My neighbor is not a dividend investor. My neighbor purchases index funds and hopes to rely on an asset depletion strategy commonly referred to as the four percent rule. You can read more about the original research about it here. Basically, my neighbor is relying on total returns from index funds, in order to fund their retirement. Historically, stocks have produced an annual return of 9% - 10% per year. If one owns $1 million worth of an S&P 500 index fund, their return would be approximately $90-$100 thousand per year. Thus, selling $40,000 worth of stock each year would lead to a portfolio value of 1,050 to 1,060 million by the end of first year.
This was a good strategy for generations of do it yourself index investors. Accumulate as much in index funds as possible, and then sell off 4% of your initial portfolio value each year, while also adjusting for inflation. The one problem that this strategy creates is that it leads to a rapid depletion of the asset base during extended bear market declines or during flat markets. Stocks do not go up or down in a straight fashion each and every year. Investors who retired in the early 2000s and 2007-2009 saw this first hand.
In fact investors who put $1 million in an S&P 500 mutual fund in 1999 and using the 4 percent rule for withdrawals now have only $360,000 left.
The calculations assume a 3% annual inflation rate and a quarterly distribution. In addition, investors would have sold more than half of the shares they originally owned by August 2011. Given the expected withdrawal of $55,369 in 2011, the portfolio would be depleted in 6.50 years if stocks do not appreciate by 2020.
I have always had an issue with index funds. They are a decent vehicle for accumulating wealth, as they provide ordinary savers with the ability to have exposure to the stock market without understanding much about it. However, the traditional methods of selling off portions of your portfolio each and every year, is similar to cutting off the tree branch you are sitting on.
That’s why the idea of creating a dividend portfolio makes perfect sense for investors who are retired and even those who plan to retire some day in the future. Using this strategy, investors only spend the dividend income generated by their investments. Dividend income is more stable in comparison to relying exclusively on price appreciation. If you compare the price returns of my benchmark the S&P 500 index to the dividend returns you would see why retirees prefer the stability of dividends in retirement.
Dividend investors should carefully select stocks with solid fundamentals which could afford to grow distributions for years to come. They should also have a set of written rules, which would help them in evaluating stocks. You could read more about my entry criteria in this article. Investors should also try to create a diversified portfolio in order to minimize sector risks on their dividend income. There are approximately 300 dividend growth stocks in the world. After further screening, the enterprising dividend growth investor would likely find a more manageable list of 40 -50 securities which could be accumulated at the right prices.
By relying exclusively on spending only the rising income stream, investors would avoid depleting their asset base by selling off shares every year. As a result, dividend investors would not have to sell in a depressed market in order to pay for their living expenses and risk depleting their assets. Instead, dividend investors generate stable dividend income which rises over time and ensures that they generate an inflation adjusted stream of income. Dividned growth investors could thus avoid paying attention to rising and falling prices, because their dividends arrive timely, like clockwork. In essence, it feels as if dividend investors are getting paid for holding these stocks. Contrast this to the traditional model of retirement investing, where a flat or declining market would lead to outliving your assets and having to return back to work at the most unfortunate times for you.
The types of stocks which could provide such a stable dividend stream of income include:
McDonald’s Corporation (MCD), together with its subsidiaries, operates as a worldwide foodservice retailer. The company has raised dividends for 34 years in a row and has a ten year annual dividend growth rate of 26.5%. Yield: 2.80% (analysis)
The Coca-Cola Company (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. The company has raised dividends for 49 years in a row and has a ten year annual dividend growth rate of 10%. Yield: 2.80% (analysis)
Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company has raised dividends for 49 years in a row and has a ten year annual dividend growth rate of 13%. Yield: 3.60% (analysis)
Aflac Incorporated (AFL), through its subsidiary, American Family Life Assurance Company of Columbus (Aflac), provides supplemental health and life insurance. The company has raised dividends for 28 years in a row and has a ten year annual dividend growth rate of 21.3%. Yield: 3.20% (analysis)
Colgate-Palmolive Company (CL), together with its subsidiaries, manufactures and markets consumer products worldwide. The company has raised dividends for 48 years in a row and has a ten year annual dividend growth rate of 12.40%. Yield: 2.80% (analysis)
Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. The company has raised dividends for 24 years in a row and has a ten year annual dividend growth rate of 8.10%. Yield: 3.30% (analysis)
Wal-Mart Stores, Inc. (WMT) operates retail stores in various formats worldwide. The company has raised dividends for 37 years in a row and has a ten year annual dividend growth rate of 17.80%. Yield: 2.90% (analysis)
Eaton Vance Corp.(EV), through its subsidiaries, engages in the creation, marketing, and management of investment funds in the United States. The company has raised dividends for 30 years in a row and has a ten year annual dividend growth rate of 12.60%. Yield: 3% (analysis)
Air Products and Chemicals, Inc. (APD) provides atmospheric gases, process and specialty gases, performance materials, equipment, and services worldwide. The company has raised dividends for 29 years in a row and has a ten year annual dividend growth rate of 10%. Yield: 2.90%(analysis)
Enterprise Products Partners L.P. (EPD) provides midstream energy services to producers and consumers of natural gas, NGLs, crude oil, refined products, and petrochemicals in North America. The company has raised dividends for 14 years in a row and has a ten year annual dividend growth rate of 8.30%. Yield: 5.60% (analysis)
Full Disclosure: Long all stocks mentioned in this article
Update October 2017:
Looks like the investor from 1999 would have $330,000 left today. Their annual withdrawals are now up to $66,114, which is equivalent to a 20% withdrawal rate at the current balance. This retiree is scheduled to run out of money in 5 years. It is very likely however that this person would have bailed out on their investments a long time ago, and would have returned to work.
Update October 2017:
Looks like the investor from 1999 would have $330,000 left today. Their annual withdrawals are now up to $66,114, which is equivalent to a 20% withdrawal rate at the current balance. This retiree is scheduled to run out of money in 5 years. It is very likely however that this person would have bailed out on their investments a long time ago, and would have returned to work.
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