these many years ago, but I stopped adding money into these funds as I was distracted by other new investments. However, when I look back the performance of my investments, I am blown away by the returns from these Vanguard diversified managed funds, and they pay regular quarterly distributions into my bank account.

Furthermore, at the end of the financial year, Vanguard provides a full tax summary that you can simply give to your accountant (I use H&R Block). For simplicity and effectiveness, investing in Vanguard and getting H&R Block to manage your taxes is, in my opinion, a foolproof strategy.

One of the main issues with Vanguard’s diversified managed fund was that its fees were quite high. However, recently Vanguard has released their suite of four diversified ETFs:

  • Vanguard Conservative Index ETF (VDCO)
  • Vanguard Balanced Index ETF (VDBA)
  • Vanguard Growth Index ETF (VDGR)
  • Vanguard High Growth Index ETF (VDHG).

Investors now only need to determine how much risk they are willing to tolerate and then allocate money appropriately, e.g. if you are willing to take on more risk then invest in VDHG whereas if you want to take less risk you pick VDCO. Everything else is handled by Vanguard, which makes investing simple and easy.

These ETFs can be purchased off the ASX, which can be done with an online broker such as CommSec. I try to purchase ETFs in $25,000 increments on CommSec as the fee is $30, which is the most bang for your buck.

Most financial advice follows the “age in bonds” principle whereby you own your age in government bonds, e.g. if you’re 30 then 30% of your wealth is in government bonds. Whether you strictly follow “age in bonds” or not, the main principle is that as you are nearing retirement you reduce risk in your portfolio. With Vanguard diversified ETFs, you can simply carry this out by buying VDHG when you’re young but as you get older you start to buy more VDCO to reduce risk. Although not exactly conforming to “age in bonds”, “age in VDCO” is a simple alternative rule-of-thumb. For example, if you’re 30, own 30% VDCO and 70% VDHG. As you buy, simply buy whichever ETF you’re underweight in.

I love to dabble in new exotic investments such as ROBO and cryptocurrencies, but I try to follow the core-satellite approach, which states that you limit exotic investments (the “satellite”) to a small portion of your portfolio (e.g. only 30%) while the bulk of your investments (the “core”) are in low-cost passive index funds. Vanguard’s diversified ETFs are perfect investments to take the role of “core” investments.

More information can be found at Vanguard Australia’s official website on its diversified ETFs.

https://www.vanguardinvestments.com.au/diversifiedETFs/

For those who prefer managed funds rather than ETFs, see below Vanguard Australia’s page on its diversified managed funds.

https://www.vanguardinvestments.com.au/diversified