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

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