Can you rely on the stock market to fund your retirement?
Financial experts often advise that shares return 8% to 10% per year on average. But can you trust that assumption with your retirement at stake? Consider the hypothetical scenario below...
Index fund retirement strategy
Charles and Nicole have just retired. The couple have a pension of £500,000, invested in index funds to keep fees low. In retirement, they plan to withdraw £25,000 capital at the start of each year for living expenses and they figure with an 8% return on the portfolio, they should be able to achieve this comfortably and still grow their portfolio.
However 'Mr Market' has other ideas. In the first year of retirement, shares have a tough time and the market falls 10%. This reduces the portfolio to £428,000 after living expenses. The couple are undeterred by the fall and continue with their investment strategy. However in year two, the market falls by another 16%. Their portfolio falls to £338,000 after living expenses. Charles and Nicole hold on, hoping for a market rebound, but in the third year of retirement, the market crashes heavily, falling 25%. Their portfolio is now worth just £235,000, less than half of what it was three years ago.
Having seen their pension decimated, Charles and Nicole are panicked and decide that the emotional strain of investing in shares is too much to handle. They sell the remainder of their portfolio at precisely the wrong moment, locking in losses right before the market rebounds.
While the example above sounds like a worst-case scenario, believe it or not, the returns I've used are actual FTSE 100 returns for the years 2000-2002. Put yourself in Charles and Nicole's shoes for a moment. Would you trust yourself to stick to your investment strategy having seen over half your portfolio wiped out in three years?
More importantly, is there a better investment strategy?
A dividend strategy
Dividend investing, offers an alternative investment strategy. Indeed, a dividend investing strategy is capable of generating excellent long-term returns and regular cash payouts, with lower volatility than the market in general. Here's an alternative scenario.
Andrew and Kate have just retired with a pension of £500,000, invested across a diversified portfolio of high-quality dividend stocks with an average yield of 5%. Their dividends grow by 4% per year, and they plan to spend £25,000 per year in retirement.
In the first year of retirement, Andrew and Kate receive £25,000 in dividends alone, covering their living expenses. The value of their portfolio declines (less than the market) however, as they haven't had to touch their capital, the value of their portfolio is largely irrelevant. In year two, their dividend stream grows to £26,000. This comfortably covers their living expenses again, meaning that although their portfolio has continued to fall, the value of their portfolio is still not a problem.
In year three, the couple's dividend stream is over £27,000 and again pays their living expenses. Their portfolio has fallen significantly in value, but Andrew and Kate still haven't had to sell any shares to fund their retirement. At ease with their investment strategy, the couple remain invested and capitalise as the market rebounds significantly in coming years.
Can you see the appeal of dividends? Whether you're building a portfolio for the long term, or already retired, a dividend strategy has many benefits, including regular cash payouts, and more peace of mind when markets get volatile. Can you afford to not invest in dividend-paying stocks?