Dividend Growth to the Rescue

Here is an alternative calculation of the worst case outcome of a 50% stocks-50% TIPS portfolio.

I described such a portfolio as a Middle Ground approach in the Dividend-Based Design Example. The stocks in such a portfolio started out at a 3.0% dividend yield. Back when I wrote the article, DVY yielded 2.95%. DVY’s yield has increased. Today, 3.0% corresponds to equal portions of PID and DVY.

Dividend-Based Design Example

NOTE: Do not interpret this as a specific recommendation. I mention these details only to show that my assumptions are reasonable.

Alternative Worst Case Outcomes

In the example, I withdrew a total of 4.0% of the original balance (plus inflation) until stock prices fell enough to make their dividend yields attractive. At that point, which can reasonably be expected within ten years, I replaced the TIPS with high dividend stocks from high quality companies. This would extend the 4.0% payout into the indefinite future. Most likely, the income stream would grow faster than inflation.

To reach a 4.0% (plus inflation) withdrawal rate, I withdrew all of the dividends from my stock holdings and 5.0% (plus inflation) from my original TIPS holdings. For purposes of analysis, I assumed that my stock holdings would grow only enough to match inflation. That is, they would always yield 3.0% of their original balance (plus inflation).

For an alternative estimate of the worst case outcome, assume that I never find stock yields attractive enough for me to replace my TIPS.

Assuming a TIPS (real) interest rate of 2% and making 5% (plus inflation) withdrawals from TIPS, the TIPS would last just under 26 years. At that time, I would be left with my original stock holdings and nothing else.

Brute Force Calculation

I could maintain my 4.0% (plus inflation) withdrawal rate in terms of my original balance if my stock dividend yields were to jump suddenly to 8.0% (plus inflation) in terms of the original stock balance at the end of 26 years. This jump from 3.0% to 8.0% is a factor of 2.67. This corresponds to a dividend growth rate of 3.84% plus inflation.

Assuming that inflation remains of the order of 3%, a dividend growth rate of 7% (before making an adjustment for inflation) would be sufficient.

Brute Force Spreadsheet Calculation

As an alternative, I constructed a simple spreadsheet for steady dividend growth. I maintained a 4.0% (of the original balance, plus inflation) total withdrawal amount. I continued to withdraw all dividends. I reduced my TIPS withdrawals as dividends grew so as to keep the total amount steady.

Assuming a (real) dividend growth rate of 1.0% above inflation, I was able to maintain full withdrawals for 29 years. The withdrawal amount fell from 4.0% of the original balance (plus inflation) to 2.0% of the original balance (plus inflation) at year 30.

Assuming a (real) dividend growth rate of 2.0% above inflation, I was able to maintain full withdrawals for an additional decade, until year 39. The withdrawal amount fell from 4.0% of the original balance (plus inflation) to 3.2% of the original balance (plus inflation) at year 40.

Assuming a 2.5% (real) dividend growth rate above inflation, I was able to maintain withdrawals indefinitely. The TIPS principal hit its low in year 39. It was 23.3% of its original amount. After that, I had to increase withdrawals or add to principal.

Assuming a (real) dividend growth rate of 3.0% above inflation, I was able to maintain withdrawals indefinitely. The TIPS principal hit its low in year 31. It was 41.4% of its original amount. After that, I had to increase withdrawals or add to principal.

Summary

This should comfort those who start out with a 50% TIPS-50% stock portfolio. You can withdraw 4.0% (plus inflation) far into the indefinite future. Even if stocks never become attractive enough to purchase, dividend growth can do the job all by itself. According to my spreadsheet, a dividend growth rate of 2.0% faster than inflation extends full withdrawals to year 39. A dividend growth rate of 2.5% extends full withdrawals indefinitely and generates a surplus beginning in year 40.

Since inflation is typically close to 3.0% (long-term), (nominal) dividend growth rates of 5.0% to 5.5% are sufficient to support younger retirees.

Have fun.

John Walter Russell
November 30, 2006