Are you saving enough for retirement, and will your retirement plan survive a damn good buffeting by an uncertain future? Obviously nobody knows, but you can stress test your strategy with a Monte Carlo simulator.

A Monte Carlo simulator takes your predicted pension pot and pits it against multiple visions of the future. It subjects your portfolio to random return sequences to determine the chances of your money running out before you breathe your last.

Staying in the black until you cark it is a win.

In contrast eating dog food in your eighties is not shown, but is the unsavoury implication of failure.

Retirement roulette

In some return scenarios, the 1980s dream sequence for equities will bubble into the dot.com boom and turn you into a multi-millionaire.

In other possible worlds, you’ll get hit by the Great Depression then World War 2 then the 1970s oil crisis, coming one after the other, like the three buses of the Apocalypse.

The main interest lies in the big % number written on your scorecard at the end. Handed out, as if Death himself was a Strictly judge, this shows the likelihood that you haven’t emptied your pot before you’ve completed the waltz of life.

To run a stress test on your own retirement plan, head to Vanguard, which hosts a free Monte Carlo retirement calculator that’s very simple to use.

The calculator wants to know:

Your total pension pot – I used the figure projected by Hargreaves Lansdown’s calculator based on my existing salary and contributions (as we’ve previously discussed). Ignore the Vanguard calculator’s request for your portfolio’s balance today. Instead insert your projected pot as it will stand on the day you retire (but in today’s terms).

The annual income you require ¹ – I used my current budget because I’m already a money-saving maven. I’m not going to spend much less in retirement unless I’m afraid to leave the house. If you’ve never imagined what your retirement income might look like, try this suggest-o-tron.

How long you plan to live – Use the national averages, or try a life expectancy calculator, or accept the 30-year default.

Your asset allocation – Use your current risk tolerance and these rules of thumb to guesstimate your likely asset allocation when you’re retired. Once you start playing with the calculator you’ll discover that there’s much less room for manoeuvre than you might imagine.

Place your bets

Run the simulator, let the digital dice roll, and you’ll end up with something like this:

The green zone represents all the time streams in which I lived happily after. The orange area shows the scenarios in which I bitterly regret not having children. In the worst-case scenario, the money tap runs dry after 16 years.

The important number is 78%. That’s the probability of my portfolio lasting for 30 years based on every scenario in the sim.

That’s not great. I’m not prepared to risk a 1-in-5 chance of hitting the skids.

Options for remedial action

So what am I to do?

Well, I could plan on cashing in my chips earlier.

Hmm.

What else? I can spend less, retire later, save more, and invest more aggressively.

Sticking with the moveable parts of the calculator, I try upping my equity allocation. But I can only hit an 81% success rate even with portfolios of 50 – 75% in shares. Not good enough.

Time to pinch the pennies. I can reach an 88% survival rate by spending only £18,000 a year. 10% less than I planned. This I can live with.

To hit the magic 100%, I either need to exit the stage after 20 years or get austere on my ass and only spend £12K a year.

A kick in the assumptions

For simplicity’s sake, I haven’t taken into account my state pension or the fact tax would reduce my £18K spending money to £16.5K. Do work these factors into your own retirement plan.

UK investors should bear in mind that this is an American calculator that uses historical US asset return data (from 1926 to the present day).

Many commentators argue that this was a golden age for US assets that’s unlikely to be repeated. On top of that you can knock off about a point of growth every year to represent UK returns lagging the US.

As the returns data is based on indices, there’s also every chance that the simulator doesn’t take into account investment fees (although it doesn’t say so in the fine print), which will deplete a pot even faster.

Not including my state pension makes my results conservative enough to allow me to feel comfortable about the above issues, however.

Another thing to keep in mind is you don’t know how often you ran out of money with, say, less than 24-months on the clock. Quality of life may not matter as much near the very end.

Lastly, this kind of calculator assumes you draw down your portfolio until it runs out or you do. In reality, you may want to annuitise a large proportion of your pot and take the guessing out of the game. But that’s a different story.

This is the end, my friend

For all these reasons and more, you shouldn’t treat these numbers as gospel. At best they enable you to circle within the vicinity of your retirement destination. They’re not exact co-ordinates.

Darrow KirkPatrick from the excellent Can I Retire Yet? blog advises using several different retirement calculators. That way you’ll get a range of answers that would make an astrologer sound precise. The process should dispel the notion that there’s one, ‘true’ number to shoot for.

