In Part-1 of this series, I will examine the concept of dividend income as a viable means to support retirement income. In Part-2 I’ll examine the yield on cost illusion.
Dividend Income in Retirement
We all invest for the same end result – to sustain our retirement or lifestyle when we are older. All of us have different goals and reasons, but the end result is the same. How much can we safely withdraw from our portfolio without depleting our original investment capital? Does a primarily 100% dividend stock portfolio support a retirement income?
The Golden 4% Rule
Most of the experts agree that 4% is the amount that you can safely withdraw from your portfolio without depleting your original capital. So in a simplistic example if you have 100K in assets, you can safely withdraw up to 4K per year ($330 monthly) without depleting your original capital. Doesn’t sound like much does it?
Most investors will likely exceed that 4% rate with capital gains, dividends, and interest in any given year. From and Index Investor’s point of view, as Dan Bortolotti points out, “It doesn’t really matter whether that return comes from interest, dividends or capital gains.” Funding retirement comes down to establishing a withdrawal rate to the expected total return of the portfolio. That is no easy task. To be safe, most financial planners or advisors will stick to a 4% withdrawal rate.
A much better approach is to assume that your actual income or cash flow from your investments (such as dividends, interest and capital gains) is what you should withdraw – regardless of the rate. Andrew Hallam wrote an interesting post recently regarding this in What Are Your Investments Really Worth?
Dividend investors are able to predict monthly dividend income very easily, so they are ahead of the game in this respect. If you want to live off your dividends (rate of return) without redeeming any shares (capital), then you only need to consider income. This is one of the main advantages of a dividend investing focused strategy.
In the same post mentioned above, Andrew writes in his comments:
“My online friend, Passive Income Earner has the right idea. To him, his portfolio is worth as much as the dividends it throws off in cash. This is a more conservative estimation of the cash flow potential of his account, because his analysis involves an assessment of the dividends only, and not the portfolio’s cash flow potential, based on selling 4% of his assets each year, upon retirement. He continually updates his passive income (dividend income) which I think is fabulous. Remember: Your account is only really worth as much as its cash flow value.”
The real question for a 100% dividend portfolio, is not what your income will be, but rather is it enough to support your retirement?
From Dripping to Collecting
DRIPs (Dividend Reinvestment Plans) are based on the simple concept of compound growth. Dripping Shares is the simple process of reinvesting dividends into new shares to increase growth. It is the same process as reinvesting GIC interest into another GIC, reinvesting mutual fund or index fund distributions into new units etc. Most dividend investors rely on the growth from DRIPs to increase their portfolio value over time.
If you are relying on a 100% dividend portfolio to fund retirement, then at retirement you can no longer DRIP your shares, since you need the dividend income. That means you go from being a Dripper to a Collector, and you lose any potential future growth in your portfolio. All your growth now becomes your income!
Can Dividends Support Retirement?
Some investors are considering a 100% dividend stock portfolio to fund their retirement. However there are two key considerations that should be taken into account with this approach. First, what is the dividend yield (rate of return) of the entire portfolio? Second, what original amount of capital (shares) do you need, to obtain a specific income? It comes down to being able to make that 4% withdrawal rate.
Back in February I did an interview with Dan Bortolotti at the Canadian Couch potato. In the first question I asked Dan if a portfolio of 100% dividend paying stocks could indeed support retirement income:
4% Isn’t Easy!
While it may not be the title of next year’s country hit, as a dividend investor getting a consistent 4% return from dividend income isn’t easy! Most of the big blue chips in the US for example such as JNJ, MCD pay dividend yields around 3.4% or lower. In Canada solid Dividend Paying stocks will get you a higher yield at around 3.5% to 5%. That higher yield also translates into much less capital growth!
So as a dividend investor, you are likely going to need a larger portfolio with a lower yield to sustain your retirement income. Or you take additional risk and add higher-yield stocks to a smaller sized portfolio, to achieve the same result.
Think about it, if you have a portfolio comprised primarily of big blue-chip giants such as JNJ and MCD, your dividend yield is around 3% to 3.4%. These are big safe blue chips, but they also have less growth overall than other stocks in the market. It’s going to take a lot of JNJ and MCD to fund your retirement, excluding the real return after inflation! Dividends don’t come cheap; you pay a premium for safety. That premium is the higher share price and the lower dividend yield. That lower dividend yield means you need a lot more capital to fund your retirement income!
For example using the Golden 4% Rule, you will need a dividend stock portfolio of 1 million at a generous dividend yield of 4% to earn $40K per year in dividend income. Cut that dividend yield down to 3.5%, and to earn the same $40K requires an initial portfolio of $1.14 million. Cut the yield down to 3% and you need an initial portfolio of $1.33 million. Since you are withdrawing 100% of your dividend income, you only have the capital appreciation of the stocks to increase your portfolio value.
It is possible to support your retirement with a 100% dividend stock portfolio. However, to earn a reasonable retirement income, you would need a very large basket of dividend stocks earning a low rate of return. While living off your dividends sounds catchy, in reality you need a very large portfolio to do so!
In Part-2 coming next week, I’ll examine the yield on cost illusion.
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