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Living off Dividends in Retirement

Living off dividends in retirement is a dream shared by many investors. But in today’s environment marked by rising life expectancies, extremely low bond yields, and elevated stock market valuations relative to history, retirees face challenges on all fronts to build a stable income stream that will last a lifetime.

Before zeroing in on any particular strategy or investment vehicle, retirees need to understand how much risk they are willing to tolerate in the context of their entire portfolio and the corresponding rate of return that can reasonably be achieved.

While each of us will ultimately reach different conclusions and asset allocations, we are united by common desires – to maintain a reasonable quality of life in retirement, sleep well at night, and not outlive our savings.

Dividend investing is one way to achieve these objectives. The strategy can help preserve your capital over long periods of time and generate a growing income stream regardless of market conditions.

The Wall Street Journal provided a practical example of how dividends can help fuel a healthy and sustainable retirement. 

The article assumed you retire with $1 million and desire $40,000 in annual inflation-adjusted retirement income. It also assumed that inflation runs at 2%, Treasury yields match the inflation rate, and stock dividends grow 3.5% per year.

It goes on to state that you invest $400,000 into Treasury bonds and $600,000 into stocks that yield 3%, good for $18,000 in dividend income each year. 

After spending every dollar of dividends, you sell part of your bond portfolio to hit your $40,000 inflation-adjusted annual income target. After about 21 years, your bond portfolio would be fully depleted.

However, over that time period, your annual dividend income might have grown by a third to reach $24,000 per year, even after accounting for inflation. Most importantly, you would still own all your stocks. 

If your dividend income grew by about 33% after adjusting for inflation, then it is reasonable to believe that the value of your stocks could have appreciated by a similar amount as their growing cash flow made them worth more over time, perhaps reaching close to $800,000 in value. 

Assuming you retired no sooner than the age of 60, you would now be in your 80s and have a healthy amount of funds left for the rest of your retirement.

While your initial bond / stock mix will vary based on the size of your nest egg, your risk tolerance, and your return objectives, building a portfolio of several dozen quality dividend stocks that collectively yield 3% or higher and grow their dividends by at least 3.5% per year is very attainable.

In fact, even in today's market environment characterized by historically low interest rates, we believe it is reasonable to construct a conservative dividend portfolio that yields between 4% and 4.5% without sacrificing on business quality, income safety, or portfolio diversification. 

Regardless, as The Wall Street Journal’s example showed, building a growing stream of dividends can help offset today’s low bond yields while avoiding some of the problems caused by potentially inflated stock prices.

Let's take a closer look at the benefits and risks of leaning on dividend income in retirement. 

Living Off Dividends: The Benefits of Dividend-Paying Companies

There's nothing necessarily magical about dividends. As an asset class, we would expect dividend stocks to deliver long-term total returns that are not all that different than the returns of the broader market.

The key difference is that more of the return comes from income rather than price appreciation. This can reduce volatility and make it psychologically easier for retirees to stay the course during times of turbulence.

If your dividend income stream remains intact and you can make ends meet without needing to touch principal, there's some comfort in knowing you are unlikely to outlive your savings or face major setbacks if the market's performance is poor, particularly during the crucial early years of retirement.

Simply put, depending on companies that pay safe and growing dividends for retirement income alleviates many of the worries that come with the ups and downs of the market.

Focusing on growing dividend income rather than the noise caused by volatile stock prices fits well with a long-term investment strategy and removes some of the emotional risk associated with investing, such as panic selling during downturns.

While a portfolio of dividend growth stocks will experience some variability in market value like any other equity-focused strategy, the income that a quality portfolio churns out should consistently grow over time.

Many investors enjoy the simplicity of this approach compared to a systematic withdrawal system for retirement income.

Which situation sounds more stressful – the investor who lives off cash flow produced and distributed by his investments each month, or the investor who must estimate a safe withdrawal rate in a variety of market conditions and then select which assets to sell to generate enough cash flow each year?

Living on dividend income in retirement can make it easier to stick to a plan by providing passive cash flow without incurring the stress of figuring out which assets to sell and when, especially if another market crash is around the corner.

