Wednesday, May 25, 2011

How to live off dividends in retirement

The goal of every dividend investor is to generate enough in distributions every year that cover their basic expenses. After spending many years meticulously saving and investing in dividend growers, there comes a time when investors reach that elusive goal of living off dividends in retirement.

The question is, how should one invest their hard earned dollars in retirement? Should they invest in higher yielding stocks or move everything to fixed income and call it a day? In this article I would try to answer these questions, propose more solutions and provide a basic outline of what my strategy is for living off dividends in retirement.

First, I do not plan on changing my stock asset allocation in retirement. I do try to target an overall portfolio yield of 3% - 4% which would be sufficient to generate enough income to live off of. My dividend portfolio has three types of stocks which I discussed in this article. I am also interested not just in earning a dividend from the stocks I purchase, but I also in generating total returns that match the returns of S&P 500 over longer periods of time, with lower volatility cushioned by the regular dividend payments.

The first type includes higher yielding stocks which are not expected to generate much in distributions growth. If they do, that would be a plus of course. This is the component that would increase your current portfolio yield. Stocks I own which fit this characteristic include:

Kinder Morgan Partners (KMP) Yield: 6.40%|10 Year Annual Dividend Growth Rate: 10.90%
Realty Income (O) Yield: 5% | 10 Year Annual Dividend Growth Rate: 4.50%
Con Edison (ED) Yield: 4.50% | 10 Year Annual Dividend Growth Rate: 0.90%

The second type of stocks I own include companies in the sweet spot. These companies spot an average yield in comparison to the S&P 500, which I use to benchmark my dividend income against. They also spot on average higher dividend growth in the upper single digits. This is the component that would increase dividend income at or above the rates of inflation. Companies in the sweet spot include:

Procter & Gamble (PG) Yield: 3.10%| 10 Year Annual Dividend Growth Rate: 10.90%
Coca-Cola (KO) Yield: 2.80%| 10 Year Annual Dividend Growth Rate: 10%
Wal-Mart Stores (WMT) Yield: 2.60%| 10 Year Annual Dividend Growth Rate: 17.80%

The third type of dividend stocks I own include companies which do not yield much today, but based on the distribution raises of the preceding years have a high chance of increasing dividends at a growth rate in the double digits. Companies like that include:

Walgreen (WAG) Yield: 1.60% | 10 Year Annual Dividend Growth Rate: 16.50%
Yum! Brands (YUM) Yield: 1.80% | 5 Year Annual Dividend Growth Rate: 32.60%
Family Dollar (FDO) Yield: 1.30% | 10 Year Annual Dividend Growth Rate: 10.80%

Second, while I will maintain the structure of my dividend portfolio, I will look to add some fixed income exposure right before hitting the target retirement date. Based off studies of the 4% rule, which I have discussed before, it seems that even a modest 25% allocation to government bonds could provide some stability to portfolios during recessions, depressions and deflationary conditions. At the end of the day, placing a 25% allocation to fixed income would not detract from total return performance by much. It would also provide some stability that could be beneficial by decreasing the chance of outliving your money. Right now this is a miniscule portion of my portfolio, consisting mainly of long term CD’s purchased when interest rates were slightly higher. If I had a portfolio of $1,000,000 and four or five years until retirement I would start putting the dividends I received in US Treasury Bonds for half a decade until I reach a 25% allocation to fixed income in retirement.

While many investors proclaim that we will have a massive inflation because of the Fed printing press, I doubt the future will turn out exactly as everyone expects it to turn out. I discussed this issue in this article. Japan has a high amount of debt, yet it has seen to inflation over the past 20 years, and government bonds have been the best investment during that time period.

Last but not least, while I target an overall yield for my portfolio, I do not just look at yield alone. I tend to require a minimum number of consecutive dividend increases for stocks before I even place them on my watch list. After that I look at distribution coverage, business model, competitive advantages, potential for earnings and distribution growth and valuation. I also make sure that my portfolio is not concentrated in a few sectors as well. Check my entry criteria for more information on how I evaluate stocks.

Full disclosure: Long KMP, O, ED, PG, KO, WMT, WAG, YUM, FDO

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This post was included in the Carnival of Personal Finance #311


  1. Once you're retired, I'd suggest that you add some preferred stocks to your first category. If you insist on dividend growth, floaters would fit the bill and offer inflation protection as well. Otherwise, investment-grade preferreds, purchased below par, offer modest capital appreciation and yields comparable to MLPs and REITs with less volatility.

  2. I like your idea of the 3 different types of dividend stocks. This is an added layer of diversification.
    I would be careful of adding bonds just for the sake of asset allocation. A retiree should consider TIPS. The interest rate risk of bonds is higher today that anytime in the last 30 years. Valuation should always be considered when choosing an asset allocation target.

  3. With dividend growth stocks, I think that it should be OK to spend some portion of the company's that you own retained earnings. If the retained earnings do not increase the future dividends and value of the company the company is investing poorly.

  4. This partly comes back to good wealth management in your career. Wealth management can be an important service, particularly for those who don't work in finance. Werner Mathys, Rolf Koller and Urs Meisterhans are all experts who can show you first hand how to live off dividends in your retirement, and advise like this is great but not personalised.

    Mathys is at MT Mathys, Koller is at Seismo, and Urs Meisterhans is from Sinitus. All well worth checking out.

  5. I also like you allocation into 3 groups. I am not sure I follow your comment about Japan. They seem to have been printing money for the last 20 years and suffer from deflation. I think part of the reason is the high savings rate for that culture.

  6. @Herman,

    Its good you mention Urs Meisterhans! I'm into my 50s now and looking to retire within the next decade so it was more than high time to get my investments sorted so I can retire at the time I want to and in the way I always wanted to.

    Urs Meisterhans was very good, and I would recommend him and Sinitus.

    That being said, haven't heard of the other gents but if your net-worth is substantial its worth looking at CSF Management and SIMPLE Group, very professional.

  7. I like your 3 groups ... I use a strategy of 2 groups of dividend stocks, one that has a current high dividend payout and the other that has a track record of the highest year-over-year increases.

  8. I certainly disagree that dividend stocks are a separate asset class. To say that dividend stocks are a separate asset class is similar to saying that growth stocks are a separate asset class as well.


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