Dividend Growth and Bond Ladders

How do you provide for your heirs? How do you put everything on automatic? I addressed this recently in a letter to the editor. I recommended setting dividend thresholds, using a bond ladder and withdrawing 5% of the original balance (plus inflation) with reviews at five year increments.

This article shows that a 5% withdrawal is reasonable even today.

August 29, 2007 Letters to the Editor

Expanded Allocator Conditions

I cannot simulate a bond ladder with thresholds directly on my Income Allocators. What I did do was to simulate the first few years on my Expanded Allocator. I started out with 20% initially in a stock investment with a yield of 3% or higher with growth and two identical fixed income investments (constant income) with a total allocation of 80%. At year 5, I removed one of the fixed income investments, reducing the allocation to 60%. At year 5, I added a second stock investment with a yield of 4% or higher and a 20% allocation.

I had a TIPS account at a 2% real interest rate to manage cash flows, taking excessive amounts out of the earliest years and adding money later to maintain a constant withdrawal rate.

Background

The S&P500’s dividend (nominal) growth rate has been almost exactly 5% per year since 1950. It currently yields less than 2%.

Inflation has averaged close to 3% per year, although it has fluctuated wildly.

DVY, the first dividend focused Exchange Traded Fund ETF, recently yielded close to 3.4%. JPMorgan Chase has preferred shares that recently yielded 6.7%. Investment grade corporate bonds are averaging 6.0%.

With this in mind, we can see what would be required to allow a 5% (plus inflation) withdrawal rate.

Examples

All of these combinations have a continuing withdrawal rate of 5%.

Inflation: 3% per year.

Allocations:
A: 20% starting at Year 0.
B: 20% starting at Year 5.
C: 60% starting at Year 0.
D: 20% starting at Year 0 and ending at Year 5.

Combination 1:
Dividend Yield A: 3.0% with 6.0% per year growth.
Dividend Yield B: 4.0% with 6.0% per year growth.
Interest C: 6.7% with 0.0% growth.
Interest D: 6.7% with 0.0% growth.

Combination 2:
Dividend Yield A: 3.4% with 5.0% per year growth.
Dividend Yield B: 4.0% with 6.0% per year growth.
Interest C: 6.8% with 0.0% growth.
Interest D: 6.8% with 0.0% growth.

Combination 3:
Dividend Yield A: 3.4% with 5.0% per year growth.
Dividend Yield B: 5.0% with 5.0% per year growth.
Interest C: 6.8% with 0.0% growth.
Interest D: 6.8% with 0.0% growth.

Combination 4:
Dividend Yield A: 3.4% with 5.5% per year growth.
Dividend Yield B: 4.2% with 5.5% per year growth.
Interest C: 6.7% with 0.0% growth.
Interest D: 6.7% with 0.0% growth.

Remarks

All of the conditions stretch some factor ever so slightly.

Combination 1 assumes 6.0% per year dividend growth, slightly more than that of the S&P500.

Combination 2 assumes 6.0% per year dividend growth for the second stock investment and adds 0.1% to the fixed income components.

Combination 3 uses DVY’s 3.4% initial dividend yield and a 5% initial dividend yield for the second stock component. It also adds 0.1% to the fixed income components.

Combination 4 uses DVY’s 3.4% initial dividend yield and a 4.2% initial dividend yield for the second stock component. It increases the dividend growth rates to 5.5%. It leaves the fixed income components at 6.7%.

All of these are reasonable. An investor can expect success.

Reviews every five years can assure success. This is frequent enough to react to unfavorable developments.

Have fun.

John Walter Russell
September 15, 2007