Dividends: An Old Idea for a New Reality
As more baby boomers ease into retirement, the notion of distribution, of spending from assets, has been the subject of the day—especially since they are being greeted with one of the toughest economic environments of their lifetimes.
The key question on everyone's mind is: Will my money last as long as I do? Retirees have become more painfully aware that their investment capital must provide life support for now and into old age.
Many financial professionals suggest a withdrawal rate of 4 to 5% per year, plus increases to adjust for inflation. Gains from stock are often presumed to be some regular percentage, such as the historic 10% per year. But history tells us that those gains don't necessarily arrive on a convenient schedule. This charts shows the annual returns for the S&P 500 during those 50 years. As you can see, there were years when returns were negative. What does that mean for a retiree? In those years, they must sell principal shares at depressed prices to meet their spending needs.
There is a qualitative difference between total return and return made up of dividend income, plus appreciation. The difference is that the dividend income is always positive and readily available to meet a retiree's income needs, whether the market is up or down.
Let's look at a hypothetical illustration comparing a total return approach to a dividend income approach for generating 5% annual income.
One million dollars was invested on January 1, 2000, and 5% was withdrawn from both portfolios at the end of each year. In one case, the portfolio was invested in high yielding stocks and in the other case in the S&P 500. Dividends and excess of withdrawals were reinvested. Notice that the ending market value of the high-yield stock portfolio that used a dividend income approach is 60% greater than the ending market value of the S&P 500 portfolio that used a total-return model. Why? Because the dividend portfolio generated enough cash flow to meet the annual spending requirement eliminating the need to sell principal shares in any given year.
Here we show a total amount of distributions an investor would have received over the 10 years ending December 2009, if they invested in the dividend portfolio versus investing in the S&P 500 portfolio. Both withdrew 5% at the end of each year. The dividend portfolio would have produced over $510,000 of cash flow compared to about $352,600 for the S&P 500. What this implies is that a retiree invested in the S&P 500 would have had to make standard of living adjustments or meet their annual spending requirement from other sources.
Now let's look at positive versus negative compounding. This graph shows that by reinvesting the excess dividend income above the 5% needed each year by the end of 2009 the dividend portfolio would have contributed almost $133,000 toward positive compounding, compared to the more than $232,000 in principal shares an investor in the S&P 500 would have had to sell to meet in order to meet their annual 5% income need.
So the question on retiree's mind: Will my money last as long as I do? Our solution: After nearly two decades of managing dividend focused portfolios for a full range of clients, we firmly believe that a portfolio targeting financially strong dividend paying stocks is the key to building long- term sustainable wealth and is essential to maintaining wealth for investors who spend income.
