Updated on 12.16.09

Living off Capital

Trent Hamm

Philip Brewer is perhaps my favorite personal finance blogger. I thoroughly enjoy his writings and I’ve told him so in the past. A few months ago, I offered him a very rare guest post slot here at The Simple Dollar so I could share his writing more directly with you all. This is the article that Philip contributed. If you enjoyed it, feel free to read some of his other stuff.

People who come from wealthy families learn how to live off capital. The rules are taught along with all the other things they learn from their parents–how to dress, how to eat, how deal with bankers and trust officers. But even though most people don’t learn the rules, living off capital is just a skill, and it’s one that everybody should learn, because everybody lives off capital sometimes.

People usually think about living off capital in the context of retirement, but that’s just one (albeit important) example. Perfectly ordinary transitions, such as losing a job and having to find another, also amount to living off capital. There is also the broad swath in between: Living off capital for longer than just the length of time it takes you to run through your emergency fund, and doing so without the institutional support–social security, medicare, maybe even a pension–that comes along with retiring at an ordinary retirement age.

If you’ve got a lot of capital–that is, if you’re wealthy–then living off capital is easy: You invest enough in treasury bonds that you can live off the interest.

It’s not trivially easy, of course. You have to allow for taxes. You have to allow for inflation. You have to have some sort of cushion or reserve in case your investment return falls. But, generally, living off your income is straightforward.

You allow for taxes by setting aside enough of your income to pay your taxes. This isn’t hard, even if you have to file quarterly estimated taxes, but you have to do it yourself; you don’t have an employer automatically taking care of it for you by deducting it from your pay. Screwing up is expensive–screwing up badly may even be criminal.

You allow for inflation by reinvesting enough of your income to preserve the value of your capital. If your money is in US dollars, TIPS (Treasury Inflation-Protected Securities) will do exactly that. The principle value of the bonds increases automatically to keep you even with inflation, and the interest is paid out on the inflation-adjusted principle, so your income rises with inflation as well. (The adjustment is based on the Consumer Price Index while what matters to you is your own cost of living, so you can’t entirely delegate the job of allowing for inflation, but TIPS will do most of the heavy lifting.)

You allow for reversals by having a cushion somewhere. Ideally, have two cushions: First, a reserve fund with enough money to cover any unexpected expenses. Second, some flexibility in your cost of living, so that a decline in income can be matched with a decline in spending.

Beyond just income
The wealthy have other concerns than just supporting themselves–they want to pass down an estate. Because of that, they teach their kids this rather conservative version of living off capital. If you only spend your income, and if you reinvest enough to keep even with inflation, then you’re preserving your capital intact. (If you reinvest more then the minimum, or if some of your capital is invested for growth, than you can be growing your capital at the same time you’re living off it.)

If leaving an estate is not a concern for you, then you can spend more than just your income.

There’s a common rule of thumb that (if you have a well-diversified growth portfolio), you can probably spend about 4% of your capital and still expect to have more capital the next year. That won’t be true every year (it was really, really not true in 2008, for example), but historically it’s been true on average.

Still, the wealthy know that spending capital is a bad idea. Anytime you spend more than your income, you’re in danger of entering a death spiral: Your reduced capital earns less money so you have to spend even more capital to support your standard of living; repeat until broke.

A lot of people have back-tested versions the 4% rule, looking at historical periods to see if following that rule ever led to a death spiral. From what I’ve seen, it looks pretty good, but the current circumstance is going to put it to a particularly harsh test–especially for people who started living off their capital in 2007.

If you can afford it, choosing to spend only income is a safer strategy. If you can’t, you probably ought to accept that at some point you’ll have to earn some more money–and if you’re going to do that, sooner is probably better than later (before you’ve depleted your capital). Happily, a pretty small amount of money can make a big difference, if you’re right on the edge of being able to live on capital. Every dollar you earn is a dollar of capital that can go unspent.

If you were really rich, the safest thing to do would be to invest enough in TIPS that the income would support you. Then you could invest the rest of your money however you liked. Most people aren’t that rich–at the moment you’d need close to $2.5 million invested in TIPS to earn an inflation-protected $50,000 a year. Treasurys without inflation protection are earning more than twice as much. (Of course, you have to reinvest a big chunk of that to keep even with inflation).

Dividend-paying stocks can earn still more money, and dividend growth can provide some amount of inflation protection (as can capital gains). in recent years it has been tough to invest for dividend yield, but even with the recent recovery in the stock market, there are plenty of companies paying a reasonable dividend now–there are more than 40 companies in the S&P 500 whose dividend yield exceeds the yield on a 30-year treasury. None of those will be as safe as treasurys, but at least there are some options now for someone looking for income.

If you have it in you to be a landlord, there’s also the option of earning rent on real estate investments.

