July Rally Yanks Timing Outlook Into Positive Territory; Time to Wade Back In?

1. Summary

The stock market rallied strongly in July, although not a straight-line fashion. The market’s volatility continues to have the Timing Outlook jumping around too. The last five readings have been negative-positive-negative-negative-positive. Today’s value is positive at 7.5, significantly better than 4.5 last time.

To repeat a message from the last several Timing Outlooks: The Timing Outlook is least useful when the market is gyrating, as it is pretty sensitive to short-term (2 to 3-week) market moves. Despite the strong (if choppy) July, we have been in a volatile market since mid-April. If U means up and D means down, the weekly market changes since mid-April have been D-U-D-D-U-D-U-D-U-D-D-U-U-U-D. This week is too soon to call.

(click on chart to enlarge it)

My Capital Appreciation Portfolio has remained 100% in cash since early May. With the July rally, let’s look at the criteria for re-entering the market. As noted in this article, I look for:

• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.

An astute reader has pointed out that I actually overlooked a “Buy” signal in early July. As of the close today (Thursday), we are just short of 3-week and 4-week “Buy” signals. The percentage increases are sufficient, but the number of positive trading days falls 1-2 short in each case. I will be watching the trading ranges more closely, and if a “Buy” signal comes along, I will re-enter the market with a portion of the portfolio’s cash, with any purchase protected by a sell stop.

Subjectively, this is a hard market to have confidence in. Q2 earnings reports are coming in strong, but economic factors and the general “feel” of things does not inspire confidence. Nevertheless, if the criteria generate another “Buy” signal, I will be buying. Gotta go with the system.

As usual, my Dividend Portfolio remains 100% invested. While its value has been dancing along with the market, its main goal—generating ever-increasing income streams—is still being met. None of the stocks in the portfolio has cut or frozen its dividend this year. Many have raised their dividends. The holdings are not protected by sell stops.

2. Market Performance Since Last Outlook
(“now” figures are as of close Thursday, August 5, 2010)

Last Outlook (7/19/10): 4.5 (negative)

S&P 500 last time (7/19/10): 1071
S&P 500 now: 1126 Change: +5%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1126 Change in 2010: +1%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1126 Change since 3/9/09: 66+%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The most recent report showed a decline in this index. The index has had a couple of declines in the past few months, rendering it ambiguous. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5

• Fed Funds Rate: No change. The Fed and people speaking for it continue to reinforce the idea that rates will not be raised anytime soon. With the Federal Funds rate near zero, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar shows the current P/E of the S&P 500 is 15.2, up from 14.3 last time. This indicator stays in positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.98, up from 0.93 last time. That keeps this indicator in the neutral range, which is any value between 0.90 and 1.10. +5

• S&P 500 Short Term Technical Trend: The market has rallied, in fits and starts, since the beginning of July. It has now reclaimed the value it had in early June. This short-term technical indicator uses the two shorter SMAs. The configuration is Index > 20-day > 50-day. That is the best configuration to indicate a rising market. Positive. +10

• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day). The lineup is Index > 200-day > 50-day. This is an ambiguous configuration. Neutral. +5

• DJIA Short Term Technical Trend: This chart looks basically like the S&P 500 chart. Positive. +10

• DJIA Medium Term Technical Trend: Same as the S&P 500. Neutral. +5

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Positive. +10

• NASDAQ Medium Term Technical Trend: Same as the other two. Neutral. +5

TOTAL POINTS: 75
NEW READING: 75 / 10 = 7.5 = POSITIVE

Financing Retirement IV: Asset Allocation

In the previous article in this series (immediately below this one), I stated that in conventional retirement planning, there are three critical steps:

• Maximize your capital before you retire.
• Make your capital a lot “safer” as you approach retirement.
• In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.

Coincidentally, AAII Journal ran two articles in their July, 2010 issue that address all three of those bullet points. Or I should say that it mentions them—they took all three bullet points above and used them as unquestioned truisms. From this foundation, they built two entirely contradictory models for asset allocation before, at, and after retirement.

Under Modern Portfolio Theory (MPT), it is said that proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. It is commonly accepted that your selection of individual securities is secondary to the proportions in which you allocate your investments in stocks, bonds, and cash. I believe that the rule of thumb is that 70% of your investment results will come from asset allocation, not from what securities you pick.