The focus can remain on locating safe dividend payments rather than getting concerned with the market’s price volatility and how that might impact your withdrawal amounts in down years. As long as there is no reduction to the dividend, passive income keeps rolling in regardless of how the market is behaving.

Johnson & Johnson, a diversified healthcare giant, provides a great example of the strategy's appeal. The chart below shows that over the past two decades J&J's stock price (blue line) has experienced plenty of volatility despite the firm's reputation as a defensive stalwart.

Shares of Johnson & Johnson during the 2007-09 financial crisis plunged 40%, and they fell 30% during the 2020 pandemic. But the company's fundamentals remained supportive of its dividend (orange bars), providing income investors with steadily growing paychecks every year.
Source: Simply Safe Dividends

As Johnson & Johnson demonstrated, another benefit of owning dividend stocks in retirement is that many companies increase their dividends over time, helping offset the effects of inflation. 

The S&P 500’s dividends over the past 50 years grew at an average 5.7% per year, outpacing the average 4.1% inflation rate, according to The Wall Street Journal. 

While past performance is not necessarily indicative of future results, retirees who depend on a meaningful amount of dividend income are likely to be in a good position to protect their purchasing power with a diversified basket of quality dividend stocks.

This contrasts sharply with bonds, which make fixed interest payments and offer paltry yields. The financial world has changed a lot over the last 40 years. Long gone are the days of double-digit bond yields, and many quality stocks now yield significantly more than corporate bonds.
Source: The Hartford Funds

As Warren Buffett stated in May 2018, "Long-term bonds are a terrible investment at current rates and anything close to current rates.”

Why the hate for long-term bonds? Like many things, it’s simple math for Buffett. Long-term bond yields sit near 2% today, and their interest income is taxable at the Federal level. In other words, their after-tax yield is about 1.6%.

Meanwhile, the Federal Reserve is targeting 2% annual inflation. So for investors who buy today and hold through maturity, long-term bonds’ after-tax return, adjusted for inflation, is a loss of about 0.4% per year. 

As Buffett put it, long-term bonds at these rates are “ridiculous.” It’s hard to disagree when you consider that long-term stock returns have averaged close to 10% per year, and unlike bonds, dividend stocks grow their earnings and payouts. 

Besides fueling healthy long-term returns and income growth, dividend investing has historically exhibited less volatility than the broader stock market as well.

As seen below, dividend-paying stocks in the S&P 500 Index have recorded significantly less volatility (i.e. a lower standard deviation) than non-dividend paying stocks over the last 47 years.
Source: The Hartford Funds
Stocks that pay a dividend often have characteristics that appeal to conservative investors. For one thing, a steadily growing dividend is often a sign of a company's durability, stability, and confidence in its underlying business. 
 
In order to continuously pay a dividend, a company must generate profits above and beyond the operating needs of the business. They are also incentivized to be more careful with their uses of cash.
 
These qualities filter out many lower quality businesses that have too much debt, volatile earnings, and weak cash flow generation – characteristics that can lead to large capital losses and sizable swings in share prices.  

The lower price volatility profile of dividend-paying stocks is attractive for retirees concerned with capital preservation.

Coupled with the strategy's reduced need to sell shares to make ends meet, dividend investing increases the chances of preserving and growing your principal over long periods of time. This allows you to leave a legacy for your family or favorite charities. 

Dividend investing also provides flexibility to sell off assets if market conditions have been favorable and you want to fund special retirement activities. Other strategies such as annuities typically lack this flexibility. 

When it comes to implementing a dividend strategy in retirement, holding individual stocks rather than dividend-focused ETFs or mutual funds protects the full income you signed up to receive while keeping you in complete control of what you own. 

Investing in individual securities yourself eliminates the fees assessed each year by ETFs and mutual funds, potentially saving thousands of dollars along the way. And with trading commissions having been eliminated across most brokerages, the direct financial costs of implementing this strategy are virtually nothing.

However, actively managing a portfolio requires time and behavioral discipline, making it inappropriate for some people. For investors interested in pursuing this path, better performance is not guaranteed but a do-it-yourself strategy does eliminate a major drag on returns – the high fees charged by many fund managers and advisors on Wall Street. 

