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

14 comments:

  1. I did the math recently and found I can cover 92% of my budget with dividends and other distributions. Covering the rest with dividend strategies is a low hurdle.

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    1. That sounds like a pretty decent amount of dividend income coverage. Now all you have to make sure is that those dividends and distributions are sustainable, and stand the chance of growing over time in order to compensate for inflation

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  2. DGI,
    Great article. Are you going to put out an article for November stocks you are considering purchasing? Thanks.

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    Replies
    1. It is possible that the next month will be light on purchases. I am selling a few puts, which would consume money if exercised. For example, I recently sold a put on HSY.

      DGI

      Delete
  3. Although you do address inflation, you sort of gloss over it without crunching the numbers. I think you would do your readers a lot of good to present dividend growth in real terms. Your spreadsheet goes out to 194 monthly periods, or slightly more than 16 years. At a 2% annual inflation rate, a $3,000 monthly income will only have the purchasing power of $2,178. A higher inflation rate lowers the purchasing power even more. You are comparing future dollars to today's expenses. I think the 6% growth rate you use is a good consensus number, but it is a nominal number. I would suggest adding a monthly income column in inflation adjusted dollars.

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    1. While I didn’t explicitly talk about inflation adjusted dollars, I also kept the amount of money invested fairly constant. Plus, this article illustrates a concept – we can nitpick all we want, and talk about inflation, taxes etc – but the concept is still there, neatly illustrated.

      In reality, I would have put $2,000/month in year one, and then $2040 in year two etc assuming a 2% inflation. Instead, I kept putting the same dollar amount for over a decade. Over a period of 5 years or so, inflation is not as visible. When you expand to 10 years and beyond however, it is very visible. Of course, personal inflation can vary and can be managed – e.g. I used to spend $5 per trade and now I spend 35 cents.

      The issue is that whenever I have presented this table before, I have always managed to confuse a lot of people ( many have ignored the fact that the shares column shows shares, not dollars). So by adding an extra column, it is quite likely that I will compound the level of confusion. What could be improved in a new table is to essentially show only inflation adjusted dollars. That would mean that the scenario will have a yield of 4% and real dividend growth of 3% ( 6% nominal minus 3% inflation)

      You may like the following link: https://docs.google.com/spreadsheets/d/1f6M_A0qzVv-OOQ2n29CiYfkpq03egmuh-QHt1phruh4/pubhtml

      The first $500 in monthly dividend income takes 62 months

      The first $1,000 in monthly dividend income takes 109 months

      The first $1,500 in monthly dividend income takes 145 months

      The first $2,000 in monthly dividend income takes 175 months

      Delete
  4. DGI - I'm curious do you plan to do something like a CD or bond ladder as additional margin of safety ?

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    1. Another anonymous here. My name is Beth but I couldn't find out how to post with a link to my email.

      I would also be interested to know if you were going to have some funds in something other than stocks.

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    2. My readers are very perceptive. I actually have an article on this topic tomorrow.

      I have discussed fixed income before however:

      http://www.dividendgrowthinvestor.com/2013/04/does-fixed-income-allocation-make-sense.html

      Best Regards,

      DGI

      Delete
  5. Ok thanks for replying. I look forward to all your articles, but especially the monthly "Stocks I am considering purchasing in ...."

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    1. The issue is that I may have an idea of what I want to buy at the beginning of the month, but then I see something even better. For example, at the end of October I would not have even considered HSY, but now I am ;-)

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  6. Good read DGI. Aways enjoy receiving that email notification that you've posted up another article. recently got back on the capital adding ball again. 500 a week going in at a minimum . Just used one months worth of new capital to buy 35 shares of HCP and 30 of T today. 2000$ invested for an annual dividend increase of about 135 bucks. Full position now in T as its DGR is lack luster. Looking forward to your future insights. Jim

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    Replies
    1. T is one of the companies where dividend growth will likely be slow to non-existent for years to come. I am not sure how sustainable their dividend is either. I do own some from time to time, as I sell puts to buy it cheap, and then sell calls to sell it higher ( all while collecting the dividend). This is the only company I have done that.

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  7. I've been reading your articles for the past 6ish months and have been quite pleased with your approach and ability to teach this style of investing. It may seem difficult or like another language to some, but these articles have been clear and concise for the most part.

    I've always been curious as to how much money you will hurl at a new position for your portfolio. 1K, 2K, 5k? This question is mostly for a beginner to this strategy, because it is difficult to figure out how much money to put into a new position when starting out because your money is pretty finite. Your buying power later down the road is much stronger over time, but starting off can be a little rough when selecting your first positions.

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