So let’s say you suddenly have a million dollars, and you want to put it to good use.
As a Mustachian, your first instinct would naturally be to invest the money somewhere, in such a way that it provides reliable income to you for the rest of your life. Thus, you would be Financially Independent, and all future decisions of what to do with your time could be made independently of whether or not you get paid for those activities.
But how do you invest a chunk of money, such that it provides this reliable income without running out? If you just pull a few garbage bags of cash out of the ATM and hoard it at home, inflation will destroy its purchasing power over the course of your lifetime, and you’ll spend your last few decades in relative poverty.
You can put it in a savings account at your local bank and earn 0.1% Maybe you’ll get as high as 0.8% at a more modern bank like ING Direct.
Forget it. For large sums of money, a savings account is little better than storing it under the mattress these days.
You can use certificates of deposit or government bonds. Some of these pay 2-3% in exchange for locking up your money for a very long time. You might keep up with inflation, but only if you reinvest all the interest payments, leaving you with nothing to spend.
Many early retirees have turned to owning rental real estate, because it provides a much higher annual cashflow (10% or more is possible), even while the core asset (the houses or apartment buildings), tends to automatically appreciate with inflation. But not everyone has the patience or the interest to be a landlord – even with the option of hiring a property manager to handle the day-to-day operation of the properties.
Real Estate Investment Trusts (REITs) encapsulate many of the benefits of rental house ownership, with fewer drawbacks and absolutely no work. The downside is that your money is still concentrated in one potentially volatile asset class (usually commercial buildings), the tax treatment isn’t nearly as good, and the yield is lower than owning your own property.
While the real estate options sound good, most diehard investors (myself included) feel safer not having all of their eggs in one basket. After all, real estate is only a tiny slice of the world’s economy, so it makes sense to own parts of all of it instead. Because of this, I try to maintain a more diverse “Asset Allocation” that includes plenty of good old-fashioned stocks.
“Stocks!”, you may say. “But how do I fund a retirement with stocks, when they’re always jumping up and down? Won’t I lose all my money when I’m forced to sell low?”
In a word: No. Stocks make a great companion to the early retiree, even when your goal is a steady stream of income.
First of all, by owning index funds, you’ll automatically own a large number of companies that pay regular dividends. This generates a stream of payments that can show up automatically in your bank account on a predictable schedule.
The problem is that dividend yields aren’t all that high these days. Despite the fact that US stocks seem reasonably priced these days when judged by historical standards, the dividend yield is much lower than it was in previous decades. You can blame this on a cultural shift in investors: many of us prefer to have companies re-invest more of their earnings, or repurchase their own shares (multiplying the value of the shares still in the hands of shareholders), instead of paying us their earnings in cold sweet cash. This helps lower the tax burden of owning stocks. I’d prefer higher dividends myself, but I’ve heard from many who like the system how it is now.
So your stocks will in theory go up faster than inflation, even after paying you dividends. But how do you extract this extra value from the stocks, without manually logging into your retirement account every month and deciding exactly how many shares to sell?
One answer is the Managed Payout Fund – which brings us to the real point of this article!
As it turns out, my old standby Vanguard has at least three funds that do exactly what we’re talking about here. You throw in some money up front, and they handle asset allocation and payout, automatically managed with a reasonably low expense ratio.
Depending on how much of your ‘Stash you want to spend each year, you can chose any of the following three funds:
- VPGFX pays you 2.7% per year:
- VPGDX pays 4.7% per year:
- VPDFX pays 6.8% per year:
“So what is really inside these funds, providing the great returns?”, you may ask.
First of all, don’t confuse payout with actual return. While the fund values will tend to grow with the world economy, the payout amount may turn out to be larger than the growth, slowly draining away your principal.
In fact, VPGFX is likely to be the fastest-growing (and most volatile) fund based on its asset mix, even while it has the lowest scheduled payout. The idea is that younger people would use VPGFX, and older would buy VPDFX.
With that caution aside, let’s look at the actual contents of the first fund in our list, just to get an idea of what’s inside.
- Vanguard Total Stock Market Index Fund Investor Shares 45.8%
- Vanguard Total International Stock Index Fund Investor Shares 19.5%
- Commodities 10.2%
- Vanguard REIT Index Fund Investor Shares 10.1%
- Vanguard Market Neutral Fund Investor Shares 9.7%
- Vanguard Total Bond Market II Index Fund Investor Shares†† 4.7%
- Total — 100.0%
Aha – from their description we can see that it’s a nice mixture of other Vanguard funds, automatically maintained in a roughly fixed ratio. Very diverse, which means much more stable than an all-VFINX (US stocks) portfolio.
Their stock/bond mix changes to become more conservative as you move down the list – suggesting the older you get, the further down you go. You’ll get even more stability, in exchange for lower expected returns (even as the actual payout increases).
Thus, the highest-payout fund would be likely to draw down your principal faster than inflation over time (unless we see great stock/bond returns from this point on, a little unlikely given that bond prices are already high, which is why yields are almost zero). So you wouldn’t want to count on a lifetime of retirement with, say, $300k in VPDFX, unless you had some nice safety margins elsewhere in your life.
But if I had to take a big chunk of money and convert it to a relatively safe, stable source of lifetime income by making a single investment, I’d feel pretty good about just throwing everything into VPGDX, and simply enjoying the 4.7% annual paychecks for decades to come. For those who just want a single easy answer, a managed payout funds like these can truly become an Automatic Grocery Buying Machine that funds your Early Retirement. Even if you prefer the lower expense ratio and greater control of buying your own selection of index funds, following the allocation ratios set out in these funds represents a pretty good starting point at sensible investing.
Every time I write about my love for Vanguard funds, Canadians ask me if there’s an equivalent available to investors in Canada. This is an important question, since expense ratios for Canadian mutual funds (called MERs) are often ridiculous, 1-2% annually or more. In a world where you’re only earning 7% total, this means your fund company is siphoning off up to a quarter of your total income! Therefore, you should be looking for the lowest fraction of a percent possible, and laughing at anything over 0.5% or so (most of my own funds charge well under 0.2%).
A few answers:
Vanguard Canada is now offering some low-fee ETFs on the toronto stock exchange. Although they are not managed-payout funds, you can still create a nice porfolio from them, collect dividends, and sell off shares as needed to fund retirement.
TD’s e-series funds are another competitive source for Canadian investors. MERs are among the lowest in the country, and the funds are no-bullshit index funds. This allows you to steer clear of traditional mutual funds, which underperform even while overcharging. It also allows you to invest without a financial advisor or stock broker. All funds can be bought directly from TD or Vanguard without commission.