Wednesday, April 21, 2010

Living off dividends in retirement

My article on the four percent rule for dividend investors created a lot of discussion. One financial adviser strongly doubted the sustainability of the portfolio, by criticizing its individual parts, without understanding the basic premise behind the idea of living off dividend income.

First, Dividend stocks are a proxy for equities, and not a different asset class. For many decades before the big bull run of the 1980s started, investors held common stocks exclusively for the right to receive dividend distributions from corporate profits.

Second, Dividend investors live off dividend income. The goal of every investor is to have their portfolio throw off enough income which would be more than enough to cover their expenses. Dividend investors do not plan on selling off principal to live off assets, which is similar to cutting off the branch of the tree you are sitting on.

Spending only income and keeping capital gains reinvested into the portfolio and not spendable is something that many organizations have done for decades. Most endowment funds, trusts and foundations follow the principle of spending only income from dividends and interest or rent and treating capital gains and losses as additions or subtractions to principal. Some examples include the Hershey Trust or the Nobel Foundation. These entities have managed to remain “retired” for far longer than most fee hungry financial advisers have stayed in business. While a typical retirement is expected to last for approximately three decades, investors could definitely learn something from these endowments. They should try to find an optimum balance for sustainable income generation that would provide maximum longevity for portfolios just in case.

The goal of every portfolio is to ensure maximum sustainability for the longest term possible as investors would never know how long they would need to live off their income. As a result focusing on the four pillars that I mentioned previously should be a good starting point. Focusing a portion of the portfolio on higher yielding names is helpful to boost the current yield a little bit, and provide current income for the first few years. Some examples of types of companies which historically have provided higher current yields include Master Limited Partnerships such as Kinder Morgan (KMP) and Real Estate Investment Trusts such as Realty Income (O), Health Care Property Investors, Inc. (HCP) or National Retail Properties (NNN).

Utilities such as Con Edison (ED) and Dominion Resources (D) are also known for their decent yields. There are of course other individual names such as British Petroleum PLC (BP) or Philip Morris International (PM) which also offer good current yields. Investors should of course try not to overpay when purchasing stocks, and should try evaluating sustainability of the distribution payments.

The focus on the last two components was to provide rising dividends, which would match or exceed the rate of inflation. The growing dividend stream would generate yields on cost that are higher than the current yields on many high yielding stocks of today, This is the component that would increase portfolio longevity. Few investors appreciate and understand stocks like Johnson & Johnson (JNJ) or McDonalds (MCD) which yield about 3%. What investors fail to understand is that the rising dividends of stocks with solid competitive advantages which could raise earnings for many years, could afford growing their distributions over time. This would generate mind blowing yields on cost, which are sure to exceed returns on even the highest yielding Canadian royalty trust. Johnson & Johnson (JNJ) or McDonalds (MCD) yield only 3% for new investors. One decade from now they would still be yielding 3% each. For today’s investors however, such stocks would have most likely generated a yield on cost of 8% to 10%.

Last but not least investors should not forget the power of the 3 D’s – diversification, dollar cost averaging into your investments and selective dividend reinvestment. That means one should accumulate positions over time, without overpaying for stocks. In order to reduce company specific risk and avoid having a few dividend cuts derail your total dividend income, one has to diversify and hold at least 30 individual issues representative of different sectors in the economy. In addition to that if dividend reinvestment is feasible, one should do it selectively by allocating extra dividends to stocks which are attractively valued.


Full Disclosure: Long MCD,JNJ,ED,D,BP,PM,NNN

Relevant Articles:

- Four Percent Rule for Dividend Investing in Retirement
- Inflation Proof your income in retirement with Dividend Stocks
- Three Dividend Strategies to pick from
- High-Yield Canadian Royalty Trusts vs Dividend Growth Stocks

8 comments:

  1. Great counter-points to the Seeking Alpha criticism. The author of that post seems to have totally missed the "growth" concept. He apparently thought you were suggesting that a new retiree could buy dividend stocks the day after he received his last paycheck, and then live off the current yields. You'd think an "expert" would be more appreciative of a plan that requires actual forethought and well, planning.

