The Story Behind My 8% Obsession
If you read any of my subscription columns, you will know that I am a bit obsessed with 8% annual yields. There’s a reason for that.
The 4% Rule
My obsession stems from the “4% Rule.” This is a rule of thumb used to estimate how much a retiree can withdraw from their retirement funds each year. Conventional wisdom puts that amount at ~4%, because that’s roughly in line with conservative estimates for growth and income from a retirement portfolio over a long period of time.
William Bengen, an MIT graduate and certified financial planner, did the math that backs this up. Bengen looked at historical market returns over the 50-year period from 1926 to 1976 and concluded that a portfolio allocation of 50% stocks and 50% cash and bonds was best for retirement accounts.
Bengen concluded that retirees could safely withdraw 4% from such retirement accounts in the first year of retirement, and then increase that each year according to the previous year’s inflation rate. A portfolio using this strategy was calculated to last for at least 50 years 70% of the time, and in the worst case it would have still lasted 29 years.
But a 4% withdrawal rate isn’t a lot. If you apply Bengen’s rule, in the first year of retirement you could reasonably withdraw $40,000 for every $1 million you have in your retirement portfolio. However, most Americans don’t have a $1 million retirement portfolio.
How to Achieve 8%
However, if you can conservatively push the yield on your investments to 8%, it halves the amount you need for retirement. You could draw $40,000 each year from a $500,000 portfolio yielding 8%.
The kicker is that companies yielding 8% typically have some underlying issues that dramatically increase their risks. Often, yields are at 8% because the underlying share price has plummeted, which pushes yields higher. But those circumstances also greatly increase the chance that the high yields will be cut. In other words, they aren’t sustainable.
There are some exceptions. There are a number of master limited partnerships (MLPs) that yield 8%, and they pay for that sustainably out of cash flow. Enterprise Products Partners L.P. (NYSE: EPD), for example, currently yields 8.02%, and has consistently grown its cash flow over time.
EPD is one of the best pipeline companies in the business, and I personally own units. But it is more volatile than the S&P 500, and it went on a wild ride during last year’s pandemic. Notably, EPD never cut its distribution despite the volatility, because underlying cash flow supported it.
But it wouldn’t be prudent to build a retirement portfolio from companies with high volatility. An 8% yield is great, but not if you experience a 50% decline in the underlying share price. There is, however, another way.
Conservatively Boost Your Income
You can build an 8% portfolio using conservative, blue chip stocks. This can be done using one of two conservative option strategies: covered calls or cash-covered puts. I won’t delve deeply into the strategy here, but I will show one example.
Consider a classic consumer defensive blue chip like Procter & Gamble (NYSE: PG). The company has a 52-Week beta of just 0.51, meaning it has been 49% less volatile than the S&P 500 over that time. PG currently pays an annual dividend of $3.48, to yield 2.4%. To push that annual yield to 8% requires an additional $7.83 of annual income. That’s easily achievable.
If you own at least 100 shares of PG, you can sell a call option against your shares. This is called a covered call, covered by the shares you own. At present, you could sell a $145 call expiring on June 17, 2022 call (in 311 days) for $7.40 a share. That amounts to $8.68 annualized, pushing the total annualized yield to 8.5%. (If you choose shorter trade durations, you can push the annualized yields much higher).
What’s the catch? If shares of PG are trading at $145 or higher by expiration, they will be called away. You will have to sell them for $145, regardless of the price. You are giving up the potential for more upside for the certainty of the higher overall yield. In case shares are called away, you still profited from the call premium ($7.40) and an additional $3.59 of appreciation (2.5%) based on the current share price. So, your guaranteed yield is 8.5%, plus an opportunity for another 2.5% by expiration.
This isn’t a strategy designed for growth investors, although there are more aggressive covered call strategies for growth investors. The example I used is primarily directed at income investors who wish to boost their retirement income into the 8%+ range. It’s a conservative strategy, but note that the underlying share price can still fall. But by sticking to conservative blue chip stocks, you reduce the chance that the yield, and thus your retirement income, will be reduced.
Hence, the reason for my obsession with achieving conservative 8% yields.
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