I think the biggest retirees’ concern regarding their portfolio is probably the fear of losing money. During all those years, you have worked very hard and saved every penny you could. Then, you turned around and invested this hard-earned money in the hope of building a comfy nest egg for the day you will finally stop working. You finally hit your magical number and say “goodbye” to your boss for the very last time. Your coworkers throw a retirement party, you have a few renovations planned on your house and your airplane tickets are already bought for the destination you dreamed about for many years.

After a few months having fun and enjoying life, you open your portfolio statement; there is a number between parentheses. Panic. You go white. For the first time in your life; you lose money while you have no ways to generate more. You depend on your nest egg and you realize it is not as solid as you thought it was. In fact, you realize your retirement portfolio could melt. What can you do?

This is the final article of a 3 parts series on factors hurting your portfolio at retirement. This article is all about how withdrawing money at the wrong timing could affect the rest of your retirement. You can read about the other 2 factors crucial to your retirement with part I here and part II here.

When do you withdraw your money?

In an ideal world, you have saved millions and you only live off your dividends. But this only happens if you managed to saved over 1M$ and all your holdings meet 3 criterions. For others, chances are your retirement income will be a combination of dividend payments and shares sold. If it’s your case, the last thing you want to do is a big withdrawal right in the middle of a market crash.

During my financial planning years, we used to make lots of simulations. One that particularly struck my mind was the difference between an investor retiring right before a bear market vs one that would retire at the bottom of the bear market. The impact of withdrawing money at the same time your portfolio is free falling is catastrophic on your retirement plan. Just imagine if you had retired in July 2008…

Source: Ycharts

I bet that looking at this graph gives you chills considering we have been running a bull market for 10 years and we all know that one day (probably sooner than later), we will get hit by another bear market.

Don’t be desperate just yet; I have good news! If you look closely on the graph above, you will notice that the stock market recuperated most of its’ lost money by January 1^st. Statistically speaking, most bear markets will last about 18 to 24 months. Therefore, if you get enough money on the side (e.g. in cash or close to cash), you will not have to sell shares at a loss.

The year before I retire, I intend to make sure I have the equivalent of a full year budget in cash. For example, if I need 50K per year and my portfolio generates 30K in dividend per year, I will cash sell for 50K of shares before day 1 of my retirement. Then, if the market drops, I have a full year where I can withdraw money from my “cash account” without being worried by the market.

During that year, I still have an extra 30K deposited in that cash account. Therefore, at the beginning of year 2 of my retirement, my “cash account” will still show 30K (dividend paid by my portfolio during the first year). If the market hasn’t recuperated yet, I still can use my cash account for another 6 months without being worried. And guess what’s the best part? After 6 months, I will have spent 25K (remember, my yearly budget is 50K/year). Then, my cash account would show a remaining 5K (30K in dividend – 25k withdrawn). I would also add an extra 15K to this amount since my portfolio kept paying the same 30K in dividend. Therefore, I would have enough money to wait until the end of year 2 before I need to share my first share.

As most bear markets don’t last over 24 months, I’m 90% sure of not selling shares at a loss due to a bear market using this method!

Final thoughts

Honestly, if you are retired or about to retire, I think you should make an investment of $1,000 to $2,000 outside your portfolio. These two grands may very well be the most important investment of your life. Here’s what you should do: find a fee-based financial planner and pay him to write down a full retirement plan.

He will not only take care of those three factors, but he will also be able to integrate tax optimization in your asset allocation! While you can’t control the stock market and guess how much return you will make next year, you can certainly control how much you will pay on taxes in regards to your withdrawals!

In my latest post, I started a 3 parts series on factors making a big difference in your retirement portfolio. If you don’t consider them, your retirement plan could go bust faster than the plane you are taking to travel Europe this summer.

The first article was about the infamous inflation.  This post will explore another problem many retirees face when building their portfolio; asset allocation. There are a handful of sectors offering what retirees want: high yield and a solid business.

Retirees want both high income and safe return when they invest. Unfortunately, financial theory has decided that this combination isn’t possible. At best there is an anomaly in the market that will quickly be found and corrected. When a company is offering a high yield and there are no important risks attached to it; it’s probably because you have missed something doing your research.

