Investors who plan on living off their assets in retirement face several risks. The risks include inflation, longevity risks, extreme market conditions and liquidity. By creating a diversified dividend portfolio, investors can not only address these risks, but they can have very good odds of achieving a rising stream of dividend income, which means that they might never have to dip into principal to finance their retirement.
The first risk includes inflation. Over the past century, inflation has averaged 3% per year. While the effects of inflation are not visible over a period of five years or less, over the long run its eroding effect is significant. Even at 3%, the purchasing power of the dollar decreases by 50% in 24 years. That means a bottle of Coca-Cola that costs $1.25 would likely cost $2.50 in 2034.
Investors should realize that this is just an average, however. Some costs will increase much faster than the average, while others likely will decrease over time. As a result, investors should be able to invest in assets that not only generate an inflation adjusted stream of income, but also protect the purchasing power of their principal.
Companies such as Procter & Gamble (NYSE:PG) and Coca Cola (NYSE:KO) have the pricing power to pass cost increases over to their consumers. As a result, their earnings should be able to increase if there is any inflationary pressure.
The second risk is longevity risk. Investors typically depend on the 4% rule, which requires that a set percentage of one’s portfolio is sold each year, no matter what. In an event of an extended flat market — or if the retiree happens to have started retirement during a significant stock market top like the one in 1929 or 2000 — they likely would deplete their assets in less than two decades. A male that was born in 1946 is expected to live 19 more years, according to this SSI Life Expectancy Calculator.
The problem is that this is just an estimate — a significant portion of those who have chosen to retire at 65 likely will live longer than the average. Running out of money in retirement should never be an option, since it is impossible to predict the life expectancy of an individual with any precision.