Asset allocation for retirement is a hot topic. On June 18, The Department of Labor and SEC held a joint hearing related to target date funds, many of which underperformed the S&P 500 in 2008-09. Target date funds have rapidly gained popularity since they were introduced in 1996. At the moment there are nearly 300 of them, with $176 Billion in assets. Their attraction is that, once you designate your retirement date, they offer the automatic achievement of the first two bullet points above.

• They maximize your capital via diversification and an ideal stock/bond ratio while you are in the accumulation years of your life. Investors with different risk profiles can select from among funds that are more or less aggressive. “Aggressiveness” is always equated with what percentage of stocks the fund contains. At a young age, the most aggressive fund may contain 90% or more stocks. Even at retirement, an aggressive fund may still contain 75% stocks.
• They make your nest egg safer as retirement approaches by automatically shifting from equities to bonds as you grow older, theoretically arriving at a perfect mix just in time for your retirement. “Safety” is always equated with holding more bonds and fewer equities.

When the market crashed in 2008-09, some of these target-date funds looked very inept. Losses were more severe than they should have been, especially for “I’m nearly retired” funds with short-term horizons. Either many of them did not keep the promise of shifting to bonds, or they did not do it fast enough, or it just plain did not work. “Target date funds have produced some troubling investment results,” said SEC Chairman Mary Schapiro in a June 2 speech before the subcommittee on Financial Services. “[The] varying strategies among these funds produced widely varying results. Returns of 2010 target date funds ranged from minus 3.6 % to minus 41%.” Obviously, retirees who lost 41% of their nest eggs in 2008-09, when they were expecting to retire in 2010, were catastrophically affected--especially when the third step of conventional retirement practice, namely selling off some of your nest egg each year, came into play.

In MPT, the hypothesis is that stocks are riskier than bonds, but that they hold the promise of better long-term returns. As the AAII says in its beginning investor series, “Stocks are more volatile than bonds, but have historically provided higher long-term returns.” Historical data supports this. It is hard to find a 30-year period, ever, that stocks have not outperformed bonds. But at shorter timeframes, stocks are considered riskier because of their price volatility. Thus the conventional wisdom is that the way to make your portfolio safer as you approach (or are in) retirement is by switching from stocks to bonds in your overall allocation.

As I stated in the last article, the problem I have with that thinking is that (1) it presumes that all retirement income will come from selling off assets, and (2) it ignores the fact that some stocks generate income themselves.

In the two AAII articles, there is not a single mention of dividend stocks as a separate asset class that may have different risk characteristics from all stocks as a class or bonds as a class. There is not even a suggestion that they might form a different category of stocks. The omission is puzzling, because stocks are traditionally sliced and diced into so many categories that supposedly offer different risk/reward profiles within the broad classification of “stocks.” Thus you get categories like U.S. Large-cap, Mid-cap, Small-cap; Foreign stocks, often nowadays themselves divided by size, country or region of the globe; Emerging markets; Value vs. Growth; and so on. But the simplest, most obvious categorization of all—do they pay a dividend?—is ignored.

It’s an important distinction. Dividend-paying stocks tend to move less (in both directions) than the market, meaning that they have a different risk/reward profile. Their dividends yield positive income even when their prices are falling. The companies that raise their dividends regularly tend to keep doing so even when the market as a whole is falling. The dividends themselves, being always positive (there is no such thing as a negative dividend), change the risk/reward profile. And studies show that the best overall returns come from dividend-raising stocks.

So the question begs to be asked: If the goal of a retirement nest egg is to provide its owner with sufficient income in retirement, and some stocks provide rising income streams by their very nature without the necessity of selling them, then why are those facts ignored in conventional retirement planning? Why are they ignored in asset allocation discussions?

It is certainly a paradigm shift to think of dividend stocks as a separate asset class, but for purposes of this article, that’s just what I am going to do. Here’s why: Traditional methods of classifying assets divide them into three major realms: Stocks, bonds, and cash. Stocks are evaluated on their prices; and bonds are evaluated on their yields. But dividend stocks have both characteristics: Their prices vary (but in a more muted fashion) with stocks generally. And their yields provide income, but with a growth kicker that most bonds don’t have—dividend-growth stocks are rising income instruments rather than fixed income investments. (In some texts, you will see the phrase “fixed-income investment” used interchangeably with “bond.”)