You can arrange the mechanics several different ways. The simplest version is simply to have the income from your investments directed into your checking account and use it to pay your bills. A slightly more complicated version would direct your income into the savings account where you keep your reserve fund, and then transfer money from there into your checking account. That makes it easier to even out the month-to-month money flows, which tends to be necessary because stocks generally pay dividends quarterly and bonds generally pay interest semiannually.

(If a lot of your capital is tax-sheltered in an IRA, 401(k), or similar vehicle, the tax rules make it more complex to use that capital for spending, but there are rules for handling the case when you’re actually retiring early.)

The key step–the one that rich families make sure that their children know–is to evaluate your capital every year: Make a new budget with your projected expenses for the following year, and then reinvest enough of your surplus that its earnings will cover any increase in your cost of living.

If you don’t have enough of a surplus to do so, you were living beyond your means.

It’s easy to do this by mistake. Even most people with a budget don’t know their cost of living accurately enough to know if they’re properly accounting for things like those large-but-rare expenses like a new car or a new roof, and any particular category of expense can rise much faster than overall inflation. (Think health insurance, college tuition, and fuel.)

People who are accumulating capital (rather than living on it) can use each year’s new savings as a buffer–even a major un-budgeted expense can often be covered out of this year’s planned savings without needing to dip into capital. Someone already living off capital doesn’t have this option. They have to provide their own buffer out of their reserve.

Fluctuations in income
There’s a second reason that a reserve is essential: The income earned by capital fluctuates. Anyone living off capital right now knows this quite acutely–the rate paid on Treasury securities is at generational lows. Other investments (such as dividend-paying stocks) earn an income that doesn’t necessarily shift in lock-step with treasurys, but can still go down–particularly during a recession.

The children of rich families learn that the key technique for stabilizing your earnings from capital is diversification.

You should diversify across time by investing some of your money in long-term treasurys, which will pay a fixed rate for a long period (decades). That offers some stability, but has two downsides. First, it while it protects you from falling rates, it makes it harder to take advantage of rising rates. Second, if all your treasurys mature at once, you might have to reinvest the whole sum at a much lower return. Avoid that making sure that your long-term securities mature in a staggered fashion. (Arranging for a fraction of your long-term securities to mature at regular intervals is called setting up a ladder.)

You should also diversify across kinds of investments by investing in more than one kind of vehicle. As attractive as TIPS are for someone living off capital, you probably want to have some of your money invested in ordinary treasurys, in stocks, and maybe in real estate. Other options (such as owning a business) are worth considering as well. This reduces the chance that your income streams will all fluctuate in the downward direction at the same time.

Other kinds of diversity are good as well. Consider investing in foreign treasurys as well as US issues, and maybe in corporate or municipal bonds.. Your stock investments should include multiple companies in different industries, and should include foreign companies as well as domestic ones.

The other key for dealing with a fluctuating income is to have a flexible cost structure, so that you have the option to cut your expenses, if necessary, to match your diminished income.

Those are the basics:

Invest for income
Reinvest to preserve your capital
Keep enough flexibility that you can adjust your expenses

Learn those skills and you’ll have as much ability to live off capital as someone who grew up in a wealthy family. Then you just need the wealth.

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  1. Your post perplexed me. You mention preservation of capital, passing on money and you make no mention of life insurance. Couldn’t life insurance allow you to have your cake and eat it to. You would be able to preserve and pass on the capital and also (if you wanted to) spending down your money? I understand that the set up might be more complex but wouldn’t the end result give you more flexibility?

  2. I think the idea of “living off the income” is more complicated than you have stated. If you are going to use the 4% rule then that 4% (adjusted for inflation) applies to any money being withdrawn from your accounts – it doesn’t matter if the money came from interest, dividends or selling some of the capital.

    I’ve read some people talk about “living off the dividends” and not withdrawing anything from their investments which is an illusion.

    Another factor is that you can invest in very low-income investments (treasury bills). Living off that income might mean withdrawing only 1-2% of the portfolio each year. On the other hand you can invest in securities (REITs come to mind) that have very high dividend yields – partly due to riskiness of the underlying business and partly because some of the dividend is probably return of capital). Living off that income might mean you are using a withdrawal rate of 10%+ each year which is quite dangerous.

  3. @Evolution Of Wealth: Life insurance can work great for protecting people from your premature death, but it doesn’t do so much for passing wealth on if you die at a ripe old age. If you’re 90 and want to buy $1 million in term life insurance, it’s gonna cost a lot. You could buy a paid-up policy when you’re younger, but that’s really just another form a capital.

