Wednesday, December 8, 2010

The case for dividend investing in retirement

There are over 60 million baby boomers in the US, most of which will retire over the next two decades. Most of them will generate income in retirement through social security, while some of the lucky ones will also enjoy a pension provided by their employers. Some boomers might also have some amount of money that they want to learn how to invest, in order to generate income in retirement.

Financial Advisers typically offer the four percent rule as a solution for managing ones money in retirement. This method assumes that investors will rely on total returns in order to monetize their portfolio for living expenses. According to the four percent rule, investors would spend four percent of their portfolio in year one of retirement, followed by an increase in distributions by factoring in inflation. For example, an investor with a $1 million portfolio invested in index funds and US treasury bonds would sell $40,000 worth of assets in year one. If we assume an annual inflation rate of 3% per year, in year 2 our investor would have to sell $41,200 worth of assets from his or her portfolio. The danger of this method is that it requires total returns each year in order to grow your portfolio, and avoid eating/spending your principal. Otherwise investors could end up depleting their asset base and might not be able to enjoy retirement for long.

One of the best kept secrets in retirement investing seems to be dividend stocks. Dividend investors receive positive feedback in the form of dividends every time they receive a dividend payment. In fact, as long as the company they purchased is stable and grows distributions out of rising earnings, dividend investors could care less about volatility in the stock market altogether. An investor relying on the four percent rule will feel the pain of selling his assets during bear markets and would fear that their account would be depleted sooner than expected. Many investors that have followed the traditional retirement path over the past decade have much lower networths and income today after the dot-com and the financial bubbles burst. Investors in dividend stocks on the other hand who only spent their dividend checks, could afford to ignore stock prices.

The benefit of dividend stocks, is that over time dividends increase at a rate that is two percent higher than the rate of inflation. This makes them a must own asset class not only for the retired investor who needs income for the next three or four decades, but also for the investor who expects to retire in 30 or 40 years. Fixed income like bonds for example, will pay a fixed interest payment every year, which will certainly lose its purchasing power over time. This could mean downgrading your lifestyle from eating caviar at the onset of your retirement to endulging on cat good at the end of it. In addition to that, if the world economy does well over the period you are invested, chances are that your untouched principal invested in quality dividend stocks would appreciate as well, matching or exceeding the rate of inflation.

Dividend investing was a widely followed strategy to obtain income until the bull market of 1980’s and 1990’s, when growth stocks were all the rage. In order to be successful at dividend investing and create a lasting stream of dividend income, retirees should follow a few simple principles.

First and foremost, investors should pick companies whose business they understand. In addition to that investors should purchase stock in equities that have solid competitive advantages and a sound business model which could afford to not only maintain but also grow earnings over time. This would allow companies to raise dividends over time, which would inflation proof your dividend income in retirement.

Second, investors should diversify their risk and avoid being concentrated in a certain sector, even if it produces high yields on the surface.

Third, investors should avoid paying top dollar for dividend stocks. If you cannot justify a high price, then either wait on the sidelines for the price to get lower or buy another stock that is cheaper.

Fourth, investors should pick stocks that have sustainable dividend payments. This means that the dividend is adequately covered from earnings, and that earnings per share are not more than twice the amount of dividends per share. The exceptions to the rule are certain pass-through entities such as master limited partnerships, real estate investment trusts and utilities.

At those exceptions investors should make a trend of distributions relative to cash flows or to earnings in order to determine the sustainability of the payout. Dividend sustainability is important, because if a company distributes a dividend which it cannot afford to pay, it would cut or eliminate the payment. This would be a blow to your portfolio dividend income, and might set you back in your goals.

The companies that meet the criteria above include:

Medtronic, Inc. (MDT), which manufactures and sells device-based medical therapies worldwide. The company is a member of the dividend champions index and has raised distributions for 33 years in a row. Yield: 2.60% (analysis)

Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The company is a member of the dividend aristocrats index and has raised distributions for 48 years in a row. Yield: 3.40% (analysis)

The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. The company operates in three global business units (GBUs): Beauty and Grooming, Health and Well-Being, and Household Care. The company is a member of the dividend aristocrats index and has raised distributions for 54 years in a row. Yield: 3.00% (analysis)

McDonald's Corporation (MCD), together with its subsidiaries, operates as a worldwide foodservice retailer. It franchises and operates McDonald's restaurants that offer various food items, soft drinks, coffee, and other beverages. The company is a member of the dividend aristocrats index and has raised distributions for 34 years in a row. Yield: 3.10% (analysis)

The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. It principally offers sparkling and still beverages. The company is a member of the dividend aristocrats index and has raised distributions for 48 years in a row. Yield: 2.80% (analysis)

These companies are just a starting block in building a lasting dividend portfolio. Investors should look for stocks with similar characteristics as they strive to create a diversified portfiolio of at least 30 stocks.

Full Disclosure: Long all stocks listed above

This article was included in the Carnival of Personal Finance

Relevant Articles:

- Four Percent Rule for Dividend Investing in Retirement
- Living off dividends in retirement
- Why dividend investing beats US Treasuries today?
- Dividend Stocks for the next decade and beyond

5 comments:

  1. On sustainability, you write "that earnings per share are not more than twice the amount of dividends per share." This seems backwards to me. Wouldn't that mean that dividend coverage would be more than 50%?

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  2. A very good case. Being exposed to the potential yield cut however would make many retirees nervous. I understand that the "plan" is to pick historic div. yield growth companies but one can never be certain the growth will maintain itself.

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  3. As one of those nearing retirement I know that assets must be diversified in methods as well as asset class. It is a good idea to have a portfolio of strong dividend growth stocks. But is it also important to have a portfolio of strong growth and value stocks as well as exposure to areas outside of the U.S.

    While we cannot bank on growth in the market, we also cannot bank on steady dividend payments from historical payers, ie., over the last few years we seen greats such as GE, PFE, and tons of bank stocks cut their dividends. Driving by looking through the rear view mirror can lead to problems.

    I strongly concur that a portfolio of dividend stocks is an ideal way to maintain a steady stream of cash flow. I also know that having a portfolio driven by a well defined array of securities covering all bases also works. I'm lucky that SS and my pensions will cover my fixed costs, and my investments will give me a "life".

    Best to all.

    ReplyDelete
  4. DGI seems like a great approach to wealth accumulation, but I'm not sure that I'd like to actively monitor a large portfolio once I get to retirement. Growing dividends offers the chance to beat inflation (vs. Treasury bonds), but the trade off is the risk of an individual company cutting its payment. As David above pointed out, that happened a lot in the past two years (and don't forget BP). To minimize this risk, one would need to mainain a large basket of stocks (and other investments) to diversify. In principle, this is fine, but I don't believe the majority of retirees out there have the desire or background to do this properly. Fixed income / annuities seem like a good choice for those who can't/won't handle individual stocks, or for those without a nest egg large enough to build up a sufficiently diverse portfolio.

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  5. Re: the difficulty maintaining a large basket of stocks - one could avoid that by buying into a low-expense ratio ETF that tracks a n appropriate index based around dividend-paying stocks.

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