Thursday, February 09, 2006

Cash Flow vs. Nest Egg Retirement Savings

Now that RSP season is in full swing, many publishers are providing special features and extra material geared towards investment strategy, retirement planning, and general good personal finance behavior. As pointed out by Canadian Capitalist, the Toronto Star is no exception. That being said, I read Ellen Roseman's article in today's edition (How Much Do You Need to Retire?) with that same mix of doubt I experience with every planning workbook or RRSP calculator (usually produced by companies that sell investment products) that focuses on determining the size of the nest egg needed to generate a targeted retirement lifestyle.

In most cases, the 'next step' after calculating the nest egg (while struggling to mask the fear and incredulity that accompanies this) , usually involves a selection of investment products or mutual funds with MERs > 2% from the workbook/calculator sponsor. I went through this same process when recently setting up my employer-matched RSP at work. No where in this literature do we see promoted low-cost index funds, DRIP programs, value dividend investing, etc. that offer a mathematical advantage to the small investor. As my favorite professor in school insisted we ask ourselves of all things (he was a wee cynical) I find myself wondering qui bono - who profits?

This is why I'm perhaps instinctively attracted to the (deceptively?) simple approach of placing a greater priority on passive income/cashflow over the size of the nest egg. Where the nest egg model dictates that I accrue 1M? 2M? and then whittle away 4-7% per year in retirement, the cashflow model dictates that I buy and hold (hopefully forever) quality securities that continue to pay dividends year after year. In growth mode, these are reinvested, and in retirement mode, its income. This model also says that the underlying value of assets supporting the cashflow may fluctuate all over the place and it doesn't really matter. Even in crashes the dividends for such companies, in most cases, continue to be paid out.

I say 'deceptively' simple as I have also begun to carefully consider if the Fosterian approach is as much a repeatable strategy as it was a phenomenon of market conditions over a particular period of history, coupled with a bit of luck. All this being said, my long-term goal is really based on a nest egg-cashflow hybrid, and I imagine I will continue to track my monthly accruals (read nest egg building), and not income from investmensts, for quite some time.


For the record, I enjoy Ellen Roseman's columns. It was one of her articles, in fact that made me aware of the financial blogging community.


Anonymous 0xcc said...

I agree with you, HI and your approach seems similar to mine. I am current tracking cash flow in my investments but I am also quite focused on nest-egg building. I hope that through tracking my 'everyday' living expenses over the mid to long-term I will be able to figure out what I need in terms of cash flow to maintain my current lifestyle. At the same time I am working to reduce those expenses (paying off the mortgage being the most obvious way to do that for me right now) as well as build up my investment income.

Based on my current planning I will have the mortgage paid off in 5-7 years and over that same period my investment income should cover about 50% of my living expenses. I'm currently 33 and I hope to be totally financially independent by the time I am 45.

One last point, financial independance doesn't necessarily mean retired; My goal is to be able to do what I want when I want without being concerned about the financial impact.

2/10/2006 8:45 AM  
Blogger Seattle Simplicity said...

This is an excellent post. I had never considered nest egg building vs. cash flow. You have given me some food for thought.

2/10/2006 12:10 PM  
Blogger Humble Investor said...

Int3 - you've given me some ideas for some interesting new new metrics I can hopefully use one day, i.e. % of expenses covered by passive income is a nice 'cashflow investing' measurement. I'm also 33, so my 14-year plan takes me to 47, though I don't think my current goal is sufficient for financial independence. That being said I've always found that even *having* a plan seems to put a bit of wind in your sails.

SS - Thanks for the compliment. I hope to be able to post more on this as time goes by.

2/10/2006 9:11 PM  
Blogger Dus10 D said...

I think both net worth and cash flow are important. If you consider them equally important, then it is likely that you will choose investments that build your net worth and produce a nice cash flow. In other words, the higher your net worth, the higher your cash flow... They are not exclusively tied together, but they can be, if you make the right investments.

2/13/2006 9:51 AM  
Anonymous Canadian Capitalist said...

I wanted to leave a detailed comment, but then decided it is a good topic for a post.