    @ABCs of Investing: You’re right that you have to be very clear about how much of the money that you’re getting is really “income” and how much is simply a return of your own capital. With TIPS it’s quite clear, but with most other investments you have to look pretty closely before you can just assume that the dividends that you’re getting are being paid without invading your capital. In the end, you have to take the responsibility to reinvest enough to keep your capital intact against not just inflation, but also sneaky fund managers that are trying to make themselves look good by paying you dividends out of your own capital.

  4. Kevin M says:

    @ABCs – how is living off dividends an illusion? I have a couple clients that do just that.

    I liked this guest post if for nothing else it introduced the concept of living off something else than “earned income”. I would bet 50% of people (or more) don’t even realize that is an option.

  5. dagny says:

    This post looks at capital in a limited way – financial assets. An additional way of living on capital is residing in a home one owns without a mortgage. The capital asset here is the mortgage free home, the return on this capital is shelter without rent or mortgage payments. One still pays property taxes, homeowners insurance, maintenance and repairs. As a bonus there is no income tax on the shelter service. I’ve lived in a mortgage free home since 2003 – it’s great!

  6. @Philip Brewer I read your post as how wealthy families plan ahead in regards to capital, spending and passing the money on. I would think life insurance would be a pretty big part of that. Are you saying wealthy families don’t plan ahead with life insurance? I understand that 90 might be a little too late. I’m guessing there isn’t a lot of 90 year old people reading this post. For the younger crowd (<90), should life insurance play a role in the planning you mention in this post?

  7. @dagny If someone said I have an asset for your to purchase. You will pay into it each month. The price you pay in will only go up. It will never provide any income. It is illiquid. In fact, if you want to try and get some money from it you have to ask someone else’s permission and prove to them you are worthy. And when you want to sell it you are subject to a supply/demand marketplace so good luck. To get a good price it might take a year. Does that sounds like a good investment?

  8. Kevin – there is nothing illusionary (is that a word?) about living off dividends – my point had to do with the 4% withdrawal rule. I’ve had people tell me that if you only withdraw dividends or interest payments from your portfolio then your withdrawal rate is 0% because you are not cashing in any of your original investments. In fact the 4% rule applies to any income earned within the portfolio as well.

    I didn’t word my original comment very well.

  9. I agree with Kevin M (#4) that many people (it’s probably closer to 95%) do not realize that THEY can join the class of wealthy and live off their capital. As Philip mentioned, the best way to do that is not to consume the capital but to use it to generate income, at least it makes for a better night’s sleep. Now for ordinary people with an ordinary income, this is only possible by not living a consumerist lifestyle. I think the numbers here are somewhat similar. Most people do not know how to do that although I’d say readers of TSD are well underway/better prepared than so many others.

    If you do want to get there, you have to save substantially more than the 15% that is generally recommended. 30% will not cut it either. These numbers have been computed to maximize your lifetime consumption; not your financial independence. It’s a trade off.

    If you save 50%, we’re getting there and you could become wealthy in around a decade, certainly less than two. This means that if you start early, you could live off your capital starting from your late 30s or early 40s. If you save 75% you can make it in half a decade. That may sound unbelievable, but if you run the numbers, it bears out: 5-6 years is enough.

    Naturally, to reach these numbers some “stuff” must be sacrificed and only a few people are willing to give up their stuff. Yet for those who are, it can be done.

  10. Ken says:

    Interesting post. Maybe one day I’ll be able to do this? Still working on ‘building the caoital’ at this point in my life. I do see the logic of it.

  11. Great post.

    For those off us not yet there, I think it is important to understnad the concept of getting our “extra” income to do something for us financially. Big or small, get it to do something.

  12. getagrip says:

    I’m all for understanding and being smart about living on your capital, yet one point that I have to wonder about is this need (promulgated by everyone in the financial industry to my knowledge) to preserve capital forever, with the typical excuse that it’s for the heirs. Why? If I die early in my sixties, there’s every chance if I’ve taken even some care in planning they’ll get a very nice chunk of change. If I die in my 90’s, and I’ve lived reasonably, I should have helped them with weddings, homes purchases, college savings for their kids (my grandkids), etc.

    In other words, if I die early, they get their goods, and if I live long they get their inheritance over time with a warm hand rather than a cold one.

    Regardless, I’d like to see some articles on reasonable life planning, not living forever planning. I think the differences could be eye opening for some who are often borderline when considering the gargantuan amounts of capital it takes to maintain income indefinitely.

  13. conny says:

    life insurance is not a good way of transfer money.
    First thing its a Death insurance. It pays out when someone dies. The capital comes from insurance payments made by the insured. the insurance company will never ever return any of their gains to you.