It’s almost like MPT has a huge hole in it. It does not miss the obvious income-producing ability of bonds—after all, that’s what a bond is, a debt instrument. The income it produces is interest on the money lent. MPT does not miss the price-appreciation potential of stocks, nor the short-term volatility they have displayed over the years. So why does MPT miss the income-producing ability of dividend stocks, the rising income-producing ability of habitual dividend-raisers like the Dividend Champions, or the muted price volatility that is characteristic of dividend stocks?

I cannot answer that question. But my conclusion is that for those who get it, dividend stocks, especially dividend-growth stocks, should not be lumped in with all stocks when it comes to making asset allocation decisions. A retiree’s portfolio can safely contain a higher percentage of dividend stocks than is normally associated with the low level of risk tolerance of a retiree. And the reason that is true is precisely because the dividend stocks throw off a continuing income stream and do not have to be sold to produce retirement income. Thus, maintaining a fairly high percentage of your retirement portfolio in well-selected dividend stocks is not too aggressive or risky for a retiree. It is safer.

Financing Retirement III: Turning Capital Into Income

This is the third article in a series on financing retirement as seen by someone who is retired (me). It’s a view from the front lines. It is pragmatic, not academic.

To recap the first two articles:

• In “Thoughts on Financing Retirement I--Beware Rules of Thumb,” I made the point that in retirement, you need to generate the income needed to cover your expenses. There are many ways to generate income—consulting, part-time work, Social Security, pensions—that may be overlooked in conventional retirement planning. Of course, income from your assets is an important ingredient in the recipe.

• In “Financing Retirement II: What’s Your Number?,” I criticized the “maximize capital” approach to retirement planning, noting that the “number” to focus on is not the capital value of your nest egg, but rather its annual income-generating ability. The two are often assumed to be proportional, but they are not. I used myself as an example, noting that according to conventional calculators, I was years and more than $1,000,000 from being able to retire, whereas in fact I have been retired for almost 9 years and live comfortably.

In this article, I want to focus on that disconnect. I believe that it comes down to how capital in a nest egg becomes income in retirement. I will be careful here in my use of the word “assets.” It is tempting to use “assets” and “capital” interchangeably. But to do so is misleading, because it assumes that the only value of an asset lies in its price if sold, and thus that the only measure of its value is its price. That notion is incorrect.

In conventional retirement planning, there are three critical steps:

• Maximize your capital before you retire.
• Make your capital a lot safer as you approach retirement.
• In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.

The problem I have with that thinking is this: It ignores the fact that some assets generate income themselves. They do not have to be sold to produce income. A few examples of such assets are:

• Pensions
• Social Security
• Annuities
• Bonds
• Dividend stocks

That is why it is important to distinguish assets from capital. The first two items above are not capital at all, but they generate income. They are truly assets: They are rights that you have acquired to receive income. If you have a pension, you earned it over time from your employer. You earned your right to Social Security payments in the same way, by working and contributing (along with your employer) to the system.

The last three items, on the other hand, are investments purchased with capital. Once purchased, they confer an important right: The right to receive an income stream.

• Annuities allow you to purchase that right from an insurance company for a price and fees that depend on your age, gender, the payout system you choose, etc. You never get your capital back, you trade it for the right to receive income for the rest of your life. (There is a useful annuity calculator at Immediate Annuities.com.) Assuming that the insurance company remains solvent, your right to the income is totally safe, except from inflation. The price you paid is totally gone.

• Bonds are also purchased with capital. Let’s assume that you invest only in “investment grade” bonds and hold them for income. The income they generate is as safe as with annuities. Instead of being for life, your right has a term limit stated on the bond, which is a contract of debt (you loaned your money to the bond issuer). Being fixed, the income stream is not safe from inflation. The capital you purchased the bonds with is safe in the sense that you will get it back at the end of the bond’s term, but its value will also have been eroded by inflation. So with investment-grade bonds, the income is safe, except from inflation. The principal is also safe, except from inflation.

• Stocks are also purchased with capital. Conventional wisdom is that they are far less safe than bonds, because their prices are volatile. Retirees who invested throughout their lifetimes mainly in stocks to maximize capital, and who then unfortunately suffer a significant loss in the value of their portfolio just before they reduced their stock exposure—because of, say, a bear market—are screwed. The income available from selling a percentage of their assets each year falls proportionately with their stock portfolio’s total price. Even after the stock exposure reduction, that percentage of your nest egg still in stocks is subject to the usual risks of the market.

