How much do you need invested in stocks and bonds to retire? It’s an important question to ask yourself. The number varies from person to person and depends on the lifestyle you want to live, as well as the stocks and bonds you are invested in.
Are you looking to simply live comfortably in your older years, or are you trying to retire as early as possible to live off passive income and achieve financial freedom?
This article will look at what you should consider when investing in stocks and bonds for passive income, and how much you will need to have invested to be able to live off the dividends and interest payments you receive.
Calculating Your Income
So firstly, how exactly do we work out how much we need in income to live off in retirement. We simply add up all the expenses we incur throughout the year, as well as adding a margin for discretionary spending.
In this example, we will use the number of £30,000 a year, assuming that this covers all of our monthly expenses and leaves additional spending money each month for discretionary items like eating out, clothes, holidays and so on.
This number focuses on financial independence primarily, rather than all the bells and whistles of a lavish lifestyle. When we run the calculations, we can flex this number up or down depending on your own personal circumstances.
Now that we have the target income, we need to work out how our investments can achieve this annual amount in dividend income and bond interest payments. Here are the calculation steps to do this:
Calculation:
- Take the dividend yield and bond yield of the assets you are looking to invest in or already hold. For this example we will assume bonds at 5% and dividend stocks at 5% as well, as these are both achievable yields in the current market
- Next, we divide the annual amount of your retirement income by the dividend yield, in this case dividing 30,000 by 5%. This tells us how much we need invested to achieve an annual income of 30,000. In this example, our target number invested is £600,000. You can see that if your target income was in fact 50,000, dividing by 5% would give you a target investment value of £1,000,000. Similarly if your target investment was 30,000 but your assets were yielding 4% instead, your investment required would increase from 600,000 to 750,000.
These calculations are dependent on the assets you hold. Take these differences in dividend stocks as a key example. Legal & General and Aviva both yield over 7% currently. Investing in these stocks would get you to your target income much quicker than others, but they typically do not grow their dividend at any more than single digit percentages year-on-year, if at all.
If you invested in a US dividend aristocrat like JNJ, while the yield may be lower at 2.52%, the company has a much stronger record of dividend growth over long periods of time, meaning that your income is almost guaranteed to increase steadily as you hold it.
Having multiple dividend stocks in your portfolio means you need to factor in the weighting of each stock to find out what your blended yield is. This is the cumulative total of all dividend yields, factoring in the weight of the total investment.
Blended Yields
So how can we calculate a blended dividend yield? Let’s look at the following example with 2 dividend stocks.
Adam has 2 investments, the first amounts to £50,000 in Tesco which has a dividend yield of 4%, while the second amounts to £75,000 in Glencore which yields 6.5%. Each stock has a different investment amount and different yield, so what is the calculation that we use?
The blended rate is equal to the sum of the income received by all investments, divided by the total investment amount. Firstly, let’s calculate the sum of dividend income across the two:
(50,000 * 4%) + (75,000 * 6.5%) = 2,000 + 4,875 = 6,875
This gives us the total dividend income across both stocks. Now we can use this number to work out the dividend yield across both investments.
(6875 / (50,000 + 75000)) *100 = 5.5
This gives us a blended yield of 5.5%. This example may seem simple, but the same principle can be used across a portfolio of 20 individual stocks to work out your blended rate. Once you have this, you can calculate the target investment amount needed to achieve financial freedom.
Remember that dividend yields change all the time due to stock price fluctuations, increases and decreases in dividend payouts, and even dividend suspensions. Always make sure to recalculate your blended rate frequently, perhaps every quarter to see how it changes.
There are other important considerations when planning for retirement. These include always factoring in a margin of safety when calculating your financial freedom.
An example of this might be adding a 10-15% safety net on top of your expenses in the event of any unforeseen costs like medical bills or emergency maintenance on your property.
On top of this, you should always have an emergency fund set aside. This should come as a priority to investing for the future, and should equal to approximately 6 months of expenses, but preferably more.
You may want to continue saving in retirement to have more money reinvested to allow for compounding of your returns. Compounding is one of the most valuable principles in investing and can be incredibly rewarding if done over long periods of time. I have covered this in a separate video which I will leave a link to.
To minimise the risk of dividend reductions or cuts, you should also look to diversify your risk away from a single stock. This also reduces the risk of significant capital loss, however this is never guaranteed.
In the event of a market crash, you want to still be able to fund your lifestyle without being forced to sell your assets as they fall. These opportunities are ideal times to be investing more in the market, not selling.
Finally, you want to look for stocks with strong dividend growth prospects. High yields are an indication that the company does not have strong future growth ahead, and is choosing to give its profits back to shareholders, rather than reinvesting for the future.
Companies with low dividend yields but excellent growth can turn out to be much better dividend investments in the future because of this. I have covered a list of 10 of the best dividend growth stocks in history in another video, so be sure to check that out.