  14. By the way – great post Phillip. I too enjoy reading your work.

  15. Kevin says:

    Great article, but I wanted to add one comment. The 4% Safe Withdrawal Rate (SWR) is based on Monte Carlo simulations that examined several decades of market performance, and it is designed to deplete the capital in approximately 30 years. It is NOT intended to allow the capital to last forever. In order to achieve that, you’d have to use a much smaller withdrawal rate.

  16. Alexandra says:

    This article is not just for the wealthy folk out there, but for anyone who wants to retire – I think that is applies to most of us. We’ll all have to start planning our expenses and giving ourselves allowances so that our retirement money will last over the rest of our lifetime.

    As for the “need to preserve capital forever”, while it might be nice to predict the exact date and die with a zero balance, that ain’t going to happen.

    In my grandfather’s time, he was told to save enough to last him till he was 72. He is now 93 years old and still with us. Thank goodness, he saved more than the average guy and only semi-retired at 65, working part-time until he was 89. He lived a great retired life as well – winters spent in Florida golfing. In the last few years he has started to feel a little pinched financially, but still has enough to support him and my grandmother (87) in the style they are accustomed to. There may not be very much left over for their kids, but they are happy to have made that trade.

    Anyway, my point is that you have to save more just in case you live longer than expected.

    Great article, by the way. A nice change from the usual “use one less toilet-paper square and save $50 over 10 years” stuff.

  17. There are a lot of versions of the 4% rule.

    They have their roots in an older 5% rule that is used by charitable foundations. There the rule of thumb is that you can spend 5% of your capital every year and still grow your endowment. The catch is that you have to be willing to cut your spending in years when your endowment is down.

    If your household spending is very flexible–if you could react to a 40% drop in the markets with a 40% drop in household spending, you could probably spend 5% of your capital every year and still grow your capital (on average). But most people’s household cost structure isn’t so flexible as that. Hence the 4% rule.

    Most versions of the 4% rule allow you to grow your spending with inflation even when your portfolio is down. That’s what (on average) leads you to depleting your capital in a few decades. The real solution (no matter what rule you follow) is to do what I suggest in the main post–pay attention to your capital levels and reinvest enough income that you’re preserving the value of your capital.

    (By the way, I had another response up above, but it’s being held for moderation, probably because it had links in it. I suppose it’ll show up eventually.)

  18. Debbie M says:

    @getagrip, I plan to “preserve capital forever” even though I don’t have kids because the difference between preserving it forever and preserving it until I am, say, 100, are miniscule since I am planning to retire at age 52. As Alexandra pointed out, the good thing about preserving your capital forever is that you know it will be lasting long enough.

    Now, if you only need your money to last 20 years or less, such as you’ve waited until age 80 to retire, or you’re 65 and everyone in your family has died by age 80 of the same diseases and you have all the same risk factors, or you’ve been diagnosed with something incurable, then it would be silly to try to preserve your capital forever.

    For me, the hardest thing about retirement planning is remembering that I’ll probably be quite old during part of it. I probably won’t be able to have the same lifestyle if I get really bad arthritis, start forgetting important things on a regular basis, etc. What will I be doing instead? Will that cost more or less than what I’m doing now? Will it probably be okay to start spending capital by the time I’m having expensive health problems?

  19. In regards to preserving capital, I am a big proponent of owning life insurance to leave something behind and then spending down your money. When planning I recommend using very conservative rates of return and a long tie horizon such as age 100 or even 110. You want to be on the safe side so that if you make it that far you are probably still going to have extra money.

  20. Robin says:

    Though my family, through inheritance and lifelong frugality, is close (and probably could right now) to just being able to live off of our capital, the health insurance question is keeping me at my job currently, since when I factor in getting a good health insurance plan OUTSIDE of work, it scares me to death. It might be a mental thing on my part, but I’ve always had health insurance through a large employer for incredibly cheap rates and feel very protected by that. So currently though my spouse does not work, I am keeping my teaching job for the benefits, and we are living off of my salary only, while still contributing to my 401K, Roth IRA, and to our dividend stocks. Our house is paid off (cars too), we have college funds in place and we have several rental properties. But being 45 and having a child in kindergarten, the health insurance issue is huge to me, and I plan to just keep my job for now and let our money grow. We are not very materialistic, and for now I feel that the financial security we have is our reward and I will just keep working for a while. We did let our life insurance drop a few years ago since we feel we are now self-insured, but have a will/trust in place.

  21. Daniel says:

    This is an exceptional post, and ERE (comment #9) is right on that very few people comprehend the principles and even fewer are willing sacrifice their “stuff” to get there. Fortunately, Trent is building a culture here that helps foster these ideas.

    And I’ll second the thoughts on dividend paying stocks. That’s a class of investments that I can’t emphasize enough. It’s pretty easy to assemble a diversified portfolio of stocks with a yield of 3.5-4.5% if you choose carefully.

    Dan @ Casual Kitchen

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