But what if the stocks were well-selected—“investment grade”—dividend-growth stocks? Does the same misfortune happen? No.

• Dividend stocks generate income. Their value does not lie in their ability to be periodically sold off. Their true value lies in their ability to generate income on their own. In that respect, they are like bonds.

• But unlike bonds, dividend growth stocks are not fixed-income investments. Their yield on cost—which is comparable to the yield on bonds—goes up each time that they raise their dividend payout. They are rising-income investments. In fact, the income from investment-grade dividend growth stocks generally keeps up with or surpasses inflation.

• Unlike bonds, there is no term. Ideally, dividend-growth stocks can be held “forever.” You do not have to worry about the impact of inflation on your principal. An investment-grade dividend-growth stock whose price goes down does not necessarily reduce its dividend nor even stop increasing it. Scores of stocks have been raising their dividends for 25 to 50 years or more. They have done this since the Eisenhower administration, through every kind of economic condition—wars, recessions, inflation, stagflation. See the Dividend Champions document here that lists them.

• Finally, unlike bonds, over long periods of time, investment-grade dividend-growth stocks are likely to increase in principal value too. Every study that I have seen shows that dividend-growth stocks have the best total returns of all categories of stock.

Conventional wisdom is that a retiree’s stock-to-bond ratio should go way down as one approaches retirement age. The reason, of course, is that bonds are considered to be much safer than stocks. But are they? How do you weigh the safety of bonds’ principal and interest payments—both fixed and subject to the ravages of inflation—against dividend-growth stocks’ ability to raise their rate of return and potentially increase their principal value too? We are conditioned to think, when talking about safety, only of the principal (or capital) side of the equation. Subliminally, we fall into the “capital is everything” mind-set very easily.

But let’s raise that up to a conscious level and actually think about it. If you believe, as I do, that “it’s all about income” in retirement, then the safety we should be focused on is the safety of the income stream, including its safety from inflation.

Looking at dividend-growth stocks in this way is a paradigm shift. We are brought up and taught as investors to maximize that nest egg. But in retirement, it’s all about income. In a well-chosen ‘investment grade” dividend stock portfolio, very few stocks will fail to consistently increase their dividends each year. So the income stream goes up, in most years easily surpassing inflation. Even in bad dividend years for stocks generally (like 2009, when the total dividends paid out by the S&P 500 declined by billions), a portfolio of stocks chosen specifically for their dividend-raising prowess will throw off more dividends. I maintain a demonstration portfolio about this (see it at my Web site, Sensible Stocks.com), and in 2009, I received 19% more dividend dollars than in 2008.

Am I suggesting that conventional approaches to asset allocation in retirement—heavy on bonds, light on stocks—might be improved upon if the stocks in question are investment-grade dividend-growth stocks? Yes. And I am also suggesting that the income available for retirement from a portfolio that includes a heavy dose of excellent dividend stocks may exceed the income created by slicing off and selling a portion each year of a maximum-capital portfolio—even if the max-cap portfolio is significantly larger in size.

That may be why the retirement calculators tell me that I can’t retire until I accumulate $1,000,000 more—they don’t know about my dividend stocks. They didn’t ask.

In the real world, most retirees gather their income from a variety of sources. While the goal for dividend investors may be to live off of the dividends without selling off any of the base, the dividend stream may not be large enough. So some of the base—but far less than the “4% + inflation” standard—may be sold off to close gaps. There is an excellent recent article by Morningstar author Christine Benz that addresses how real retirees achieve the right balance: “Income or Total Return? Retired Investors Weigh In.” I highly recommend it.

Timing Outlook Remains Negative

1. Summary

The market’s volatility has the Timing Outlook jumping around too. The last four readings have been negative-positive-negative-negative. Today’s value is 4.5, which is the same as last time, the second negative reading in a row, and the third negative reading out of the last four.

As mentioned last time, the Timing Outlook is least useful when the market is gyrating. My studies of the Timing Outlook’s performance show that it is least useful when the market is going back and forth every week or every other week. That’s the kind of market we have been in for almost threee months. If U means up and D means down, the last 10 weeks of market action have been U-D-D-U-D-U-D-U-U-D-U-D.

