Monday, November 9, 2015

Margin of Safety in Retirement Income: How to create a fool proof dividend machine for retirement

In a previous article titled, My Dividend Retirement Plan, I outlined the concept of the dividend crossover point. This happens when your dividend income exceeds expenses for the first time. The dream of every dividend investor is to achieve this point of financial independence. However, do not quit your day job yet. It might make more sense for income investors to postpone their retirement by a couple of years, simply to ensure an adequate margin of safety behind their dividend income.

In order to succeed, you need to layer your portfolio in a way that one black swan event is not going to derail your retirement plans. If you really want to fool-proof your plan, you should design your income strategy in a way that would allow you to retire, even if multiple torpedoes hit your portfolio. This is why I focus on building a diversified portfolio of dividend paying stocks, purchased at attractive valuations. I try to own at least 30 - 40 individual quality companies with competitive advantages, which are likely to increase earnings over time. In this article I am making assumptions that these qualitative factors are already accounted for.

In order to have a margin of safety in their dividend income, investors need to consistently generate an annual stream of distributions that exceeds their annual expenses by approximately 33% - 50%. This means that if your annual expenses are $30,000/year, your dividend income should be somewhere in the vicinity of $40,000 - $45,000 in order to have an adequate margin of safety. The factor is not set in stone, and could vary from as little as 1.20 times expenses all the way to two times expenses. This margin of safety is important, in order to protect investors against risks that they might have overlooked during the design stage of their dividend machine.

The early years of retirement are a crucial test to whether the income machine can produce dividends over the whole retirement or whether it would crumble along the way. If a retiree experiences several dividend cuts in their income portfolio early on and cannot adjust their spending any lower, their chances of returning to the workforce are greatly increased. For example, financial stocks, utilities and REITs had historically been favored by income hungry investors for their dependable yields and distribution growth. However, plenty of financial stocks and real estate investment trusts cut their distributions during the 2007 – 2009 financial crisis. A portfolio that had an above average exposure to these companies could have ended up generating inadequate income amounts.

The margin of safety could also protect the income stream in a portfolio in the low-probability scenario where dividend growth does not keep up with inflation over a short-term period of time. I define a short-term period of time as five years or less. Inflation is one of the biggest threats to retirement income, since it results in a decrease in purchasing power over time. For example, between 1968 and 1980, the dividends on S&P 500 increased from $3.07 to $6.16, for a cool 100%. At the same time however, CPI increased by 128%. Investors relying on exclusively on dividend income would have seen slight deterioration in their lifestyles. This was not too bad of course, when compared to the steep loss of purchasing power for investors in US treasuries over the same period.

So to summarize, this margin of safety in income is going to protect investors against inflation, dividend cuts and other unforeseen risks. Another factor behind the margin of safety is purely psychological. Investors who manage to put money in dividend paying stocks or other investments have managed to do so by saving a percentage of their income. It would be difficult to adjust all of a sudden to making exactly what one is spending. The notion that if one is retired they do not need to be saving is questionable because of this adjustment.

One potential negative behind this built-in margin of safety is the amount of extra time it might take. If our investor expects to achieve financial independence in three - four years, increasing the target monthly dividend income by 50% could postpone this by several years. However, it could reasonably be expected that the time to go from 100% to 150% coverage of expenses by dividends will be much shorter than the time to go from 50% to 100% coverage. Let’s illustrate it using a scenario where an investor would achieve the dividend crossover point at $1000/month.

Let us also assume that the investor plans to reach out their goal of $1000 in monthly dividend income, by investing $2000 every month in dividend growth stocks yielding 4% that boost distributions by 6% every year. This should take approximately 10 years to accomplish it through meticulous reinvestment of dividends and addition of new funds every month. The first $500 in monthly income take 60 months to generate, while the next $500 in monthly income take only 47 months. In order to get from $1,000 to $1,500 in monthly dividend income, our investor needs to spend 32 more months. The reason behind this acceleration, is the power of compounding through dividend growth and dividend reinvestment. It is much easier to achieve your income investing goals if you already have a stable base to rely on.

If the dividend crossover point is at $1000/month, the first $100 in monthly income will take a lot of time to accumulate. The last $100 in monthly income will come faster, due to power of compounding, high dividend income base, growing dividends, and dividend reinvestment.

In the above example, the investor might decide that spending an extra 32 months and getting their passive income from $1,000/month to $1,500 month might be worth the effort. After all, if having a peace of mind for a lifetime only costs 32 months, then this is a trade I am willing to take. For others who cannot really stand their current situation however and cannot make adjustments, this periods of 32 months might sound like eternity. This is why what might work for me, might not be most optimal for your situation. Knowing the concept, and thinking through various options could be helpful in designing your dividend income machine for retirement.

Thank you for reading.

Relevant Articles:

Financial Independence Is Easier to Model with Dividend Income
My Dividend Retirement Plan
From zero to $15,000 in dividend income in 8 years
My dividend crossover point
How to retire in 10 years with dividend stocks

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