Higher fees mean less dividend income for retirement. The relatively high fees charged by most fund managers are also a key reason why Warren Buffett in his 2014 shareholder letter advised the typical person to put their money in low-cost index funds for the best long-term results:

"My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers…

Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm."

The average fund tracked by Morningstar charges about 1%, according to The Wall Street Journal. If a $1 million portfolio was invested in the average mutual fund, it would pay $10,000 in fees, which grow as the account's value rises.

Suppose the $1 million was invested in a dividend-focused fund yielding 3.5%. Over 28% of the $35,000 of dividend income generated would go towards fees.

But what about some of the low-cost dividend ETFs with fees as low as 0.1%? In many cases, investors who are less willing to commit the time or lack the stomach to buy and hold dividend stocks directly would be wise to evaluate such funds for their portfolios.

However, they lose a valuable benefit: control.

Specifically, almost all ETFs own dozens, hundreds, or even thousands of stocks. Vanguard's High Dividend Yield ETF (VYM) owns around 400 companies, for example.

Some of these are good businesses with safe dividends, while others are lower in quality and will put their dividends on the chopping block. Some have high yields, others hardly generate much income at all.

Simply put, an ETF is a hodgepodge of companies which may or not match your own income needs and risk tolerance very well.

Vanguard's High Dividend Yield ETF got into trouble during the financial crisis because it was not focused on dividend safety. The ETF's dividend income dropped by 25% during this period and took four years to recover to a new high.
Source: Simply Safe Dividends

Even when times are good, dividend ETFs make variable payouts that fluctuate unpredictably each period. VYM's individual payout are below and demonstrate how volatile the income from funds can be. It's hard to know what yield you are really buying.
Source: Simply Safe Dividends

Hand-picking your own dividend stocks gives you immediate visibility into your income stream. You'll know exactly how much you're getting paid by each company and when. 
Source: Simply Safe Dividends
Selecting your own holdings with a focus on income safety can also deliver higher and faster-growing income compared to most low-cost ETFs. You will better understand all of the investments you own as well, helping you weather the next downturn with greater confidence. 

In summary, owning individual dividend stocks for retirement income has numerous benefits. Your principal can be preserved, your income can maintain itself regardless of where stock prices go, you can protect your purchasing power through dividend growth, your investment fees will be substantially lower, and you will understand exactly what you own and when you'll be paid.

However, there are several risks to be aware of when it comes to living on dividend income in retirement.

Risks of Living on Dividend Income

Proper diversification is one of the hallmarks of portfolio construction. If an investor goes all-in on dividend stocks for retirement, he or she would be concentrating completely in one asset class and investment style. 

Most advice calls for retirees to keep their equity exposure between 20% and 75% of their overall portfolio, with bonds and cash making up the balance. However, asset allocation depends on an individual's unique financial situation and risk tolerance. 

A primary investment objective in retirement is to guarantee a minimum daily standard of living so you don't outlive your nest egg and can sleep well at night. 

Some folks are able to meet that minimum income amount they need through a combination of pension income, Social Security payments, annuities, rental income, and guaranteed interest from certificates of deposit. 

In those cases, investors who can stomach the stock market's volatility could allocate upwards of 80-100% of their portfolio to dividend-paying stocks to generate more income and achieve stronger long-term capital appreciation potential and income growth. 

While this goes against traditional asset allocation advice in retirement, which calls for holding a more balanced mix of stocks and bonds (plus 2-3 years of living expenses in cash), these retired folks view their guaranteed Social Security and pension payments as their "bond" income. Therefore, they are comfortable investing more heavily in stocks. 

Going more into stocks (even higher quality dividend stocks) will increase your portfolio's volatility compared to owning a mix of bonds and stocks. The upsides are that you will generate more income, that income will grow faster (Treasury payments are fixed), and your portfolio will have much greater long-term potential for capital appreciation. 

