An efficient retirement portfolio

Beware the hype

What's popular these days among salespeople/advisors – thanks to zero interest rates from central banks – are investments that pay out high dividends or high distribution yields. The salespeople's logic is that dividends provide cash flow that you need in retirement. As a consequence, these things usually pursue some lower quality investments (e.g. junk bonds, risky stocks) AND charge higher fees. Typical examples of this, which they will try to talk you into, are “Monthly Income Funds” and “Dividend Funds”.

The problem is that these have much higher fees than plain index funds and sometimes contain worse fundamental investments. Often, they also have worse total returns than plain index funds!

A more efficient solution

I like Warren Buffett's concept. He says that it's not essential that an investment pays out high dividends. He describes the “sell-off” approach in which an investor regularly sells shares to generate cash. This achieves the need for cash flow but does not actually impede capital growth. You can read Buffett's explanation on page 18 of the 2012 letter (heading: Dividends) .

I think this is the most efficient way to manage capital in retirement. Instead of throwing away high fees or chasing yields in a “dividend fund”, you minimize fees by sticking to regular index funds and then manually sell shares periodically.

This frees you from the yield-chasing behaviour that is so dangerous.

Practical example

Let's say you're a Canadian investor with $1 million of equities at a discount brokerage. (Note! I'm leaving fixed income out of this, but I presume you have plenty of fixed income elsewhere). Let's say you hold the XIC index ETF with expense ratio 0.06%. Obviously, in reality you would hold more diverse stocks and ETFs or low-fee index funds.

You could routinely sell, for example, 3% of the stocks in a year. This might be implemented by selling 1.5% every 6 months. The overall fees are negligible.

Using XIC (TSX Composite Index) and selling 3% a year, your cash flow is:


XIC dividends: 1 M x 2.7%


XIC sell-off: 1 M x 3%


Total annual distribution, i.e. 5.7%

Need more cash flow? Increase the “sell-off” rate.

The resulting distribution yield is just as high as some of the high-fee retirement funds. I believe this is a more efficient method because you save on fees, and don't get dragged into unusual or risky investments. The point of this is to maintain a standard index fund portfolio.

But don't Dividend Funds generate cash for free?

No, they don't. It's an illusion. Dividends are simply cash that a company pays out instead of reinvesting internally. In fact, the value of a company's stock drops by the exact amount of a dividend payment. There is no free money.

Various dividend and high-yield funds have created the perception that they can pay out high dividends and still rise along with the market. For instance, “covered call” ETFs are marketed as providing a boost to regular performance by using options strategies. However when you go back and look at their performance, their total returns are actually worse than the regular indices.

It boils down to the simple equation: total return = dividends + price appreciation

The heavily marketed high-yield funds simply increase dividends (or distributions) at the detriment of price appreciation. In the process, they charge you high fees. This is the essence of their trick. There is no way they can increase the total return.

By sticking to plain index ETFs, you benefit from rock bottom fees and have the same total return. The fee savings can be tremendous; you might otherwise pay 1.5% in fees to a "yield" fund product. On $1 M, that's $15,000 a year in fees.