Tuesday, July 10, 2012

How to generate income from your nest egg

You have worked all your life and accumulated a nest egg. Now that it is time to live off that pile of money, there is no concrete advice on how to accomplish this task. Some of the most common methods that retirees are typically sold by Wall Street include annuities, mutual funds and bonds.

There are many issues with these investments. The main issue with annuities is that they are not liquid, and could be sold back only after steep fees are paid, enriching the broker and/or the insurance company that sold them to the investor. Another issue with annuities is that once the participant and his/her spouse are deceased, the income stream would not continue for future generations.

The main issue with mutual funds is that total returns are widely unpredictable. Distributing a certain amount of funds every year using the four percent rule could result in rapid depletion of funds if retirement started at a major market peak such as the ones in 2000-2001 or 2007 -2008. In addition, the fees associated with these mutual funds in addition to any front loads make them big earners for the companies selling them.

The major positive of fixed income securities such as US Treasuries is that the income is guaranteed by the US Government. Investors would have a certainty as to the amount and timing of income they would receive. The major issue with treasury bonds is that the payments will never increase, which leads to a lower purchasing power of the interest income over time.

For my own retirement, I am using the dividend retirement strategy, which has the following positives:

1) My capital produces income
2) My capital is in totally liquid investments that can be sold at a moment’s notice
3) I do not pay management fees or other expenses associated with my account
4) My capital generates income that will grow over time
5) My capital generates an income stream which is taxed favorably

The way to pensionize your nest egg is by building a diversified portfolio consisting of at least 30 dividend growth stocks. The portfolio should have stock representation of as many sectors as possible, without sacrificing quality however. The portfolio should focus on dividend growth stocks, since most of these are companies with strong businesses that generate rising amounts of profits. This has created a culture of sharing the wealth with shareholders by paying out higher distributions over time.

In order to stack the odds in your favor, the following guidelines for successful portfolio management should be implemented:

1) Investors should screen from a list such as the dividend achievers, using a set of predetermined criteria

2) Investors should then analyze the remaining securities one by one, trying to determine whether they have any wide moats, or strong competitive advantages

3) Investors should try to avoid overpaying for their income stocks, since doing so would lead to lower dividend incomes for a long period of time.

4) Investors should also focus on companies with sustainable dividends, which will minimize the risk of dividend cuts over time

5) Investors should try to own at least 30 individual securities, representative of as many sectors as possible. Buying a lower quality stock simply for diversification purposes is to be avoided.

The types of stocks that will be added to a portfolio could be any of these core dividend growth stocks or might even be any of these companies I hold in my dividend portfolio.

Some examples include:

McDonald’s Corporation (MCD), together with its subsidiaries, franchises and operates McDonald’s restaurants primarily in the United States, Europe, the Asia Pacific, the Middle East, and Africa. The company has increased dividends for years in a row and has a ten year dividend growth rate of 27.40%/year. Yield: 3.20% (analysis)

PepsiCo, Inc. (PEP) engages in the manufacture and sale of snacks, carbonated and non-carbonated beverages, dairy products, and other foods worldwide.The company has increased dividends for years in a row and has a ten year dividend growth rate of 13.30%/year. Yield: 3.10% (analysis)

Philip Morris International Inc. (PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. The company has increased dividends for since the spin off from Altria in 2008. Yield: 3.60% (analysis)

Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. The company has increased dividends for years in a row and has a ten year dividend growth rate of 12.90%/year. Yield: 2.50% (analysis)

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. It operates in two segments, Upstream and Downstream. The company has increased dividends for years in a row and has a ten year dividend growth rate of 8.80%/year. Yield: 3.60% (analysis)

Full Disclosure: Long all stocks mentioned in this article

Relevant Articles:

- Margin of Safety in Dividends
- Seven wide-moat dividends stocks to consider
- Why Sustainable Dividends Matter
- Roth IRA’s for Dividend Investors

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