Living Off Dividends In RetirementLiving off dividends in retirement is a dream shared by many but achieved by few. In today’s environment marked by rising life expectancies, extremely low bond yields, and a 7-year bull market, retirees face challenges on all fronts to build a consistent 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.


Not surprisingly, we believe dividend investing can help achieve each of these objectives. However, unless your nest egg is large enough to allow you to live off of dividend income without touching your principal, it is prudent to maintain diversified sources of retirement income.


Most retirement paychecks are funded by a combination of investment income and withdrawals of principal. Retirement income generators such as annuities or systematic withdrawals often provide more upfront income than a dividend strategy. However, they use up your principal whereas dividend investing preserves your principal over long periods of time and can 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 dividends grew by about a third after adjusting for inflation, it’s reasonable to believe that the value of your stocks could have appreciated by a similar amount, 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 plenty of funds 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 50 blue chip dividend stocks that collectively yield at least 3% and grow their dividends by at least 3.5% per year going forward is very attainable.


As the Wall Street Journal’s example showed, building a growing stream of dividends can help offset today’s low bond yields while avoiding problems caused by potentially inflated stocks prices – high quality dividend stocks can continue raising their dividend during bear markets. While some retirees on a systematic withdrawal plan would feel pressure to cut back during stock market declines, you can enjoy a pay raise with the right dividend stocks!


Living Off Dividends: The Benefits of Dividend-Paying Companies

Stocks that pay a dividend often have characteristics that appeal to long-term investors. A growing dividend is often a sign of durability, stability, and confidence in the business. In order to continuously pay a dividend, a company must generate profits above and beyond the operating needs of the business and tends to be more careful with their use of cash. These favorable characteristics show up in the amount that dividends have contributed to the market’s total return over the past 80 years. According to Pimco (see below), dividends have accounted for at least 30% of the market’s total return in seven of the last eight decades. With the market trading at a historically elevated earnings multiple today, it seems likely that dividends will account for an equally favorable proportion of the market’s total return over the next decade.


Living Off Dividend Income


Importantly, dividend investing has historically exhibited less volatility than the broader stock market as well. As seen below by the narrower blue band, dividend-paying stocks in the S&P 500 recorded a lower annualized standard deviation than non-dividend paying companies in each of the last 25+ years. While historical performance is no guarantee of future results, lower price volatility is attractive for retirees concerned with capital preservation.


Living Off Dividends


From a retiree’s perspective, owning dividend stocks has several additional allures.


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. While a portfolio of dividend growth stocks will experience some variability in market value, the income that a good portfolio churns out should consistently grow. Even during the financial crisis, over 230 companies increased their dividend.


This contrasts sharply with a systematic withdrawal system for retirement income. Which situation sounds more stressful – the investor who lives off cash flow thrown off from his investments, or the investor who must sell assets to generate cash flow each year? Living on dividend income in retirement provides cash without incurring the stress of figuring out which assets to sell and when, especially if another market crash is around the corner.


Once again, 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. As long as there is no reduction to the dividend, income keeps rolling in regardless of how the market is behaving.


Another benefit of owning dividend stocks in retirement is that many of these companies increase their dividends over time, helping offset the effects of inflation. According to the Wall Street Journal, over the past 50 years, the S&P 500’s dividends grew at an average 5.7% per year, outpacing the average 4.1% inflation rate. 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 the right dividend stocks.


Additionally, a dividend investing strategy preserves and grows your principal over long periods of time, unlike most annuities and withdrawal strategies. This allows you to leave a legacy for your family or favorite charities. Dividend investing also provides flexibility to sell off assets if you need to fund special retirement activities or offset some unexpected dividend cuts. Once again, annuities typically lack this flexibility.


Finally, holding individual stocks rather than dividend-focused ETFs or mutual funds protects the full income you signed up to receive. Investing in individual securities yourself eliminates the costly fees assessed each year by many ETFs and mutual funds, saving thousands of dollars along the way. All you pay is a one-time commission cost (typically $10 or less per trade with discount brokers) to execute your initial trade to buy the stock.