However, your short-term returns will be less predictable, which can be troublesome if you need to periodically sell portions of your portfolio to make ends meet in retirement or don't have a stomach for much volatility. A 0% return from bonds looks a lot more attractive if your stock portfolio drops by 25%. 

Another way you could run into trouble with a dividend strategy is by only owning high-yielding stocks concentrated in one or two sectors, like real estate investment trusts (REITs) and utilities. Should interest rates rise and trigger a major investor exodus in high-yield, low-volatility sectors, significant price volatility and underperformance could occur.

Dividend investors can also fall into the trap of hindsight bias if they are not careful. The desire to own consistent dividend growers has caused groups of stocks like the S&P 500 Dividend Aristocrats to become popular with investors. Dividend aristocrats are stocks in the S&P 500 that have increased their dividend for at least 25 consecutive years. 

These stocks get the attention of dividend investors because they have outperformed the market and we like to assume that they will always keep paying and growing their dividends, which is not guaranteed. Look at General Electric or AIG prior to the financial crisis as examples.

And General Electric and AIG aren’t alone. According to the Wall Street Journal, companies in the S&P 500 reduced their dividends by 24% between late 2008 and early 2010. The Dividend Aristocrats Index also fell 22%, outperforming the broader market but still taking a much bigger hit than bonds.

The pandemic was another reminder that dividend income is not risk-free. With the U.S. economy experiencing its sharpest contraction in history, 25% of companies covered by our Dividend Safety Scores (333 out of 1,313) cut their dividends in 2020.

This doesn't invalidate a dividend investing strategy but rather highlights the importance of focusing on owning companies that can sustain their payouts in good times and bad.

The bottom line is that dividends have risk. Investors pursuing this strategy in retirement should monitor the dividend safety of their portfolios, make adjustments as necessary, and diversify their holdings.

Focusing on income return at the expense of total return (income and price return) is another trap dividend investors fall into – just because a stable company pays a dividend doesn’t mean it is a superior investment or resistant to price drops in the broader stock market. In theory, whether your retirement cash flow comes from dividend income, bonds, or sales of your portfolio’s holdings shouldn’t matter.

However, many of us would prefer to leave our principal untouched and live off the dividend income it generates each month, even if it resulted in a somewhat lower total return. This mentality, coupled with a desire to produce even more income, can create an urge to chase high-yield dividend stocks.

Unfortunately, many stocks (excluding some REITs and MLPs) with dividend yields greater than 5% are signaling that something could be structurally wrong with their businesses or that the dividend will need to be cut to help the company survive. In these situations, your principal often faces the greatest risk of long-term erosion. 

You must always understand what is enabling the company to offer such a large payout. In our opinion, investors are usually better off pursuing lower-risk stocks that yield 5% or less. These companies tend to have better prospects of maintaining and growing earnings and investors’ principal over time.

Folks who view investing as more of a chore than a hobby may also find downsides to a dividend investing strategy in the amount of time it requires to stay current with your holdings and the learning required to get started. 

While investing isn’t rocket science, it does require a stomach for risk (i.e. price volatility), enough financial literacy to understand the basic guts of a company, a commitment to stay current with the quality of your holdings, and common sense.

Closing Thoughts

Managing your assets for retirement can feel like an overwhelming process. There are many big decisions to make, based on your current financial situation, long-term goals, risk tolerance, and quality of life expectations. These individual differences will drive asset allocation decisions, but they should not be rushed into. 

With every decision, be sure to thoroughly review the fees, flexibility, and fine print of the investment strategies you are considering. Remember that you are looking to meet a consistent cash flow objective and are not necessarily wedded to achieving your goal through any one source such as bond interest, annuity payments, asset sales, or dividend income.

Quality dividend stocks can serve as a foundational component of current income and total return for a retirement portfolio. A properly constructed basket of dividend stocks can provide safe current income, income growth, and long-term capital appreciation to help investors stay the course and make a retirement portfolio last a lifetime. 

Simply Safe Dividends was built specifically to help retirees build and maintain a high quality portfolio of dividend stocks. From identifying the safest dividend stocks to tracking your monthly income, our easy-to-use portfolio tools, Dividend Safety Scores, and research are here for you every step of the way.

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