My Capital Appreciation Portfolio remains 100% cash. The market’s rally two weeks ago gave some hope that my criteria for re-entering the market might be close at hand, but last week’s drop pushed that prospect off for a while.

As usual, my Dividend Portfolio remains 100% invested. While its value has been dancing along with the market (but in a more muted fashion), its main goal—generating ever-increasing income streams—is still being met. None of the stocks in the portfolio has cut or frozen its dividend this year. Many have raised their dividends. The holdings are not protected by sell stops.

If you want to learn more about these two portfolios, use these links:
• To see the long-term total performance results of the two portfolios, click here.
• To see the strategy of the Dividend Portfolio, click here.
• To read a complete description of my e-book, THE TOP 40 DIVIDEND STOCKS FOR 2010: How to Generate Wealth or Income from Dividend Stocks, click here.


Finally, as many of you know, I post articles on another investing site called Seeking Alpha. I recently posted two articles on Dividend Champions, which are stocks that have raised their dividends for 25 consecutive years or more. Here are links to those two articles:

• The Fourteen Highest Yielding Dividend Champions (July 2, 2010)--click here
• Nine Dividend Champions with the Fastest Rates of Growth (July 12, 2010)--click here

2. Market Performance Since Last Outlook
(“now” figures are as of close Monday July 19, 2010)

Last Outlook (6/27/10): 4.5 (negative)

S&P 500 last time (6/27/10): 1077
S&P 500 now: 1071 Change: -1%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1071 Change in 2010: -4%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1071 Change since 3/9/09: +58%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: No new report since the June 17 report discussed last time. Last week, Bart van Ark, Chief Economist for The Conference Board, stated in a press release that the rebound effects from the recession have almost entirely dissipated, and that a growth slowdown starting this summer is becoming increasingly apparent. The press release stated that GDP growth for the second quarter might turn out to be the highest for the year. The Conference Board is not predicting a double-dip recession, but rather continued slow growth for the rest of the year. Indicator remains neutral. +5

• Fed Funds Rate: No change. The Fed, through the release of notes from a previous meeting, also seems to be lowering its expectations for the speed of recovery. With near-zero Federal Funds rate, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar shows the current P/E of the S&P 500 is 14.3, down from 15.7 last time. That keeps this indicator in positive territory. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.93, down a couple more ticks from 0.95 last time. That keeps this indicator in the neutral range. +5

• S&P 500 Short Term Technical Trend: The market rallied July 6 through 13, pulling it above both its 20-day and 50-day simple moving averages (SMA). Then a sharp drop on Friday pulled it back. It finished today (Monday) below its 50-day and barely above its 20-day. So this indicator, which has been yo-yoing (just like the market) inches up from negative to neutral. +5

• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the index plus its two longer SMAs (50-day and 200-day). The market action since last time has finally turned this indicator negative, as the 50-day SMA fell below the 200-day SMA 11 sessions ago. In many circles, this is known as a “death cross.” The configuration is thus: 200-day SMA > 50-day SMA > Index, the exact opposite of what you would like to see. +0

• DJIA Short Term Technical Trend: This chart looks basically like the S&P 500 chart. Neutral. +5

• DJIA Medium Term Technical Trend: Same as the S&P 500. The death cross occurred 11 sessions ago. Negative. +0

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Neutral. +5

• NASDAQ Medium Term Technical Trend: The death cross occurred four sessions ago. Negative. +0

TOTAL POINTS: 45
NEW READING: 45 / 10 = 4.5 = NEGATIVE

Financing Retirement II: What's Your Number?

This is the second article in a series on financing retirement that I'm planning to put together. My first post, "Thoughts on Financing Retirement, can be found just below this one. The idea of the series is to provide one person’s view of retirement from the front lines.

You have probably seen one of the cute ING commercials where everybody is carrying their “number” around. One person will be carrying $1,305,622. Someone else will be carrying $2,201,588.” One poor guy’s number is “$Gazillion.” It turns out that he really didn’t have a plan.

“The Number” has become the holy grail in retirement planning. ING says that “Every person has one,” and defines it as “The amount you will need to have saved to retire the way you want.” On their home page, they show an example that changes each time the page is accessed. When I went there, the number was $1,280,385. It was festooned with little notes like, “Sally found her number,” “Now that I’ve found my number, I’m one step closer to retirement,” and “Bringing my lunch to work will save me $222,158 over 40 years.”

