Wednesday, March 31, 2010

Four Percent Rule for Dividend Investing in Retirement

The four percent rule is commonly used by financial planners in order to estimate the optimum amount of money to withdraw from client portfolios each year. The goal is to ensure longevity of client portfolios in retirement. Retirees are typically expected to sell a portion of their portfolios each year and adjust their withdrawals for inflation.

The possible reason for selecting 4% as a “safe” withdrawal strategy could be the fact that dividend yields have typically been around 4% on average for the decades covering the study.
In contrast, dividend investors tend to create portfolios which are concentrated around generating a sustainable income stream each year. By owning a diverse mix of income producing assets, dividend investors would ensure that a hiccup in one sector of the economy would not have lasting effects on their lifestyles in retirement.

Another positive of dividend portfolios is that investors tend to live off solely from the income that the basket of stocks produces each year. In contrast, the four percent rule contains an inherent risk because of the possibility of selling off portions of ones portfolio during a flat or down market, which could deplete the portfolios much faster, leaving retirees to rely solely on social security. By concentrating only on spending a portion of the income that the portfolio produces, investors are leaving their invested capital intact and letting it grow overtime. This is similar to having your cake and eating it too as well.

The research behind the four percent rule is still sound however, especially since index funds tended to yield approximately four percent on average over the study period. Thus I believe that a portfolio which yields between three and four percent would provide investors with adequate income for a lifetime. Even if ones income portfolio generates a starter yield which is higher than four percent, it would still be wise not to spend more than 4%. This would leave some room for maneuvering in case the income generating assets in the higher yielding portfolio cut distributions.

If I were starting an income portfolio today, I would break it down to four equally weighted basic components.

The first component would be fixed income securities such as 30 year Treasury Bonds. Having some stability in the principal and income would provide at least some cushion in certain catastrophic events such as reliving the Great Depression of 1929-1932 in US or the lost two decades in Japan between 1989 to 2009. In both scenarios stocks lost 80% of their values.

The second component would consist of higher yielding stocks with low dividend growth. Likely inclusions in this list include Master Limited Partnerships such as Kinder Morgan Partners (KMP), Enbridge Energy Partners (EEP) or Energy Transfer Partners (ETP). These companies have stable revenues from transporting natural gas and petroleum products through their pipelines. Another sector could include Real Estate Investment trusts such as Realty Income (O) or National Retail Properties (NNN). These companies also tend to generate stable cash flows from their long-term property leases. A third high yielding sector for current income could be utilities such as Con Edison (ED) or Dominion Resources (D). Utilities are natural monopolies in their specific geographic area, supplying electricity, water or natural gas to consumers.

The third component of the portfolio would include mature companies which offer yields similar to average market yields, but which have enjoyed solid dividend growth. Examples of such companies include consumer products giant Johnson & Johnson (JNJ), fast food giant McDonald’s (MCD) or Kimberly-Clark (KMB).

The last component will include companies with low current yields, which have the ability to generate double digit earnings increases. This could generate solid dividend growth in the future. Companies that fit this criteria include Walgreens (WAG), Becton Dickinson (BDX) and Medtronic (MDT).

The last two portions of the portfolio might only end up yielding between 3% and 4%, although they would provide the growth factor that would insulate the dividend income from inflation.

Full Disclosure: Long JNJ, MCD, KMB, ED, NNN, O, EEQ, KMR

This article was included in the Carnival of Personal Finance: Unanswered Questions Edition

Relevant Articles:

- The case for dividend investing in retirement
- Inflation Proof your income in retirement with Dividend stocks
- Is $1,000,000 enough to retire on?
- The Four Percent Rule in Retirement

11 comments:

  1. Would you ever check out a fixed or variable annuity, and before you say - no because of costs...think about the stability of shifting risk to an insurance company or two that have been around longer than some states lol

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  2. No annuities are a bad choice for investors. A much better alternative is to purchase US Treasury Bonds, which are highly liquid and provide a stable incoem stream. If you add in some TIPS you would also get some inflation protection.

    Of course at least 50% to 75% of one's portfolio has to be in dividend growth stocks, which are the best inflation hedge for your income in retirement.

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  3. Can someone tell me how to move my stocks from Sharebuilder to the acutal companies? I dont want to sell my stocks at Sharebuilder (ie: JNJ) and then turn around and buy them again straight from the companies. Help1

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  4. I think that you can keep the dividend and sell off stock amounting to 1/2 of your portfolio's retained earnings. This should keep your income growing.

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  5. An income investor might consider I Bonds from the US (check out treasurydirect.gov). If you can lock in a decent fixed rate, then adding in the inflation index, you can get a pretty high coupon. I suspect it could be a better deal for individuals than TIPs -- you can only buy $5000 per year, whereas the yields on TIPs will be driven down by institutional demand. People who bought these in the 90s and early 00s were getting hefty coupons (except for last year, when the inflation rate went negative).

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  6. The 4% rule comes from the research of Bill Bengen. He examined various withdrawal rates over many years and found that taking 4% in the first year of retirement and adjusting the withdrawal each year for inflation gives a high probability you won't outlive your money.

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  7. I think you would be foolish to buy treasuries of any maturity today. The price can only drop as inflation takes off. If you buy treasuries, you essentially lock in 25% of your portfolio with no upside. Your principle might be "safge', but what will it be worth when treasuries mature in 30 years?

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  8. With an annuity, you give up your principle, and they dribble your money back to you. You are betting the insurance company that you will outlive their estimated life tables.

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  9. i am 67yo and still investing in dividendgrowth stocks my current portfolio cureently yields 6% hoprfully lasts till i am 80

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  10. What management company(ies) is constructing managed DRIP portfolios around these concepts, as a long term guaranteed growth strategy, rather than as an income production strategy, and selling the product to long-life portfolios like trusts and Roths? One could construct one using the online brokerage DRIP engines, but who's testing and picking the best equities and weightings for such a portfolio growth style?

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  11. Hi. I hope I am not too late (3 years) to chip in on this comment stream.
    I am already in retirement but because I have not saved enough I need to draw about 6% of my portfolio. Can a dividend growth focus strategy help me ? If so how?

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