However, actively managing a portfolio requires time and behavioral discipline, making it inappropriate for most people. While it doesn’t guarantee better performance, it does eliminate a major drag on returns – the high fees charged by many fund managers 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 advised the typical person to put their money in low-cost index funds for the best long-term results in his 2014 shareholder letter:

“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.”

We pulled in dividend yield and expense data for some of the more popular dividend ETFs and mutual funds. The low-cost index funds Buffett talks about would be found in the first able, “Dividend ETFs.” Of the 10 dividend ETFs we analyzed, the average fund charged annual expenses that reduced income received from dividends by about 9%. A $1 million portfolio spread equally across each fund would generate about $32,400 in dividend income each year, but nearly $3,000 of that would disappear to fees (9% of income generated is lost to fees, using this example).


We haven’t dug into the quality of each ETF, but the lowest-cost funds appear to be VYM, HDV, SCHD, and VIG. Investors less willing to commit the time or lacking the stomach to buy and hold dividend stocks directly would be wise to evaluate low-cost index funds for their portfolio.


Living On Dividend Income


Just like Buffett warned, we see that the 10 actively managed dividend mutual funds we analyzed below take about 19% of the dividend income generated each year in fees, more than twice as much as the ETFs. Using our $1 million portfolio example again, an equally-weighted portfolio would generate approximately $31,800 in annual dividend income. Of this amount, a whopping $5,700 goes right back into the pockets of the fund managers every year. That is quite the price to pay for such mediocre results.


Vanguard’s actively managed funds have the most attractive cost structure, if you decide to remain hands off and desire an active manager. Buffett also recommended Vanguard’s products in his shareholder letter.


Living On Dividends In Retirement

Sources: Morningstar, Mutual Fund Websites


If you’re comfortable selecting dividend stocks on your own, it is very possible to generate a higher dividend yield than most of the products above. Using our dividend stock screener, we found that more than 75 stocks have a dividend yield greater than 3%, have raised their dividend for at least 10 consecutive years, and have above-average dividend safety, according to our proprietary dividend rating system.


In summary, owning individual dividend stocks for retirement income has numerous benefits. Your principal can be preserved, your income can grow and protect your purchasing power, and your investment fees will be substantially lower. 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 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 making up the rest.


Despite the very low bond yields available in the market today, bonds have historically been much less volatile than stocks – a return of 0% from bonds isn’t very attractive, unless your stock portfolio drops by 25%. That is one reason why retirees should consider income sources beyond dividend stocks, which are still sensitive to the ups and downs of the market. With that said, we have little problem with a retirement portfolio’s equity exposure being invested entirely in dividend-paying stocks so long as they are diversified by yield, growth potential, and industry. However, it seems prudent to diversify beyond equities, especially if a systematic withdrawal strategy is being used.


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 consumer staples and utilities. Should interest rates start to rise and trigger a major investor exodus in high-yield, low-volatility sectors, significant price volatility and underperformance could occur (an unlikely event, but you never know what the market will do – hence, diversify).


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 Index to become wildly popular with investors. Dividend aristocrats are stocks in the S&P 500 that have increased their dividend for at least the last 25 consecutive years. These stocks get the attention of dividend investors because they have outperformed the market (see below) and we like to assume that many of them will always keep paying and growing their dividends, which is far from guaranteed. Look at General Electric or AIG prior to the financial crisis as examples.


Dividend aristocrats have outperformed the S&P 500 over the last 10 years


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 market but still taking a much bigger hit than bonds. Clearly, it is important to diversify your holdings and remember that you own shares of stock, not bonds. If a company fails to pay back its debt, it files bankruptcy. If business conditions get tough, it will simply cut the dividend first to stay alive. Generally speaking, stocks and their dividend income are riskier than bonds.


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 automatically 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 results in a lower total return. While this mentality is irrational, it can also create a desire to chase high yield dividend stocks. In many cases, it’s a big mistake to simply reach for dividend stocks that match your yield objective.