I highly recommend trying Firecalc – it’s an excellent Monte Carlo sim with all kinds of tweakable options. Too much fun.

The vagaries of these calculators become a metaphor for the uncertain future ahead. Because however your retirement plan turns out, for better or worse, it won’t return the same answer as the calculator.

Take it steady,

The Accumulator

1. Again, enter your desired income in today’s money.[↩]

Good reads from around the Web.

A post of the week. Here’s Josh Brown at The Reformed Broker warning about an inevitable crash in the bond market:

I’m going to say this here and now for posterity and I hope you bookmark it:

There’s going to be such a brutal bond investor slaughter at some point over the next decade that the streets of Boston’s mutual fund district will run red with blood, the skies will be shot through with the lightning and thunder of unexpected capital losses and those who manage to survive will envy the dead.

Now a slaughter in bonds will not look like an equity market crash, the volatility characteristics are different and bonds eventually mature. But in some ways it will feel much worse than a stock crash because the money parked in bonds is thought of as low or no-risk.

The fixed income guys know what’s going to happen, too. Why do you think the Bond Kings at PIMCO and DoubleLine are pushing into equity funds? They’re getting three-year track records under their belts for when the big switch comes.

One reason Josh Brown is an excellent writer and pundit is because he doesn’t prevaricate. It may not be good advice – I have no idea about his track record, either way – but it grabs you right in your special interests.

In contrast, while I happen to think Brown is likely right about bonds, I’d feel duty bound to caveat it with warnings about deflation, Japan, market timing, and 20-year bear markets.

In fact, I already did. Some of my readers may have ended up wiser for it, but I suspect a few of them ended up asleep.

Brown’s is the strategy of a Wall Street professional. If he’s right, he can point to his prediction for years to come. If he’s wrong, nobody will ever remember – maybe not even Josh Brown, thanks to hindsight bias.

Perhaps even Google will forget his page eventually.

It’s a great post – and I think likely a good call – but it’s not necessarily correct.

[continue reading…]

Once you have established a solid foundation of dividend knowledge and understood the differences between the various types of dividend shares, you are ready to start prospecting for potential income investments.

Today I’ll discuss how you can get started in the dividend research process.

Panning for golden ideas

Poring over each of the 600-plus companies listed in the FTSE All-Share index to identify a few promising ideas is an arduous and time-consuming task.

Fortunately it’s a task that’s been rendered unnecessary by one of the most glorious by-products of the Internet: the share screener tool.

The primary purpose of a share screener is to reduce the vast number of potential portfolio candidates to a handful of names that you can research further.

You simply enter a few key parameters and the screener displays the select companies that fit your chosen attributes.

One important point to make right away is that screener results should not be considered automatic buy lists. Further research is always necessary, as screener results don’t always tell the whole story. (In the next two articles, we’ll discuss this process for researching individual shares.)

A number of helpful screening tools are available to UK investors online, including:

Free screeners:

• Telegraph Stock Screener
• Digital Look
• Morningstar

Premium screeners (i.e. not-free)

• Stockopedia
• Sharelockholmes
• Company REFS

If you’re just starting out, the free screeners will do the trick. More experienced investors may want to try the premium screeners, but for our purposes here we’ll just use the free screening tool from The Telegraph.

How to screen for high yield shares

In the previous article in this series, we defined ‘high-yield’ shares as shares with dividend yields between 1.2x and 2x the market average.

With the FTSE All-Share average yield currently near 3.6%, we can begin screening for high yield shares by entering 4.2% to 7.2% into the ‘dividend yield’ parameter about two-thirds down the screener page.

If you try this dividend yield range in a share screener tool, however, you’ll find that you get a list of several dozen companies in the results. For a more manageable hit list of potential high yield investments, we’ll need to enter a few more parameters into the screener to further narrow our search.

With high-yield shares, dividend sustainability is more important than growth potential — a high yield does us little good if the payout gets cut in the subsequent year — so the extra parameters will be designed to help us identify companies with the ability to maintain their current dividend and ideally grow it each year.

To identify high-yield shares that are likely to maintain their payouts in the coming years, we can enter the following five parameters:

• Index: FTSE All-Share. Whilst there may be good opportunities among AIM-listed shares, most investors will want to hold their dividend shares within the tax shelter of an ISA. They’ll therefore need to own LSE-listed shares and to avoid AIM-listed shares.

