True or False: Never Touch Your Principal

That ain’t workin’ that’s the way you do it. Get your money for nothin’ — Dire Straits

A lot of people say you should live off interest and dividends and never touch your principal. I disagree. In the best case, that might make you live more frugally than you could have. In the worst case, it might make you take undue risks with your portfolio.

Why It’s No Longer True

What would it take to live off the principal?  My prior post talked about a pre-tax withdrawal rate between 4%-5%  What’s Your Magic Number?  So the question is whether you can generate income of 4% or more from interest and dividends.

Let’s start by looking at current yields of stocks and bonds.  Before 1990, the S&P 500 dividend yield was rarely below 3%, but today it sits at only 1.94%.  What if you have diversified your stock holdings beyond the S&P 500 (which you should)?  The Vanguard Total International Stock ETF currently has a dividend yield of 2.15%, so not much different than the S&P500.  The Vanguard Extended Market ETF which contains small cap and midcap stocks has a dividend yield of  only 1.72%.  So all in all, a well diversified stock portfolio is unlikely to even yield 2% as of today.

How about bonds?  10-year treasuries were rarely yielding below 4% and often higher before the financial crisis.  The current yield is only 3.11%.  If you look at shorter term bonds, 5-year treasuries are yielding 2.99%.

Looking at a 60% stock/40% bond portfolio (or actually any other allocation), you will not yield enough to avoid taking out principal.  That’s not a bad thing though.   Withdrawing at the safe withdrawal rate of 4% to 5% mentioned above gives you a 90% chance of having enough money until age 95 –most likely you will end up with a higher principal that what you began with due to the appreciation of your stock portfolio.

A generation ago, the adage not to touch your principal was easier with 3% plus dividend rates and 4% plus interest rates.  What if you really want to do it today?

Here are a couple of options1. Cover your essential expenses (food, lodging, travel) through income from your portfolio and cover your discretionary expenses (travel, entertainment, etc.) by selling assets.   This is a modified version of living off your dividend and interest and something that Fidelity advocates.  In a market downturn you could decide to cut back on discretionary expenses to avoid selling as much when prices are low.  This is a nice compromise and more realistic in today’s environment.  2.  You could construct a riskier portfolio that generates more income.  I’ll show you what that looks like below and why I don’t recommend it.

How You Could Do It, Even Though You Shouldn’t

High Yield Bonds: While treasury bonds are yielding around 3% today, high yield (aka junk) bonds are yielding over 6%.  I think putting up to 20% of your bonds into a high yield bond fund is a reasonable risk, but to generate enough income to live off your principal you would need to put at least 50% of your bond portfolio into high yield bonds.   The problem with high yield bonds is their price is highly correlated with stocks and in a recession both the price and default rate will go way up.   In 2008 Vanguard’s high yield bond fund lost 26% so the risk is high.

REITs:  A second option is investing in real estate through REITs (Real Estate Investment Trusts).  Historically REITS have yielded about 1% more than bonds in income.   However, in the last recession some REITs went down in value by over 50%.   Like high yield bonds, REITs have a place in your portfolio and can generate extra income, but their risk and reward profile is closer to stocks than to bonds.

High Dividend Stocks:  You can shift your stock mix by investing in high-dividend stock funds.   These funds are generating a dividend in excess of 3% today vs. less than 2% for market index funds.   However, high dividend stock funds will take you away from weighting the overall market because they overweight and underweight certain sectors compared to stock index funds.  In particular, they overweight utilities, energy, and the consumer defensive sectors while under-weighting technology stocks and real estate.  It’s certainly reasonable to put a portion of your stock portfolio into these funds but I would not shift all of my stocks for the reasons above, not to mention the capital gains you would need to pay.

Take-Away

Where does that leave us?  You can fine tune your portfolio to generate some extra return, but going too far in order to generate 4% from dividends and interest would be overly risky.   In any case, it’s perfectly safe to take some money out of your principal each year (which in most years will grow due to appreciation in your stocks).

Some adages, like “a penny saved is a penny earned” are timeless.   “Never touch your principal” is not.

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