When it comes to making your retirement savings last, there are two fundamentally different approaches you can take. The first is the more traditional strategy, which focuses on an annual withdrawal, likely around the popular 4% theory. The hope is that by doing so, you’ll be able to pull out just enough to live while also having enough money to last for another 30 years.
The second approach is to look at an income strategy, where a portfolio is structured to generate dividends and distributions, and then live off the cash flow without touching the principal. For the most part, financial planners tend to lean on the withdrawal approach because it aligns with how they have been educated.
In other words, the 4% rule is so common, it’s almost gospel in the financial world. The thing is, the income strategy is gaining popularity, but you also have to consider that going with either option dramatically impacts how you invest and whether you might be forced to go back to work at 75 after retiring at 60 because your portfolio is running low.
How the Traditional Withdrawal Strategy Works
The traditional withdrawal strategy is built around the idea that you sell shares every year to generate cash. With this in mind, the 4% rate is typical, so if you retire with $1 million, you’d start by withdrawing $40,000 in the first year of retirement, $40,800 in year two, assuming 2% inflation, and so on. This portfolio is ideally structured to have a mix of both stocks and bonds, with the allocation becoming more conservative as you age.
The biggest risk with this strategy is how you approach your sequence of returns. For example, if you retire right before a bear market and start selling shares while prices are dropping, you could permanently damage your portfolio’s ability to recover. Selling $40,000 worth of shares when the market is down 30% means you’re liquidating more shares than you might during a bull market.
Historical tracking does indicate that the 4% rule can and does work, but “most of the time” isn’t exactly comforting when you’re the person living through a scenario where it turns out it doesn’t work. You also have to consider that you might need to reduce spending during bad years, which is a struggle for retirees who want a certain lifestyle.
How the Monthly Income Strategy Works
The monthly income strategy structures your portfolio around assets that will generate cash distributions, often in the form of dividend stocks, REITs, MLPs, covered call ETFs, and bonds. Instead of selling shares, you collect the income these assets produce and use that to fund living expenses. For example, a $1 million portfolio that yields 5% would generate $50,000 annually without requiring you to sell off any shares, and as those dividends grow over time, so too does your income.
Building an income portfolio might include positions in Enterprise Products Partners (NYSE:EPD | EPD Price Prediction), paying a 6.88% yield quarterly; Realty Income (NYSE:O), paying a 5.65% monthly yield; and the JPMorgan Equity Premium Income ETF (NYSE:JEPI), paying 8.19% for covered call income. Add to this Main Street Capital (NYSE:MAIN) at 7.01% for monthly BDC distributions, and then round everything out with dividend growth stocks from names like American Electric Power (NASDAQ:AEP) at 3.35%, all of which are increasing their payouts annually.
This portfolio is designed in such a way that the cash flow you’ll be earning covers not just any of your expenses, but enough that any excess cash can get reinvested or held as a cash buffer for years when cash distributions might be lower than expected. The key part of this strategy is that you don’t sell during market downturns.
Which Strategy Actually Lasts Longer?
The honest answer is that the strategy that lasts longer is pretty dependent on market conditions and the execution of each strategy. In a prolonged bear market or during a period of high inflation that leads to poor equity returns, the income strategy is going to outperform every time because you aren’t selling shares that are down.
However, during a strong bull market with rising valuations, the withdrawal strategy might actually be the better approach because you’re not just constrained to only high-yield assets. You could also own growth stocks that are appreciating significantly in a short period of time, even if they don’t pay a ton in dividends.
A historical analysis might suggest that dividend-focused portfolios with reinvested distributions have matched or exceeded total return portfolios over most 30-year periods, with significantly lower volatility. The income strategy does provide something of a psychological benefit that is harder to quantify, because then the market drops 25%, and it could. Retirees living on dividends have more stability in their lifestyle, while those focused on withdrawals are watching their principal evaporate.
This peace of mind matters, often more than most people consider, and it reduces the likelihood that you might need to panic sell. The income strategy doesn’t guarantee a portfolio can or will last longer, but it does give you more control over when or if you need to sell shares.
When Each Strategy Makes Sense
The withdrawal strategy ultimately makes more sense for retirees with smaller portfolios who want to maximize every dollar of return and can’t afford to sacrifice growth for yield. If you have $500,000 and need to generate income, restraining yourself to only dividend-paying stocks might mean missing out on the appreciation that a diversified total return portfolio would capture.
The withdrawal strategy can also work well for disciplined retirees who can genuinely cut spending during down years and have other income sources, such as pensions or Social Security, to cover basic expenses. On the other hand, the income strategy makes a lot of sense for retirees with larger portfolios, likely around $1 million or more, where generating 4-5% in dividends provides sufficient income. It’s also better suited for retirees who value stability and predictability above all else.
If you’re the type of person who checks your portfolio daily and loses sleep if it’s down 15%, living off dividends can eliminate a lot of the excess stress as income arrives, no matter how much your overall net worth is fluctuating. The income strategy isn’t perfect, as high-yield investments can and do cut distributions, and you might sacrifice some upside during a raging bull market, but the tradeoff might be worth it for peace of mind.
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