Find out why the 4% withdrawal rule does not mean selling investments during retirement. Selling shares reduces your retirement income. Forever.
First, a disclaimer: I am not a real estate investor.
I was a landlord for a short time after the housing bubble burst, simply because the value of the place I lived in at the time decreased so much that I did not want to sell it when I was ready to move. So I kept the place and rented it out.
That experience taught me that I am not a good landlord. I didn’t do a good job vetting my tenants, I tried to save money by managing it myself, and I ended up with a delinquent tenant that taught me way more than I wanted to know about eviction proceedings and small claims court. The experience reinforced that I prefer to invest in the stock and bond markets.
That is not to say that rental real estate is a bad investment. It is just not for me.
However, there are valuable lessons to be learned from real estate investors. There is one lesson in particular that real estate illustrates perfectly: Never liquidate your investments.
Everyone Wants to Sell Out
There is something I have found almost universally true about stock and bond investors. When they think about investing, they imagine diligently adding money to their investments during their working years. Then, when they retire, hopefully those investments will have increased in value so that the investor can sell some shares and retire.
Nearly every investor I have ever talked to has thought this way.
Really sophisticated investors have done research and heard that you can withdraw 4% of your portfolio annually during retirement and probably never run out of money.
Well, yeah, I guess that’s true. But, the devil is in the details:
You should not be selling shares to make those withdrawals.
Stocks and bonds produce a stream of income, called dividends. When you sell your shares, you are giving up the income that those shares would have produced. Forever.
If you sell shares to make those withdrawals you are guaranteeing that someday you will run out of money.
Landlords Do Not Liquidate Their Rentals
Over the last two decades, I have been chanting that same mantra about investments. I have tried explaining my position in a million different ways using a bazillion different examples. But, no matter how I explain it, the point always seems to get lost.
Except when I illustrate my point using rental real estate.
Let’s say that you spend your working years accumulating residential rentals. You do a great job building your rental portfolio and by the time you retire you have 10 residential rental units with no debt. You own them all free-and-clear.
Let’s say that those 10 units each receive $1,000 per month in rent, which would be $10,000 per month, or $120,000 per year if you had no vacancies. But, you have a 10% vacancy rate, so your revenue averages $108,000 per year. If you hold back $10,000 in reserves and pay about $20,000 in taxes, your profit would be around $78,000, which is $6,500 per month, or $650 net income per unit per month. (yes, I selected those round numbers so that the math would turn out easy… the taxes would likely be lower but the reserves should be higher, so it’s pretty close).
Now, let’s also assume that each rental unit is worth about $245,000. That means you have amassed a real estate empire worth $2.45 million that is paying $98,000 before taxes. That is a 4% cash flow return on the investment, which is pretty great.
Now, it’s time to retire. What do you do?
Would it be a good idea to sell one of those units and spend the $245,000?
I hope you’re yelling “NO” at your screen right now.
If you sold a unit and spent the money, you would be forcing yourself to take a permanent pay cut for the rest of your life. Selling that unit would force you to take a $650 per month pay cut. Forever.
Live On The Income
Instead of selling a unit for $245,000, the savvy real estate investor would live on the $78,000 annual income stream that the investments are producing.
They should treat that $78,000 exactly the same way they treated their salary from work.
They should budget and save up for big purchases. Why not should utilize short- and long-term debt (credit cards, personal loans, and mortgages) to smooth out their cash flow, just like they did when they were working?
They should not sell a unit when they want to make a big purchase.
They should not sell a unit to boost their available spending money.
If they did, they would be giving up too much future income.
The Exact Same Thing Applies to Stocks and Bonds
In the last few years interest rates have been incredibly low. That is great news if you are borrowing money. But, it also means that investors are receiving lower-than-normal dividends on their stocks and bonds.
Even though that is true, in the last few years (2016-2019) the dividend yield on my own portfolio has averaged 4.15%. (My full investment strategy is outlined in my book, available on Amazon).
That means that a stock & bond investor can create the exact same level of income from their investments that a real estate investor can.
Yes: a $245,000 investment in stocks and bonds can easily produce $650 per month after-tax income. That would be about 3.2% after-tax yield. In a Roth, that would be even easier because the taxes have already been paid!
Which also means that selling a bunch of shares of stocks and bonds has the exact same impact on future income as selling a piece of rental real estate.
If you thought it was a bad financial idea for our hypothetical investor to sell one of the rental units, then you should also think it is a bad idea for retirees to sell shares in their portfolio to pay for their retirement.
Keep the shares. Live on the dividends.
Even better: live on some of the dividends and use the additional dividends to buy more shares so you can receive even more dividends next year.
If you are retired and your total portfolio dividend distribution rate is not more than 4%, talk to your advisor and find out why.
“Never Sell” is not the same as “Buy and Hold”
I need to make a quick clarification: Never Selling is not the same as a Buy and Hold strategy.
When I say never sell, I mean never liquidate a part or all of your portfolio to pay your bills.
You should rebalance your portfolio regularly. Rebalancing keeps it in the right allocation for your risk tolerance and it manufactures new shares that have absolutely no out-of-pocket cost to the investor. (Check out my book for more details on how to use rebalancing to manufacture shares).
And, if we stick with the real estate analogy: sometimes a real estate investor will sell a building to buy some other building. That makes sense (sometimes), and it is not the same as liquidating their investments.
Somehow, we have all been trained to think of investments as a bit of a gamble.
We buy stocks and bonds and we hope that they increase in value before we “need the money.”
I want to change that mentality. Investing is not gambling. If you want to gamble, go to Vegas.
You should have a strategy that works in both up- and down-markets. You should have a plan for how often you are going to rebalance.
And, you should get paid for having money. Those payments are dividends. Those payments should be your retirement income.
I hope this has been helpful! I welcome your comments with your thoughts and questions.