Early retirement articles tell you that your portfolio will grow by a certain percentage a year.
What they fail to mention is that on top of capital growth, your investments pay dividends.
But what does this mean for you and how does this impact your early retirement calculations?
A common early retirement principle is to save up a big enough portfolio to withdraw from.
This is based on the concept of capital appreciation: your portfolio growing over a long time.
However, another concept of your investments is yield: dividends are paid to shareholders.
Having both capital appreciation and yield means that you need less money to retire early.
In this article, I talk about common early retirement concepts and where they are negligent.
I also talk about the yield concept: what it means and how much you can expect in dividends.
Finally, I share an early retirement calculator to use and where to find out more information.
Traditional Early Retirement Calculations
Typical calculations to determine how much money you need for early retirement go like this:
- Step 1: determine what you want your income to be in retirement – let’s say £40,000 a year.
- Step 2: multiple this figure by 25 – this is known as the 4% rule, a very well-known multiplier.
- Step 3: this is the figure to aim for you in your portfolio – which in this example is £1 million.
- Step 4: Withdraw 4% of your portfolio a year to live off e.g. 4% of £1 million is £40k a year.
This is all good and well, but I don’t know about you, a £1 million sounds like a lot of money.
Even with capital appreciation, your investments growing over time, this will take a long time.
What if there was a way to reduce the amount of money and the length of time required?
Thankfully there is and is known as yield: where you’re paid income in the form of dividends.
Introducing Yield: Your Investment Income
Sometimes we think of investments as just savings accounts with a fluctuating rate of return.
However if you’re invested in the stock market, it’s more than that: you own company shares.
You are an actual shareholder of those companies and are therefore entitled to their profits.
Usually what companies do is they distribute a portion of their profits to their shareholders.
This is known as dividends and usually take place once a month, quarter, year, etc. – it varies.
In theory that sounds great, but what does this actually mean for investors like you and me:
If you are invested in a fund with Vanguard for example, you will have your main investment.
However, you will also have another account within your main dashboard known as ‘cash’.
You may have noticed money going into this account and leaving again to your main account.
This means that the dividends you are receiving are automatically being reinvested for you.
Therefore, your investments are growing based on both annual returns and your dividends.
Let’s Look at your Investments without Yield
Let’s look at an example of how your portfolio would grow without taking yield into account.
Let’s say you want to have a monthly income of £3,000 from investments i.e. £36,000 a year.
Using the 4% rule, that would be equivalent to a portfolio size of £900,000 i.e. £36,000 x 25.
However, I prefer to use the 5% rule, which means a portfolio of £720,000 i.e. £36,000 x 20.
We also need to make some other assumptions: let’s say you start with a portfolio of £5,000.
Now let’s say that you contribute to your investments £1,000 monthly i.e. £12,000 per year.
Let’s assume that your investments will grow an average 10% a year for the next 20+ years.
Based on these assumptions, we see that it would take 20 years to reach our income goal.
This is also based on the assumption that no tax is charged on this account, like in an ISA.
Now let’s see how long it would take us to achieve our goal if we take our yield into account.
Let’s Look at your Investments with Yield
Now let’s look at your portfolio if we take into account the yield generated from investments.
Let’s say we want a monthly income of £3,000 i.e. £36,000 a year i.e. £720,000 portfolio pot.
Based on the above example, we know that it would take 20 years to reach this income goal.
So how long would it take if take the yield generated and reinvested it into our investments?
Let’s say the yield generated from your investment portfolio is 1.66% a year which is average.
If you are invested in an index fund/ETF, have a look at the fund fact sheet to see your yield.
As you can see from the chart, it would take just over 19 years to reach our desired income.
I know, this probably sounds disappointing – you probably expected it to take much less time!
However, if you closely examine the chart above, you are getting free money every year.
You can choose to reinvest the dividends or cash it without affecting your main investments.
What will You do with Your Yield?
So now that you know what yield is, have a look at your investments and see if you have one.
You may find that your investments pay you out dividends and you weren’t aware of it.
It may be because your dividends are automatically reinvested into your main investments.
Maybe you are happy with this set up in order to grow your investments as quickly as possible.
Or maybe you want to use the dividends paid out as an extra source of income for you.
Whichever you decide, there is no right or wrong answer, do what makes sense to you.
If you want help deciding what to do with the yield, check out my investment yield calculator.
This calculator shows you the yield that you would get from your investments every year.
You can use my retirement calculator to see what your investments would be without yield.
Using these two tools, hopefully you’ll be able to decide what is best to do with your yield!
If you’re interested to find out more about investment yield, check out: Quit Like a Millionaire.
In the book, the authors talk about how they retired using their investment yield and growth.
To find out more on investing and retirement, check out my investing and retirement articles.
I talk about early retirement strategies, which funds to invest in, and which accounts to have.
Are you on your way to early retirement? Are you investing? Let me know in the comments!
