More Income Stream Allocator Examples

I have collected another set of examples using my TIPS Income Stream Allocator B. I selected two holdings from the Morningstar Dividend Investor. I wanted to translate optimistic, but realistic, estimates of dividend yields and growth rates into information about income streams.

I included a sensitivity study related to income stream shortfalls.

Complementary Investments

I selected two high income investments from the Dividend Harvest Portfolio. They are Buckeye Partners BPL and Buckeye GP Holdings BGH. BPL was characterized as having a yield of 4% and a (nominal) dividend growth rate of 8% per year. BGH was characterized as having a yield of 6% and a (nominal) growth rate of 4% per year.

[Actually, the stated yields were almost one percent higher.]

Income Stream Data

Here is a summary in the order that I collected the data. You can download a truncated spreadsheet printout from my Yahoo Briefcase. They are the Income Stream Pictures F file in the Allocators folder.

Yahoo Briefcase

Objective: Constant high income stream to Year 30. Basic.
This uses TIPS with a 2.0% (real) interest rate (as opposed to 2.5%).
Stock A: 4% plus 8% growth.
Investment B yields 6% plus 4% growth.
35% stock A/35% Investment B.
$6200+ real withdrawals, growing after Year 20.

Objective: Constant high income stream to Year 30. Excursion A.
This uses TIPS with a 2.0% (real) interest rate (as opposed to 2.5%).
Stock A: 4% plus 8% growth.
Investment B yields 6% plus 0% growth.
35% stock A/35% Investment B.
$5100+ real withdrawals, growing after Year 19, belt tightening begins in Year 7.

Objective: Constant high income stream to Year 30. Excursion B.
This uses TIPS with a 2.0% (real) interest rate (as opposed to 2.5%).
Stock A: 4% plus 8% growth.
Investment B yields 6% plus 2% growth.
35% stock A/35% Investment B.
$5600+ real withdrawals, growing after Year 19, belt tightening begins in Year 7.

Objective: Constant high income stream to Year 30. Excursion C.
This uses TIPS with a 2.0% (real) interest rate (as opposed to 2.5%).
Stock A: 4% plus 4% growth.
Investment B yields 6% plus 4% growth.
35% stock A/35% Investment B.
$4900+ real withdrawals to Year 30, drops to $4677 in Year 31, then grows. Belt tightening begins in Year 7.

Objective: Constant high income stream to Year 30. Excursion D.
This uses TIPS with a 2.0% (real) interest rate (as opposed to 2.5%).
Stock A: 4% plus 6% growth.
Investment B yields 6% plus 4% growth.
35% stock A/35% Investment B.
$5500+ real withdrawals, belt tightening begins in Year 7.

Objective: Constant high income stream to Year 30. Excursion E.
This uses TIPS with a 2.0% (real) interest rate (as opposed to 2.5%).
Stock A: 4% plus 4% growth.
Investment B yields 6% plus 4% growth.
35% stock A/45% Investment B.
$5500+ real withdrawals.

Income Stream Analysis

I do not know how accurately Morningstar (Josh Peters) predicts dividend growth rates. Nor do I know how often his companies cut dividends. That is why I ran a series of excursions.

The basic income stream exceeds 6.2% of the original investment (plus inflation). It is growing consistently after Year 20.

This performance is highly impressive. Remember, this includes 3% inflation.

Excursions A and B show what happens if the higher yielding investment fails to grow as well as expected.

I maintained the same initial allocation and I managed the side account (the TIPS portfolio) in the identical fashion for the first six years. Only then did I react to the lack of growth of the higher yielding investment.

From Excursion A, the withdrawal rate starting in Year 7 was still 5.1% of the original balance (plus inflation) assuming zero growth. From Excursion B, the withdrawal rate starting in Year 7 was still 5.6% of the original balance (plus inflation). Both are impressive numbers.

Excursions C and D show what happens if the faster growing investment fails to grow as well as expected. Excursion C shows what happens with 4% per year growth. Excursion D shows what happens with 6% per year growth. The assumed rate of growth was 8% per year.

From Excursion C, the withdrawal rate starting in Year 7 fell to 4.9% of the original balance (plus inflation) assuming 4% per year growth through Year 30. It fell even more in Year 31. From Excursion D, the withdrawal rate starting in Year 7 was 5.5% of the original balance (plus inflation), which is still an impressive number.

I ran Excursion E to see what could be done if the high growth rate investment fails badly. Using an initial dividend yield of 4% and 4% per year growth, increasing the higher yielding investment from 35% to 45% brought the income stream back up to 5.5% of the original balance (plus inflation).

Interpretation

Keep in mind that I have assumed 3% inflation. In a sense, an income stream of 6% plus inflation is equivalent to a 9% (nominal) return in today’s market. As such, it is an impressive number.

But keep in mind that an income stream of 6% starts at 6% of the original balance, not 9%. It is equivalent to a 9% nominal income stream only if you rearrange the timing of the 9% payments (through reinvestments). In essence, this is what I do by having a TIPS account on the side to manage cash flows.

Another thing to keep in mind is that inflation varies in the real world. It is not a steady 3% per year. As a result, your buying power is likely to fluctuate above and below the indicated (real) rates. The effect should average out over time, albeit imperfectly.

The reason behind the excellent performance of dividend strategies for retirees is that dividends are stable, determined almost entirely by business conditions. Approaches that depend upon capital gains are hurt badly whenever it becomes necessary to sell shares at depressed prices. Such approaches are far more vulnerable than dividend strategies because prices are determined at auction. Prices depend on investor perceptions. They can fluctuate wildly.

Caution

I do not know the accuracy of Morningstar dividend predictions. In spite of this, I believe that withdrawal rates of 5.5% (plus inflation) and above are reasonable for careful income oriented investors.

I base my opinion on the S&P500, dividend oriented Exchange Traded Funds, and the Ben Stein and Phil DeMuth Income Portfolios (based on their book “Yes, You Can Be a Successful Income Investor”). As a minimum, I would expect a dividend focused ETF to match the dividend growth rate of the S&P500 while providing a higher initial yield. Between Morningstar’s Dividend Investor newsletter and Ben Stein and Phil DeMuth’s book, it is apparent to me that suitable high yielding investments exist.

Have fun.

John Walter Russell
February 4, 2007
Correction (April 28, 2007): BPL has the higher initial yield and BGH has the higher dividend growth rate.