The implication is obvious. If you haven’t saved “your number” by the time you retire, you’re screwed. You can’t have the retirement you want. Or you just can’t retire. ING provides a little calculator for you to find YOUR number. Just fill in your age, current income, how long you want the money to last, etc., and your number pops up (cleverly in the same font and orange color as in the commercials). I did it, and discovered two things:

• I need more than twice as much as I’ve got; and
• I can’t retire unless I accumulate well over $1,000,000 in one year.

But the facts are these: I have BEEN retired for almost ten years, and my wife and I live extremely comfortably. Lack of money will not stop me from doing anything on my bucket list. There’s obviously a disconnect. ING is clearly wrong, at least in my case, because I am already living the life they say I can’t have.

I don’t know how their calculator works, but I’ll bet they are making some of the assumptions that I criticized in my first article. Assumptions that lead to a distorted view of how retirement really works.

In that first article, I said, “It’s all about income.” Meaning that, in retirement, you need to generate the income needed to cover your expenses. And that, I think, is the disconnect: Calculators and general rules of thumb focus on the sum total they think you’ll need to generate the income you require. But there are so many ways to generate income that they overlook some, and in many cases they also make the mistake of over-estimating how much you will need. So they might say you need $2,380,507, when in fact you only need half that much.

In short, they’re focusing on the wrong number. They’re focusing on an amount of capital to fund “the retirement you want.” But they should be focusing on the annual income needed to live the retirement you want. So the characters in the ads should be carrying around numbers like $80,000, or $120,000. Not numbers in the millions or a gazillion.

In the first article in this series, I made reference to an article, “Why I Love Dividends, that appeared on another financial site, and to the comments it generated. One thread of the comments revolved around the capital versus income distinction. What I will call the pro-dividend crowd argued that dividends themselves can fund or help fund retirement. The pro-capital-retention crowd argued that one should aim to let his/her capital grow as much as possible, then sell some assets each year to fund retirement.

In the context of the current question—are you looking at the right number?—I think that this debate mirrors the disconnect between the ING ads and my point that it all comes down to income. The ING approach must assume that capital will be converted to income by selling off some assets each year. After all, your grocer will not accept a framed “$2,380,507” in payment for your tomatoes. He/she wants money, not a printout of your assets.

In my earlier article, I suggested that each person should create a retirement budget, showing the annual income needed to “retire as they want.” Then list the sources of income—a part-time job, pension, social security, dividends, interest, and the like. Only when a gap needs to be bridged—when the various sources of income don’t meet your retirement budget—do you need to sell off part of your assets. And—gasp—if you have been purchasing dividend growth stocks for many years, it is entirely possible that the yield of those stocks may have reached doouble-digits based on what you originally paid, and that they alone may be generating so much income that there is no gap that needs to be bridged.

I am no fan of annuities, but an annuity is a vehicle that converts capital to an income stream. Using the simple calculator at Immediate Annuities, one can see that you could generate $2000 per month by making a one-time payment of $326,428 (for a 64-year-old male in New York) to an insurance company. The fine print: This buys a “Single Life Income with No Payments to Beneficiaries….You receive this income for your lifetime, which means, you can never outlive this income. After you die there are no payments made to beneficiaries.”

Let’s say you have a pension that pays you $2000 per month. Many boomers have pensions from private companies. So do cops, firemen, teachers, and other former public employees. Using the same calculation, you can see that the pension is the equivalent of having $326,428 more capital than you actually have. Social Security is another income stream with a capital equivalent. It is by figuring things like this into your retirement planning that the gap is bridged between ING’s huge, scary number needed for retirement and the more commonsense annual retirement budget that actually funds “the retirement you want.”

Thoughts on Financing Retirement I--Beware Rules of Thumb

It is natural that many readers of investment sites are shooting for a retirement goal. You want to achieve a comfortable, secure retirement, with confidence that they can live at a lifestyle of your choosing without running out of money.

I have been retired for nine years. I was fortunate to be able to retire early (age 55) and turn more of my attention to one of my passions, which is helping other people through my writing about stock investing. Other passions include my wife and activities with her, golf, gaming (poker and blackjack), and the Buffalo Bills (don’t ask).