    In a related question... what do you think may happen if/when interest rates rise, possibly not too long from now? As you have noted, current yields have eroded since '09. My belief is that investors have bought up quality div payers in part because there aren't many better options (that aren't much more speculative). However, if rates go up, then bonds, even bank CDs, look better. I wonder if that would improve the current yield situation a bit?

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  2. Hey
    I can't remember the name of the book, but there's a local author who retired at 35 and currently lives off dividends.
    He must have followed strict tips on budgeting to be able to invest so much so quickly, but he also talks about finding those stocks that pay the highest dividends.
    Anyway, thanks for sharing,
    Guy

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  3. Retirement can be the happiest or saddest day of your life. It is important that you re-evaluate your preparedness on an ongoing basis. Changes in economic climate, inflation, achievable returns, and in your personal situation will impact your plan. We so hyped into believing that all we need to do is make the maximum retirement contributions every year, stay fully invested, wait for time to work it’s magic and we’ll all live happily ever after.The retirement has something like just lazing on the sofa reading a novel without any worries, then that's not very different from how most of us wish to spend our retirement, is it not? . The difference is in the planning & application to achieve that standard of retirement.

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  4. This is a very helpful article.

    It is only two years since I was introduced to the world of dividend payers and I am only sorry I didn't do the necessary research when I was younger.

    I just assumed that the mutual funds in my 401K were the way to go, and far more stable than individual stocks. I found out in 2008 that I was much too complacent. My funds did not do as well as the reliable dividend aristocrats like P&G, J&J and KO among others.

    At that point I finally took control of my own finances.

    I have been warned off these stocks by those who point out that their best days of growth are past. But the stability offered by the reinvested dividends is enough for me as a supplement to income. I only have about 15 years before retrement; hopefully younger people will 'wise up' before they reach my age.

    It seems to me this is the best kept secret among those planning for retirement; they are overwhelmingly focused on bonds and mutual funds. They certainly are good options for many people, but the dividend payers tend to be downplayed or ignored. I can't understand why, unless - like me - they don't do enough homework.

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  5. The "Canada's youngest retiree" at 35 was Derek Foster. His book was on the mark, but there are many nay sayers out there since he switched his strategy to a more options focused approach.

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  6. I would also be interested to know what will happen if interest rates rise? It seems that can be as soon as the end of this year.

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  7. Well, it's very important acctually to make plans for your retirement. A lot of people even concentrate on savings to avoid financial difficulties. Some of them even invest for retirement to feel confident in their future. Although, it's rather difficult to foresee evn the nearest future due to current unstable and difficult financial times.

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  8. I'll have to agree with some of these comments and disagree with others.

    Many years ago, I was struggling trying to build my retirement account. After dealing with mutual funds and common stocks for several years, I desided they really represented a crap game, a loosing situation in the long run for the most part. My building equity was a job and a half and I didn't have a lot of time to spend doing it. I got tired of loosing money with them and after some additional study developed a new strategy. I began investing outside of my 401k and that has served me well ever since. Divided stocks were my answer. I began investing in dividend stocks that pay good dividends, the stocks of widows and orphans as the saying goes. I had all the dividends earned reinvested in more stock. At times I even bought preferred stocks if they paid a high enough dividend and then had those dividends reinvested in the companies common stock that also paid dividends. I never concerned myself about having to pay taxes on them nor did I concern myself about which way interest rates were going except to buy the most prfitable ones I could at the time.. By the time I retired, I had built a substantial portfolio. Perhaps the portfolio isn't as big as it might have been if I had been willing to take bigger risks, but then I could have ended up with less and no good income stream.. I called them my money machine because when it came time to retire all I had to do was turn on the dividend spigot. For the last 11-years in retirement, it has served me well with a comfortable living. My income, along with my other income sources, provides me with more than what I need to live on. The excess gets reinvested in more dividend paying stocks for the future. I've recently discovered that Warrwen Buffet and I have something in common. If you do a little checking, you will find that he receives several million dollars a year in dividends and they are his main source of income.

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