This article was inspired by a series of posts by fellow early retirement bloggers about how to live off your wealth during retirement. They called this a retirement draw-down or withdrawal strategy, which, by the way, could be very different than your strategy to build wealth. I touched on my withdrawal strategy in How to Retire Early & Confidently Using Real Estate, but I will go into more depth in this article.
For me, a good retirement withdrawal strategy has two primary goals:
- Pay for all your current living expenses
- Not run out of money in the future
It turns out that rental income and other real estate investing strategies work great to achieve these goals. And real estate can make a big difference whether it's a small or large portion of your overall portfolio.
So, in the rest of the article I'll share ideas on how to use rentals for a retirement withdrawal strategy.
No Perfect Plans
As you read this, keep in mind that I am not an authority figure or guru who has this all figured out. I currently live off of my real estate investments, but I’m learning and growing as I go. Many of the ideas I’ll share below I learned from more experienced investors and teachers.
Also, keep in mind that a withdrawal strategy could vary significantly depending on your age, ability to work if needed, and personal preferences. There is no perfect early retirement withdrawal plan to copy.
Instead, a perfect plan for you should be flexible and dynamic. You’ll probably continue to tweak and improve it throughout your life. So, take and adapt the concepts here that you like, ignore the rest, and let what matters to you be the ultimate guide.
Let’s start by looking at the basic challenge of living off your investments in retirement.
The Challenge of Living Off Your Investments in Retirement
If you’re living off the income from your investments, the biggest fear is usually running out of money. Your investments are like a large lake or reservoir full of water. When you are working, you save money and continually fill the lake up. But when you stop working (or go part-time), the reservoir has to support you on its own.
When you’re building financial reservoirs, it’s not acceptable if the reservoir dries up before you and your loved ones do!
In the past, pensions were a primary solution to this challenge. People retired in their 60s, and if they were lucky, a pension (typically from a former employer) comfortably paid their bills until they died. The former employer withdrew from its own pension reservoirs so that the retirees didn’t need a large reservoir of their own.
But outside of military and some other government worker plans, pensions are by and large a relic of the past. You must create your own pension. The primary exception is social security income, which begins at the retirement age of between 62 and 67 for those born after 1960. You can estimate your future social security benefits here.
But most people are living much longer than before, and social security income doesn’t usually cover all of their living expenses in retirement. So, a personal reservoir of retirement savings is still a necessity. And for those leaving full-time work earlier in life, like in their 30s or 40s, social security income isn’t even a part of the solution until much later.
So, the plan for most of us is to build up our own reservoir of savings as large possible. This is also called building wealth.
But how will you know if you’ve saved enough to support a withdrawal plan for the rest of your life? Let’s take a look.
Do I Have Enough Saved For Retirement?
You may have heard that a nest egg of twenty-five times (25x) your annual expenses is a reasonable goal for financial independence. So, if you have personal expenses of $60,000/year, you need $1.5 million of investment savings according to this rule of thumb.
The source of this “25x expenses” goal is something called the 4% rule. It’s a rule of thumb that says you can withdraw about 4% of your investment portfolio each year without it running out (4% x 25 = 100%, thus 25x). With a traditional portfolio of stocks, bonds, and mutual funds, this rule of thumb usually assumes the 4% withdrawal will come from a combination of dividends, interest, and some sales of assets.
If you want to learn more, The Ultimate Guide to Safe Withdrawal Rates over at earlyretirementnow.com is the most detailed and nuanced explanation of retirement withdrawal strategies and the 4% rule I’ve ever seen. But I’m warning you, the author Big ERN is smart, and his graphs, statistics, and explanations may have your head swimming on your first reading!
The subject is complicated because the withdrawal strategy counts on, at least in part, selling investment assets in order to pay out that 4% annual withdrawal. And this makes you vulnerable to something called the sequence of returns risk. This means that if you sell at the wrong time, like right after a major stock market crash, you could permanently disable your portfolio.
While I’m fascinated with the 4% rule discussion, it’s honestly never been a major concern for me as a real estate investor. Real estate isn’t perfect and has challenges of its own, but it does give you a major advantage when living off your assets. The right real estate investments tend to produce passive income at a much higher rate, while also offering a reasonable inflation hedge if you choose locations well.
This combination of factors allows you to build a simple real estate portfolio where you never have to eat into your investment principle. And I’ll explain why that’s important below.
A Simple Rental Income Retirement Strategy
Let’s say you buy a single-family house in an economically strong metropolitan area. In my experience, a well-trained real estate investor can eventually find properties that produce between 5% and 10% un-leveraged rental income yields (i.e. cap rates).
And based on historical real estate appreciation rates, your rent on these well-located properties may keep up with inflation. This means your rentals should be able to buy the same amount of lifestyle in 30 years as they do today.
So, the right real estate investments allow you to have a withdrawal strategy of more than the traditional 4% rule for the same money invested. This allows you to pay for your lifestyle expenses with more ease (goal #1 of a good withdrawal plan). And at the same time, you’re not eating into any of your principal.
And why is not reducing your principal important? Because when you never reduce your principal, it’s kind of hard to run out! And not running out was my goal #2 of a withdrawal strategy.
This approach also makes the early retirement math a lot simpler. You don’t need a fancy retirement calculator with rental properties. When your real estate investments produce enough net rent to safely covers your lifestyle expenses, you can relax a little bit.
And after reaching this milestone, there is little need to sell investments to support your living expenses. You may choose to sell for other reasons, like improving your portfolio. But overall you can be a patient, opportunistic investor who can hold on even when property values drop.
But you might rightly point out that traditional assets like stock, bonds, and CDs produce income too. Can’t you use the same approach of not touching the principal with those investments? Let’s take a look.
Non-Real Estate Plans That Don’t Touch the Principal
You could use a non-real estate portfolio to produce enough income to fund living expenses. And that’s actually what dividend stock investors do. They pick a portfolio of individual stocks that pay higher than average dividends, and the income performs in a similar way to rental income within a withdrawal strategy.
But other assets like a bank certificate of deposit (CD) and broadly diversified funds of stocks or bonds give a much lower income yield (at least as I write this in 2018). This means you’d have to save a LOT more money or reduce your living expenses in order to live off income and not touch the principal.
As of January 2018, the dividend yield on the S&P 500 index is only 1.73%. The rate on ultra-safe 10-year U.S. Treasury bonds is slightly higher 2.55%. And the interest rate on the best, FDIC-insured 5-year bank CDs is 2.45% according to BankRate.com.
So, if you wanted to live on dividends of the S&P 500 without eating into principal, you’d need to save about fifty-eight times (58x) your annual expenses (100% / 1.73% = 58). So, annual expenses of $60,000 would require investment savings of almost $3.5 million!
With a portfolio of 10-year treasury bonds at 2.55%, you’d need about thirty-nine times (39x) your annual expenses. So, annual expenses of $60,000 would still require investment savings of $2.34 million.
On the other hand, with a portfolio of single-family houses with rental yields of 6%, you would only need savings/equity of seventeen times (17x) your expenses. So, with annual expenses of $60,000, you’d only need investment savings of a little over $1 million.
That’s a big net worth difference for the same income-producing result!
But this isn’t a battle between real estate investing and other assets. Every asset has its pluses and minuses and proper place in an overall diversified portfolio. But even with diversification, I like the idea of using real estate as a foundation or income floor for the rest of the portfolio.
I'll explain how to build an income floor, and invest for the upside in Part 2 (soon)!