Dividend Disaster

You rely on dividends in retirement. Everything goes wrong. How bad might it be?

Three Portfolios (Lots of Numbers)

I brought up my Simplified Automatic Allocator. It is available for free download from my Yahoo Briefcase. My Yahoo username is jwr19452000.

Simplified Portfolio

I allocated $50000 to dividend stocks with an initial dividend yield of 3.5% and a nominal dividend growth rate of 5% per year. I allocated $50000 to TIPS at an interest rate of 1.5%. I assumed a 3% inflation rate.

I withdrew 5% of the original balance (plus inflation) for (just over) 20 years before the TIPS balance was used up.

At that time, the dividend stream from stocks had grown from $1750 to $2571 per year. Assuming that the price to dividend ratio remained unchanged, the stock balance would have grown by a factor of 1.47, from $50000 to $73500. If so, you could convert it all to TIPS and, even at a 0% interest rate, it would throw off $5000 per year for another 14.7 years.

But let’s say that stocks crash. Let us assume that prices decline by a factor of 4, an extreme worst case condition. Then instead of $73500, we would have only $18375. Withdrawing $5000 per year at 0% real interest in such circumstances would reduce the remaining portfolio lifetime to 3.7 years.

In this circumstance with withdrawals of 5%, the worst case ranges between 24 and 34 years.

If I reduce the withdrawal rate to 4.5% (plus inflation), the TIPS balance runs out just before year 27. The dividend income grows to $2941. The growth factor is 1.68, from $50000 to $84000. Withdrawing $4500 per year at 0% real interest lasts 18.7 years. Assuming a worst case price reduction from $84000 to $21000, you could still withdraw $4500 for another 4.7 years.

In this circumstance with withdrawals of 4.5%, the worst case ranges between 31+ years to 45+ years.

Dividend Blend Portfolio

This time I took the investments from Taken At Face Value, Condition A. Investment A has a 3.5% initial yield and an 8% per year nominal dividend growth rate. Investment B has a 6.1% initial yield and a 2% per year nominal dividend growth rate.

I allocated 20% to fast growing Investment A and 80% to high yielding investment B.

I set the TIPS interest rate to 0% and the inflation rate to 4% per year.

I found that I could withdraw 5% of the original balance (plus inflation) indefinitely.

When I set TIPS interest rate to 0% and the inflation rate to 5% per year, I could withdraw 5% (plus inflation) for only 12 years. The subsequent withdrawal rates fell below 4% of the original balance at Year 20. It fell as low as 3.6%.

When I set TIPS interest rate to 0% and the inflation rate to 4.5% per year, I could withdraw 5% (plus inflation) for 16 years. But dividends could still provide a continuing income stream that never fell below 4.2% of the original balance (plus inflation).

Dividend Blend Component

I took the investments from Taken At Face Value, Condition A. Investment A has a 3.5% initial yield and an 8% per year nominal dividend growth rate. Investment B has a 6.1% initial yield and a 2% per year nominal dividend growth rate.

Within the dividend blend, I allocated 20% to fast growing Investment A and 80% to high yielding investment B.

However, I allocate only 50% to this dividend blend. I allocate the other 50% to TIPS at a 1.5% real interest rate.

I assumed a 3% inflation rate.

I was able to withdraw 5% of the original balance (plus inflation) for 28 years. After that, my income from dividends was only $3223, having grown from an initial $2970. Assuming that the price to dividend ratio had remained the same, the balance would now have grown by a factor of 1.085, from $50000 to $54250. If so, you could convert it all to TIPS and, even at a 0% interest rate, it would throw off $5000 per year for another 11 years. That is, it would have provided 5% (plus inflation) for 39 years before being depleted.

Assuming that prices fell by a factor of 4, the portfolio would have lasted another 3 years. It would have been bankrupt at Year 31.

Summary

The Simplified Portfolio is what you might get by buying only the dividend paying stocks in the S&P500 index. DVY does better, with an initial yield of 3.66% and a nominal dividend growth rate close to 6%.

Today’s TIPS yield about 1.5%. Their yield was above 2% just recently. They are likely to do so in the future.

This shows what happens if are not careful about your portfolio. You should reduce you withdrawal rate to 4.5% of your original balance (plus adjustments to match inflation).

The Dividend Blend portfolio shows what to expect with carefully selected investments. Although I advise caution in the early years, you should be able to withdraw more than 5% of your original balance (plus inflation) even with higher than normal inflation. With hyperinflation (5% for a number of years), expect to take a hit. All investors would be in trouble. You could survive prolonged inflation at 4.5% although it would not be pleasant.

The Dividend Blend Component shows what might happen if you use both a dividend blend and a delayed purchase approach. Even if the delayed purchase fails to pan out, you would do OK.

Comments

It helps to track your portfolio’s performance and to monitor progress, whether by hand or on spreadsheets. The Simplified Portfolio shows what can happen. You should reduce withdrawals from 5% to 4.5% of the original balance (plus adjustments to match inflation) if you do not keep up.

The Dividend Blend portfolio from Taken At Face Value shows that dividend investors can expect to do exceedingly well even in the face of severe inflation.

The Dividend Blend Component shows that the downside of a combined approach is not nearly as bad as might be feared.

Have fun.

John Walter Russell
January 26, 2008

Yahoo Briefcase
Taken At Face Value
Taken At Face Value: Upside