But buying one high yielding stock isn’t the end of the world. In a well diversified portfolio, having one or two “bet” representing less than 10% of your portfolio isn’t that bad. The problem happens when you have a concentration of high yielding stocks coming from the same sector. If you have most of your portfolio invested in REITs, BDCs, MLPs and utilities, this article is for you!

Where do you invest your money?

No matter what your age and your risk tolerance is, I think you should never concentrate your portfolio in 2-3 sectors. In my opinion, showing more than 20% of your money in the same sector is looking for trouble. Oh please, don’t tell me that you have done it in the past 10 years and you show great results; my 12 yr old could have shown great returns just by picking stocks according to companies’ logos!

The problem with the current bull market is that everybody looks like Buffett. Pretty much all sectors, even those with higher level of risks, did well in the past 10 years. Therefore, many investors see “no risks” with their strategy as they kept receiving strong dividend payments for several years. But let me show you what it looks like when you concentrate your money into a sector that eventually hits a brick wall:

Source: ycharts

As you can see, any dividend investors thinking investing in banks was a smart move to finance its’ retirement got a serious paycheck cut during the latest financial crisis. Just because I know how many retirees love REITs, I’ve done a quick check over the past 3 years. Using Ycharts, I’ve tracked 400 REITs showing a dividend growth over the past 3 years from -100% to increase to +282%. Here’s what I found:

• 192 (48% of them) shows a dividend increase stronger than 2% (beating inflation).
• This numbers drops to 46 (so 11.5%) if I select REITs paying a 6% yield and over.
• 142 (35.55%) of them cut their divided in the past 3 years.

In other words; when you pick a REIT paying a high yield (6%+), you have a higher chance to pick one that will make no increase or cut its dividend in the next 3 years to raise it to match inflation afterwards. Imagine the result if you would pick 10 REITs paying over 6% yield… Yeah, I’m pretty sure you would show a few divided cuts in your portfolio!

Do not underestimate the power of your asset allocation

When I look at the current stock market, I like saying that everybody looks great on the prom night. Pretty much all companies paying high yield are at their best right now. They have enjoyed low interest rates, they benefited from an enthusiastic market that is eager to buy new bonds and a strong economy. Pretty much any bozo with a decent accountant could run a company with those conditions.

This circus reminds me of the tech bubbles. At one point, all you needed was a cool office with wide windows and “dot com” in your name. That was enough to raise hundred of millions in capital. Everybody was on their Prom night – they all looked good until they wake up the next morning once the party was over.

While I was at school during the tech bubble, I lived through the 2008 market crash as both an investor and a financial adviser to my clients. I noticed that the ones with a well diversified portfolio weren’t hurt much. Many of my clients ended 2008 with -15% to -18% and worst performing portfolios (more aggressive) were down -26 to -30% at the bottom. As an investor with a portfolio 100% invested in stocks, I’ve finished the year at -27%. That wasn’t too bad when you considered that concentrated portfolio could have went all the way down to -80% to -90%!

Final Thoughts

Your asset allocation is your ultimate shield to protect you from any catastrophe. Those who had too many tech stocks back in 1999, paid the price the same way Canadian investors did when rushed toward the oil sand industries in the 2000’s and when the world trusted big banks in 2008. During each crisis, there were sectors that went through the storm and kept raising their dividend. Sure, their stock prices were down, but their business wasn’t.

Therefore, patient investors cashed their juicy dividend and just had to wait until the storm was over to take a walk. Each time, they walked by weeping investors cursing their advisor, the market or God for having so many stocks in the same sector. Don’t be a “weeper”, be a “winner”.

Since I received the commuted value of my pension plan last year, I’ve given lots of thoughts about building a retirement portfolio. In that optic, lots of retirees ask me to write a more detailed approach about a higher yielding portfolio. Since I’ve received lots of demands coming from my Dividend Stocks Rock members to build a “retiree ready” portfolio, I will be launching such portfolio models this month. I thought of detailing my process on this blog to help you understand the difference between my current portfolio showing strong dividend growth and how I would build an income portfolio. But before we start picking stocks, there are three factors to keep in mind at all time. Like the three stooges, they could really crash your retirement party and this won’t be funny.