2/14/2006 9:48 PM  
Anonymous Dave said...

"In growth mode, these are reinvested, and in retirement mode, its income."

It sounds like you are implying that if one is thinking about using their retirement savings as an income source rather than a nest egg that one should also invest in income-generating investments during "growth mode" as well. Which doesn't make sense because you could easily just invest in growth stocks until you retire and then switch everything into income stocks if you wanted to. There is no need to "buy and hold (hopefully forever) quality securities that continue to pay dividends year after year." At least not until you are in retirement. Of course, I, along with most people would advocate holding onto more fixed-income as you get older for obvious reasons.

Don't get me wrong, I am in favour of investing in dividend-paying stocks. But what you invest in when you are in pre-retirement has very little to do with whether you use the "cash flow" or "nest egg" model to determine how much to save up.

"Where the nest egg model dictates that I accrue 1M? 2M? and then whittle away 4-7% per year in retirement, the cashflow model dictates that I buy and hold (hopefully forever) quality securities that continue to pay dividends year after year."

I don't really see the big difference here. You aren't whittling away 4-7% if the stock also went up in value by 4-7%. You're still going to have to accrue of lot of "quality securities" such that they generate sufficient income. You make it sound like the second option (investing in "quality securities" that pay dividends) is an advantage, but what is the advantage exactly?

Thanks for this post, it has really made me think!

2/15/2006 9:49 PM  
Blogger Humble Investor said...

Hi Dave,

I agree with you when you in principle when you state that, in growth-mode, there is no difference between investing in growth (or even value) stocks vs. dividend paying stocks if the goal is to accrue a sum that can provide an income in retirement. I guess I'm not sure if we're just not caught up in semantics. For example, many have argued that the current near-ten year low for Loblaws (TSX:L) as it re-structures its business puts it into 'value territory'. But Loblaws is also a dividend-paying stalwart, consistently increasing its dividend for the last 10+ years. In other words, if all else was equal (and I realize it rarely is) would a dividend paying stock (which may also be a growth or value stock) not be a better choice, (even in growth mode) over one that doesn't pay a dividend?

In terms of what one needs to invest in order to live comfortably, I agree that one would require a sizable portfolio to live off dividends alone - i.e. one would need a $1M portfolio to generate 40K annually assuming a 4% yield. But as many others have pointed out - Thomas Carroll, Robert Gibb, and most recently, Derek Foster, that doesn’t mean you need to invest $1M. This is due to a couple reasons:

1. Companies that increase their dividend every year are nearly always growth stocks as well. As a result, buyers can wait and buy these companies when at a discount and enjoy downstream income and growth - Foster has a good real-life example of this on page 175 of his book illustrating a 300K portfolio paying 18K/year that could have been purchased, if timed correctly, with 100K.

2. The increase in yield over time with dividend payers can have a dramatic effect whether used as income or re-invested. To quote Thomas Carroll:

"We bought our BC Gas April of 1995 for $6.85. The dividend has grown from .45 to $.84 a share. Our yield on those shares is now 12.3% (.84/6.85)".

See Carroll's site.

In short, I don't think I'm disagreeing with you. I have a taxable and RRSP account I'm hoping to grow concurrently. Thanks for the feedback and the opportunity to add a few more ideas to this discussion.

2/15/2006 10:36 PM  
Anonymous Dave said...

I guess this just boils down to basic argument of dividend-paying stocks vs. non-divident paying stocks.

I actually wrote an article about this: "Growth vs. Cash" Sorry for that shameless self-promotion, but I think it's a good read, because it contradicts the opinions of many people who think that a company's income is better invested in a company because they assume management can grow the cash at a faster rate...

I don't think I'm disagreeing with you either. I think I got a bit confused about the point you were trying to make because the article mixed the dividend vs. growth stock debate with talk of how to best determine how much you need to retire (two topics that both interest me greatly) and I thought you were trying to relate the two. Thanks though, your article has really got me thinking about retirement...and do I need to target enough to live off the income? or enough to live off by "whittling" it down?

2/16/2006 12:29 AM  

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