One of the biggest risks that investors in retirement face is inflation. There is a general trend of rising prices over time, which decreases the purchasing power of cash today, as prices on many items slowly increase. A dollar today is going to have a higher purchasing power than a dollar received in 2025.
Dividend growth stocks are the ideal venue for investors in retirement. This is because the dividend income usually rises faster than the rate of inflation, in diversified portfolios of dividend paying securities. For example, historically prices have risen by an average of 3.90% per year between 1960 and 2014. However, annual dividends on the S&P 500 index have increased by 5.60%/year between 1960 and 2014. I have taken the S&P 500 as a proxy for overall dividend growth that could be expected from a diversified portfolio of US stocks.
Based on this exercise, it seems that over time, the growth in dividend payments has exceeded inflation by over 1.70% per year. While this does not seem like a lot, if this tiny amount is compounded over long periods of time, it could turn to a pretty sizeable pile of extra inflation proof cash. A dollar that compounds by 5.60%/year would grow over 19 times in 54 years. In comparison, a dollar that grows by 3.90%/year only grows almost eight times over the same time period.
The other risk that investors face is longevity risk. However, once you have assembled a diversified portfolio of dividend growth stocks, which delivers sufficient retirement income that grows above the rate of inflation, you have essentially killed two birds with one stone. As a rule, investors should plan for at least a 30 year retirement. This means that whether you retire at 40 , 50 or 60 years of age, you should follow a similar investment strategy that focuses on a sustainable and growing distribution income, that maintains purchasing power over time by the very least.
Therefore, if your portfolio generates the income you need on day one of retirement, and it can be reasonably expected that this income will grow over time, then you should be pretty set for retirement. The other defense mechanisms to ensure that dividend income grows over time is by focusing your attention only on the companies that can grow earnings over time, have sustainable distributions and are acquired at reasonable prices. If you also add in the additional layer of protection that diversification provides, by acquiring stakes in at least 30 – 40 individual securities from several sectors, you would have increased your odds of staying retired forever.
For example, at the end of 1994 Exxon (XOM) was selling for a split-adjusted $15.1875/share, and paid a quarterly dividend of 18.75 cents/share. This translated into an annualized dividend of 75 cents/share for an effective yield of 4.90%. Ten years later, Exxon had already merged with Mobil to create ExxonMobil and was paying an quarterly dividend of 27 cents/share. This corresponded to an annual dividend of $1.08/share, for an effective yield on cost of 7.10%. If we go forward by another decade to early 2015, we have ExxonMobil paying a quarterly dividend of 73 cents/share, or $2.92/share annualized. This translates into an yield on cost of 19.20%. To put it in dollar terms, if a retiree had put $10,000 in ExxonMobil stock in 1994, they would have received $490 in annual dividend income from the position. If they kept spending all the dividend income for over 20 years and never reinvested another dime into the position, they would be earning more than $1920 in annual dividend income by 2014. At the same time, the retiree would need less than $900 in 2015 to have the same purchasing power as the $490 they earned in 1995. This means that the growth in dividends outpaced inflation in a way that the retiree had the options to either succumb to lifestyle inflation or invest any extra income into other income producing assets. They could have picked companies like Coca-Cola (KO), Kellogg (K), General Mills (GIS) along the way, and further turbo-charged their dividend compounding process. Investing trough a tax-deferred account such as a Roth IRA would have also resulted in minimization of taxes over time.
Chances are that over the next 30 years the composition of your dividend portfolio will be different, as many companies merge, spin-off subsidiaries, get acquired. A few might end up cutting distributions, before failing outright. The beauty of the strategy is that on average, the winners will be able to grow your dividend income enough to compensate for those who eventually cut or freeze distributions. In my case, my organic dividend growth has always outpaced inflation since I started my journey.
Full Disclosure: Long XOM, KO, K, GIS
Relevant Articles:
- Investors Should Look for Organic Dividend Growth
- The Pareto Principle in dividend investing
- Dividend Stocks for Inflation Adjusted Income Streeams
- Dividend income is more stable than capital gains
- The Four Percent Rule is Dependent on Dividend Yields
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Nice post, DGI. Its something that I aim to achieve with my div growth stocks. I hope to beat the rate of inflation with the organic dividend growth - but I also couple that with some high yielders, which can provide income now, even though they may not raise their dividends at a high pace.
ReplyDeleteThanks for sharing another great post
R2R
R2R,
DeleteThanks for stopping by. I think most dividend growth investors out there are hoping to create a stream of dividend income to live off that will grow above rate of inflation. I wanted to "get back to basics" and discuss this simple concept again.
Good luck in your dividend investing journey!
DGI
This comment has been removed by the author.
DeleteHello DGI, I know this isn't the correct place to comment about a previous article you wrote, but it won't let me comment on that particular page so I'm going to ask it here. I just got done reading your "When to buy dividend stocks?" article, and you say to use the screener for companies raising dividends each year for the course of a decade. The screener lists dividend growth rates by 1,3,5, or 10 years. Is that percentage the average dividend growth per year over a course of 10 years, or does that mean that "was" the dividend growth over a 10 year window? I know this may sound like a stupid question, but I'm definitely a greenhorn when it comes to investing, hence why I'm here trying to learn.
ReplyDeleteThank you for your articles,
Andrew
"The other risk that investors face is longevity risk. However, once you have assembled a diversified portfolio of dividend growth stocks, which delivers sufficient retirement income that grows above the rate of inflation, you have essentially killed two birds with one stone"
ReplyDeleteDiversify!
This is the most important reason for investing in dividend growth stocks, in my opinion. The growth in income provides a hedge against inflation while also increasing income over time.
ReplyDelete