01 Have you thought of inflation?

When I read about all those amazing 8% yielders on the market ensuring a comfortable and safe retirement to several investors, I always smirk. The first thing I do is looking at the past 5 and 10 years dividend growth rate of those retirees’ best friends. Most of the time, the number I see is ZERO.

Then, many investors tell me: “Mike, I don’t mind if the company “Old Retiree’s Buddy (ticker ORB)” doesn’t increase its payment; the 8% covers the inflation”. Wrong. I know, many of you know exactly what I’m going to explain, but because I’ve received some questions and similar comments, I must take a moment to draw a line in the sand and tell you to cross it.

There is a big difference between the dividend yield and inflation. Imagine you invest $1,000,000 in “ORB” at 8% with no dividend increases. Therefore, year after year, you receive a solid pension of $80,000 per year. Let’s assume you are 60 today and you will live until 85. Your portfolio will pay you $80K/year for the next 25 years.

Now, imagine your $80K budget is subject to a 2% inflation. This means that each year, your budget (utility bills, food, gasoline, household maintenance, health and personal care, restaurants, travel, etc) cost a little bit more. 2% is nothing, right? You won’t even feel it, huh? Let’s see what will happen in your next 25 years:

As you can see, your retiree’s budget starts at $80,000, but ends at $128,674! The last column refers to the amount you must find each year to compensate for the lack of dividend growth. Your portfolio generates $80K, but you spend more year after year. After 25 years, you had to find over half a million just to pay inflation on your lifestyle!

You can replace the budget numbers and the yield by anything, if companies in your portfolio don’t increase their dividend by at least 2% per year, you will be digging your own hole. In fact, spending $80,000 in 25 years from now is like spending $48,762 today. And this is only considering a 2% inflation!

But Mike, the inflation rate has been lower than 2% for the past 10 years

You may argue with me that the inflation rate is a lot lower since the 2008 crash, but we have entered into a low interest rate environment and things have started to magically cost cheaper than ever. You can see that both the US and Canada show a very low inflation rate over the past 10 years:

Source: Ycharts

Then why not use a 1.5% inflation rate as demonstrated in the above graph? The problem with the inflation number is that it’s just a statistic. Your personal inflation rate is probably a lot higher than the one calculated by your country.

If you have some time, I’d suggest you read the CPI definition of your country to understand. Mine (Canada), can be found here. Here’s how the basket of good was composed in 2015:

Source: Statcan

• Food: 16.45%
• Shelter: 26.79%
• Household operations, furnishings and equipment: 13.01%
• Clothing and footwear: 5.68%
• Transportation: 19.48%
• Health and personal care: 4.98%
• Recreation, education and reading: 11.02%
• Alcoholic beverages and tobacco products: 2.58%

If you compare this pie chart to your budget, I’m sure you will not have 2 similar pie charts. As a retiree, you will most likely spend a lot more money on healthcare than 5% of your budget for example. Therefore, if your healthcare costs rises faster than inflation (hint; this will happen), your own inflation rate will grow faster than 2%. I wasn’t able to find statistic value on how much food inflation increases year after year, but I’m pretty sure it rises a lot faster than 2% according to my grocery bill!

Another problem I see with the CPI is the way some items are calculated. For example, shelter cost calculation could lead to several misunderstandings. Does it take into consideration mortgage payments in a super low interest rate environment? Does it include how housing prices have skyrocketed in major cities such as Toronto over the past decade? While municipal and school taxes may have risen following a small yield, if housing prices jumped, you’d end-up paying a lot more.

Since I’m not a stats guy, I can’t give you answers to those questions. But one thing is certain; the shelter cost calculation is complex and will not likely consider all factors.

In other words; do not take the 1.5%-2% inflation number for granted. If companies in your portfolio don’t increase their dividend year after year, living off your dividend will mean spending less and less year after year. For all those Split Corp fans, I’d suggest you do your calculations.

Final thoughts

Inflation is a retirement serious killer. It lurks inside your budget and hide for a very long time until you realize it’s too late. When you select a high yielding stock, make sure the company has enough room to increase its payout and at least match the inflation. If you are wondering where to start, you can check how I built my “retirement ready” stocks list here.