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A few weeks ago, fellow FIRE blogger and our good friend Jeremy from GoCurryCracker responded to a reader question about whether it makes sense to build a portfolio so that you could live off the dividend yield completely.
This is what he concluded:
The answer is simple: don’t live off just dividends.
His answer was based on looking at the relative performance of Vanguard’s High Dividend ETF compared to just the index over the period of his retirement. In the below graph, blue = the High Dividend ETF.
His conclusion: the index returned MORE during the same timeframe, so focusing on yield handicaps you. After all, if you get more yield, but less return overall, then that’s not a great deal is it?
This of course sent a bunch of emails into our inbox demanding to know our response, since we wrote a whole series about our plan to use dividends to mitigate against sequence-of-return risk, which we name the Yield Shield.
So I thought this would be a good opportunity to respond with a few slick-looking graphs of our own. But before we do, I want to take a moment to tell you all what I think of Jeremy.
This Jeremy guy…is one smart cookie, and he is absolutely right.
Total Return vs. Yield
Over the long term, a yield-centered portfolio will underperform the index.
Because whatever vehicle you use to invest to get yield, whether it’s dividend-heavy stocks like the ETF he showed in his chart, or preferred shares, or corporate bonds, the underlying companies issuing this securities will be similar: mature, blue-chip corporations with way too much cash that it doesn’t know what to do with, besides handing it back to their shareholders. These companies are the the Bank of Americas and the ReMax’s of the index.
And that’s great, but investing this way exclusively will ignore the young, faster-growing companies of the index. After all, while a mature car company like Ford is unlikely to grow 300% in a year, a smaller company like Tesla might, and that’s where the outperformance of a total-market index funds like VTI get their juice. Tesla, after all, doesn’t pay dividends.
And that’s why we actually don’t advocate chasing yield long-term. If you read our Yield Shield series carefully, you’ll notice that we actually advise using the Yield Shield portfolio in a very narrow, specific way.
And that’s at the beginning of your retirement to mitigate from of sequence-of-returns risk.
Sequence Of Returns Risk
So to recap: the whole FIRE movement is based off the 4% rule, whose full definition goes something like this:
A retiree can withdraw 4% of their starting portfolio, adjusting with inflation each year, and not run out of money with a 95% probability of success.
Great. 95% is great. But what about those 5% of people who don’t make it? Those people fell victim to bad timing.
Digging into the data, if a retiree were to invest your retirement portfolio in the stock market, and they were to experience a few good years of gains and then a loss due to a recession, they were OK. But if they happened to retire right before a bad bear market, they’d be forced to sell into a down market. And as a result, as the market recovered, the wouldn’t have been able to participate in the upside. These people would have run out of money in their retirement.
The sequence of returns becomes very important for these retirees, hence the name “Sequence Of Returns Risk”.
The Yield Shield portfolio’s job is to mitigate this risk.
By pivoting our portfolio into higher-yielding assets like Preferred Shares, Corporate Bonds, REITs, and Dividend Stocks, we raised our portfolio’s yield in the first few years of retirement from a paltry 2% to around 3.5%.
That’s 3.5% of $1 million, or $35,000, that we get paid regardless of whether our overall portfolio goes up, down, or sideways. That extra yield, combined with our Cash Cushion, made it so that we didn’t have to sell an assets when our portfolio was sitting at a loss. Because when you invest in the stock market, and it’s gone down, the WORST thing you can do is sell at a loss. You not only lock in your losses, but you have less units to carry you back up when the inevitable rebound occurs.
Charts or it didn’t Happen!
Now, all this is great, but how does the Yield Shield actually perform in a recession? Since we retired in 2015, we’ve had a few stock market downturns but not a full-blown recession. And definitely nothing like the 2008/2009 Great Financial Crisis. So how do we know that this Yield Shield stuff actually works, and it isn’t just a bunch of internet idiots patting themselves on the back?
First of all, there’s a misconception out there that the Yield Shield portfolio is a magic bullet that just saves you from market volatility on it’s own. It’s not. If anything, the Yield Shield portfolio increases market volatility, and I’ve been very open about that fact. At the end of 2018 went stock markets briefly entered a bear market, we reported that our portfolio behaved more like a 75/25 or an 80/20 portfolio rather than a traditional 60/40.
The power of the Yield Shield portfolio comes from it’s interaction with another concept we talk about here: The Cash Cushion.
To recap: The Cash Cushion is simply a pile of cash you have outside your retirement portfolio in a savings account that you use to tide you over in the case of a recession. We wrote about exactly how this works here.
We recommend keeping 5 years of Cash Cushion when you retire, and there’s a good reason why we came up with that number. To understand why, let’s rewind the clock a bit…to 2008.
Aahhh, remember 2008? Bush was president, everyone with a pulse could get a mortgage, and “sub-prime” was a term used to describe mediocre steak dinners. That shit went south fast after that, didn’t it?