When I was planning to retire—or more correctly, exploring whether I would be able to retire—the first step was to learn more about financing retirement. One thing that I decided quickly was that in retirement, it’s all about income. I mean that when you are retired, you need income—money coming in—that covers your expenses. You will need that income for the rest of your life, which may be a long time, potentially longer than you worked at your principal career. So when you are exploring retirement, the first two questions become, how much will you need, and where will it come from?

On the first question, I quickly decided that conventional rules of thumb, like “You will need 70% of your final year’s income,” are worthless. That particular canard fails on at least two levels. First, it presumes that you were spending all of your income in your last year of work. But more likely, you were saving a good portion of your income as you came into the home stretch prior to retirement. So the amount you were making in that final year probably bears little relationship to what you will actually need. Second, your expenses can change significantly the day you retire. I had a position that required formal business clothing. Since the day I retired, I have not worn a suit, and I only wear ties to weddings and funerals. That entire expense category disappeared. The “savings” category disappeared. On the other hand, I spend more now on golf equipment and greens fees.

So instead of scaring yourself silly with the 70% rule, create a retirement budget. We like to travel, so that’s part of the budget. I don’t care about having a new car every few years, so that’s gone, along with the business clothing. We paid off our house, that expense is gone. Senior discounts make a little dent. You may be surprised that your retirement budget comes in at far less than the 70% rule would have led you to believe. The point is, everyone’s circumstances are different. You cannot rely on a crude rule of thumb to estimate your expenses. You’ve got to sit down and work them out yourself.

The second question is, Where will it come from? Here, you need to list all the sources at your disposal:

• A pension. Many baby boomers, who are just starting to retire, have traditional pensions. The percentage goes down as you move back to younger people.

• Social Security. There are lots of options on when to begin taking SS, and there are tradeoffs between waiting longer versus taking a smaller amount sooner. Remember that SS is indexed to inflation these days.

• Part-time work. Many retirees don’t fully retire. They make some money through consulting, contract work, part-time jobs, or by converting a hobby into an income-producing little business.

• Your investments.

I wrote an article in February, “Why I Love Dividends,” that appeared on an investment Web site called Seeking Alpha. There, it spawned a lively discussion (over 110 comments to date), and one of the branches of the discussion is directly on point here. The debate was whether it is better to derive your retirement income from income-producing investments, or to create it by selling off part of your investments each year.

The rule of thumb on selling part of your investments to finance retirement is that the “safe” thing to do is to calculate 4% of your investments when you retire, and that’s the amount you can sell each year with confidence that you will never run out of money. You are supposed to increment that amount each year to account for inflation—commonly by increasing it 3% each year. The rule of thumb presumes that you have a well-diversified portfolio under the standards of Modern Portfolio Theory, and I believe the 4% “safe” figure has been validated by millions of Monte Carlo tests to about a 95% confidence level that your money will never run out.

Once again, I find the rule of thumb wanting. For one thing, you may not need 4% per year to round out your retirement budget. That doesn’t create a problem. But you may need more, in which case the experts I’ve read disagree on what you should do (delay retirement, lower your budget, get part-time work, withdraw 5% or 6% per year, etc.). But something must be done. I just heard of a study that found that many retirees blow through their 401(k)'s in five years or less. Clearly that is unacceptable.

A second disconnect for me is the 3%-per-year inflation adjustment. As discussed earlier, your retirement budget is unique to you. Your personal “basket of goods and services” probably bears little relationship to the government’s basket when they are figuring inflation. The costs of travel have gone down, not up, since I have been retired. Furthermore, the automatic adjustment ignores the performance of your investments. I think that’s a big flaw. What I have been doing is adjusting the 4% base amount not by inflation, but by how our investments have actually performed. I withdraw 1% per quarter of what’s actually there. If the total value of our investments has gone up, the withdrawal amount goes up a little. If the investments have declined, the withdrawal amount goes down. The change is at the margin and has been no trouble to absorb. But over time, I think it makes the 4% rule a lot safer to adjust it by how your investments are actually doing than to just automatically bump the withdrawal amount up each year and ignore what’s happening in the real world.

Frequent readers who know my appreciation for dividend investing may be wondering why I just don’t take my dividend money directly. I see this article as the first of an occasional series on retirement realities. In a future article, I will explore my reasons for using a quarterly-withdrawal system. Hint: The dividends help fuel it.