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

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