• Return on equity > 10%. Companies that are unable to consistently generate returns on equity above 10% are likely destroying shareholder value. Even though high-yield companies aren’t usually high growth companies, we nevertheless want to own shares that are at least earning their cost of equity each year. Searching for companies that generate at least 10% return on equity is a fair place to start.

• Dividend cover > 1.2 times. The Telegraph share screener tool does not have free cash flow cover, but the earnings-based dividend cover will do for now. (We’ll discuss calculating free cash flow cover in the next article.) Another way to think about this metric is that a company with 1.2x dividend cover is paying out 83% of its earnings as dividends (1/1.2). This is the absolute minimum amount of dividend cover that investors should demand when researching high-yield shares, in my opinion. Without the ‘margin of safety’ afforded by a well-covered dividend, a year or two of lower earnings could force the company to reevaluate its dividend policy.

• Five year turnover growth > 0%. Sales are the life-blood of the financial statements, so companies with declining turnover may be steadily shrinking. Companies in a state of secular decline usually feel pressure to take drastic actions to maintain profitability, such as a large merger or massive restructuring plan. Those situations can be messy and all else being equal we want to avoid getting entangled in them, because dividends can come under the chopping block in an effort to boost cash flows.

• Five year EPS growth > 3%. Similarly, we also want to see at least a little growth in earnings per share. A situation where a company’s EPS is contracting whilst dividends per share are growing is simply unsustainable. Eventually the dividend will come under pressure. Because we want our high-yield shares to grow at least modestly in the coming years, we want to see a recent track record of positive EPS growth.

By adding these five parameters, we get a much more manageable list of shares to research:

Though we still have some work to do — particularly on valuation — the screen has helped us identify some promising high-yield research candidates. My next article in this series will discuss how to further research high-yield shares once you’ve found them via a screen.

Screening for dividend growth shares

To screen for ‘dividend growth’ shares that may have lower starting yields but have more potential to grow future payouts at high rates, we simply need to make a few adjustments to our screening parameters.

Since we’ve previously defined dividend growth as shares between 2% and 1.2 times the market average, we’ll change the dividend yield range to 2% to 4.3%.

We’ll again stick with just FTSE All-Share stocks in this screen to make sure they are ISA-eligible.

Here are a few more settings:

• Return on equity > 15%. Companies that consistently generate returns on equity over 15% likely have some type of sustainable competitive advantage. Otherwise, you would expect competitive forces to drive ROE downward to the company’s cost of equity. Although ROE does have some flaws (which we’ll discuss in the next article), screening for companies with ROEs over 15% give us a better chance of finding shares with the ability to produce high rates of return.

• Dividend cover > 1.5 times. When looking for dividend growth ideas, we should demand more dividend cover than in the case of high-yield shares for two reasons. First, because we want to identify firms with higher growth rates than high-yield shares, we naturally want these companies to retain a meaningful amount of profit each year to reinvest in the business to promote sustainable longer-term growth. Second, by starting with a higher dividend cover ratio, we’re giving dividend growth shares the potential to grow into a lower dividend cover as they mature. A dividend growth share that’s consistently paying out 90% of earnings today, for instance, doesn’t have much room to augment its payout ratio as growth slows and is thus primarily dependent on earnings growth to deliver dividend growth.

• Five year dividend per share growth > 7%. Just because a company may have the financial strength to increase its dividend at a high rate, it doesn’t mean that the company’s board will do so. For instance, the board could prefer to employ share repurchases or engage in aggressive M&A rather than pay out free cash as dividends. By identifying shares with a track record of raising dividends, we stand a better chance of avoiding companies not fully committed to their dividend programmes.

• Five year EPS growth > 7%. Whilst companies can artificially boost earnings per share using buybacks, most corporate boards of directors use EPS-based payout ratios when determining dividend policy. If the board is seeing strong EPS growth, then they’re more likely to boost the dividend at a similar pace.

As you can see, we have plenty of good ideas to research and from a variety of sectors, too, including financials, commodities, consumer goods, and technology.

We’ll take a closer look at this list of dividend growth ideas after we discuss high yield shares in the next article.

Still more to do

Share screening tools have greatly simplified what was once a time-consuming task of idea-generation. Nevertheless, a successful screen is just one part of a complete research process.

Over the course of the next two articles, we’ll discuss how to use screener results to select the best of the best ideas.

In the meantime, why not try your hand at a few screens and see how they can work for you? And if you have any of your own screening tips, please share them in the comments box below!

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.