Unfortunately, many stocks with dividend yields greater than 4.5% 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, sub-4.5% dividend yield stocks that have better prospects of maintaining and growing earnings and investors’ principal over time.


Most retirees cannot afford to live off of the income generated from their dividend portfolios every year without touching their capital. These investors should especially focus on designing a portfolio for total return rather than for dividend income alone. Once the portfolio’s objectives and stock and bond allocation are determined, you can figure out how to get the cash flow out of it, whether it’s through asset sales, interest payments, dividends, or something else. Dividend payments are one important way to generate consistent cash flow, but they shouldn’t be looked at in a vacuum. Keep your mind open and be aware of alternative income sources that might be an equally attractive fit for you.


Additional downsides to dividend investing are the 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.


When you look at the savings generated from a do-it-yourself investing approach compared to handing your money over to the typical high-fee mutual fund or advisor, thousands of dollars of savings are possible for those willing to make the commitment. Of course, this also assumes that the individual investor can find safe dividend stocks that perform no worse than the dividend mutual funds and ETFs that are available.


How to Find Safe Dividend Stocks for Retirement

Regardless of your total return objective and asset allocation for retirement, dividend stocks are likely to represent a meaningful portion of your nest egg’s equity mix. In today’s low-yield environment, generating a safe yet meaningful income stream from dividend-paying stocks is no small feat.


There is always temptation to screen for high yield stocks, but many times these companies are value traps. Like Charlie Munger once said, “It’s not supposed to be easy. Anyone who finds it easy is stupid.”


Generally speaking, stocks with the safest dividend payments embody the following characteristics:

  • Low payout ratios: the amount of earnings paid out as a dividend is reasonable – less than 70% is preferred. Low payout ratios provide flexibility to continue paying the dividend in the event that a company’s earnings unexpectedly drop. More stable businesses like utilities can maintain higher payout ratios because their cash flows are safe and predictable.
  • Clean balance sheets: companies will always pay their debtholders before paying dividends. We like to invest in companies that generate steady free cash flow and have a debt to capital ratio less than 50%.
  • Durable business models: look for companies with decades of operating experience and businesses located in industries with a very slow rate of change. These characteristics reduce the company’s odds of being quickly disrupted and seeing its cash flow (and ability to pay its dividend) plunge.
  • Low industry cyclicality: some markets are very cyclical, exhibiting rolling booms and busts in demand and supply over long periods of time. Some examples include commodity producers (e.g. gold miners, oil explorers), homebuilders, and semiconductor chipmakers. If management overstretched the company at the top of the cycle (e.g. took on debt to acquire a competitor), the company’s dividend could be in jeopardy when the cycle turns down and earnings contract.

We simplify the search for safe dividend payments with our proprietary Dividend Safety Scores. We analyze balance sheets, payout ratios, profitability trends, industry cyclicality, and more to rate how safe a dividend is. Investors can access dividend scores for thousands of companies using our Stock Analyzer tool, helping them locate the safest, highest yielding stocks.


Some of the most durable dividend payers are marked by the number of consecutive years they have grown their dividend. Over 150 stocks have raised their dividend for more than 20 straight years.


Closing Remarks

Managing your assets for retirement can feel like an overwhelming process. There are many big decisions to make, based on your own objectives, risk tolerances, 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 vehicles you are considering. At the end of the day, remember that you are looking to meet a consistent cash flow objective and are not wedded to achieving your goal through any one source such as bond interest or dividend payments.


We believe quality dividend stocks can serve as a foundational component of total return for most retirement portfolios. While few of us have the large nest egg needed for living off dividends exclusively in retirement, a properly constructed basket of dividend stocks can provide safe current income, income growth, and long-term capital appreciation to help make a broader retirement portfolio last a lifetime.


Simply Safe Dividends was built to help retirees build and maintain a high quality portfolio of dividend stocks. We provide individual investors with online research tools and a monthly dividend newsletter that tracks our dividend portfolios, including our portfolio for Conservative Retirees that yields close to 4% with low price volatility. You can sign up for a 14-day free trial by clicking here and learn more about our newsletter by clicking here.