The Great Financial Crisis that followed was the worst economic calamity in decades, and in terms of recessions it was rather unique, in that the crisis originated in, and arguably was caused by both the financial industry and the real estate industry. The two industries that would get hit the hardest in a Yield Shield portfolio, since it would concentrate holdings in mature, blue-chip companies (banks) and real estate (REITs).
Eep. Did the Yield Shield survive? Or does it collapse?
And on this question, there’s a lot of debate and analysis out there in the blog-o-sphere (ugh, I hate using that word) about this. Honestly, I didn’t think we were that influential! And if you wanted to, it would be fairly easy to generate a chart showing the Yield Shield underperformed a traditional indexing portfolio, especially if you were withdrawing 4% from the portfolio as you went.
Here’s the thing: the power of the Yield Shield comes from combining it with the Cash Cushion.
We don’t advocate the Yield Shield portfolio in isolation. We never have. We advocate the Yield Shield combined with a bundle of cash. Because in combination, the Yield Shield plus the Cash Cushion allows you to do something very different important in a downturn: It allows you to reduce your portfolio withdrawal rate without reducing your spending.
For an example, let’s look at 2008.
Here’s how a 60/40 portfolio did assuming you retired right at the beginning of 2008 with a $1M portfolio, withdrew $40,000, and continued doing so throughout the storm. You would have been able to fund some of that $40,000 using dividends and bond income, but you would also have been forced to sell some assets at a loss.
Chart was created using the tool Portfolio Visualizer, and if you want to take a look at the inputs I used, click here.
Now let’s look at the Yield Shield strategy (For Portfolio Visualizer inputs, click here)
Update: A reader noticed that in the original article, the Yield Shield inputs had “Adjust for inflation” accidentally set to “No.” This has been corrected to “Yes” and the affected charts regenerated.
If we bring up a chart of the income we would have gotten during that time, we can see that it actually stayed relatively steady despite the turmoil. It started at $35,000 the first year, then went down slightly to $33,000 before recovering back up to the $35,000 level a year later.
In this scenario, our retiree would NOT have withdrawn $40,000 each year from their portfolio. Instead, they would have harvested the yield and used their cash cushion to make up the rest. How did this portfolio do during under those conditions?
Interesting. When comparing these two behaviours, the Yield Shield + Cash Cushion strategy actually beats a traditional 60/40 portfolio. Yes it was more volatile, but because we were living off just the yield and the cash cushion, we didn’t care, and by the end of 2012, our Yield Shield has returned to its original $1M value, ready to take advantage of the rip-roaring bull market that would have been ahead. Our retiree’s 5-year Cash Cushion would have been depleted, but that’s why you refill it with capital gains when markets rampage, as they did after 2012.
Why is this? It’s not rocket science. The Yield Shield strategy isn’t some magical investment that doesn’t go down in recessions. It simply allows you to do something that every retirement planner agrees works in a downturn: reduce your portfolio withdrawals so that you don’t sell assets. And it allows you to do it while keeping a relatively small amount of cash sitting on the sidelines of just ($40,000 – $35,000) x 5 = $25,000. We didn’t need to keep hundreds of thousands of dollars of cash out of the market, because that would have been a huge drag on our long-term performance, not to mention delay your retirement.
And that’s during 2008, a once-in-a-generation confluence of events that caused the Great Financial Crisis. In a more “normal” recession like the one in 2001, the Yield Shield outperformed a traditional 60/40 portfolio even more.
(Source: Click here for inputs. Note that I had to swap out some assets in the Yield Shield due to not enough price history in the tool).
The Yield Shield Is Not a Forever Portfolio
So to recap, over the long term the Yield Shield portfolio will underperform a pure indexing portfolio. But in a recession, it, combined with a 5-year Cash Cushion, gives you the ability to reduce your portfolio withdrawals without sacrificing your spending. And since the first 5 years of retirement are the most dangerous due to Sequence of Return Risk, we only advocate for pivoting towards Yield for the first 5 years of retirement.
Personally, we retired in 2015. Since then, we’ve experienced 2 down years: 2015 due to the oil crash, and last year when our portfolio dropped 5.66%. In both cases, we were able to harvest the yield, use up some Cash Cushion, and not sell anything. And in both cases, the subsequent rebound took our portfolio even higher. When we retired our portfolio was $1M. Now it’s sitting around $1.1M.
That being said, we are now into year 3 of our retirement, so we’re starting to approach the point in which we’ll need to drop our Yield Shield assets and move back into the fold of traditional indexing. Personally, we’re planning on doing this in stages: half next year, and half the year after that, and we’ll document exactly when/how we go about doing that on this blog.
So that’s how the Yield Shield protects you in recessions. Questions? Comments? Let’s hear it below!
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