Taken At Face Value

I have taken the Morningstar Dividend Investor newsletter at face value. I have assumed that its portfolios meet their goals. I have put its numbers into the Income Stream Allocator. This is what the portfolios do for retirees.

I include a sensitivity study.

Income and Growth Estimates

The Builder portfolio has a current (April 2007 issue) dividend yield of 3.5%. It has a target dividend growth rate of 8% to 10%. The dividend growth rate forecasts of its current holdings range from 7.5% to 10.0% per year.

The Harvest portfolio has a current dividend yield of 6.1%. It has a target dividend growth rate of 2% to 4%. The dividend growth rate forecasts of its current holdings range from 2% to 8%.

Taking the Morningstar Dividend Investor at face value, I assign Stock A an initial dividend yield of 3.5% per year and a dividend growth rate of 8% per year. I assign Investment B an initial dividend yield of 6.1% and a growth rate of 2%.

I assumed 3% inflation and 2% (real) interest for the TIPS.

Results

I started without making any deposits or withdrawals from the TIPS. I varied Stock A and Investment B allocations. I found that the best allocation [using an increment of 10%] is 20% Stock A and 80% Investment B.

Even without making any cash flow adjustments, the minimum withdrawal rate was 5.53% of the original balance (plus adjustments to match inflation).

The withdrawal rate grew gradually after Year 8. It exceeded 6.0% (plus inflation) in Year 25. It was 7.7% of the original balance (plus inflation) at Year 40.

I looked at a finer allocation increment. With 15% Stock A and 85% Investment B, the minimum withdrawal rate was 5.54% (plus inflation). It started at 5.7% (plus inflation), fell gradually to a bottom of 5.54% (plus inflation) in Year 13 and then grew gradually. It exceeded 6.0% (plus inflation) in Year 31. It grew to 6.88% (plus inflation) in Year 40.

The income stream was steady enough to make the cash management (TIPS) account unnecessary.

Sensitivity Study

I reduced the Stock A dividend growth rate from 8% to 4% per year.

I stayed with the 15% Stock A – 85% Investment B initial allocation. I made deposits into and then withdrawals from the TIPS account to manage the income stream.

I was able to maintain a 5.2% (plus inflation) withdrawal rate through Year 26. It fell to 4.7% (plus inflation) in Year 27 and decreased gradually to 4.3% (plus inflation) in Year 40.

I was able to maintain a 5.1% (plus inflation) withdrawal rate through Year 32. It fell to 4.5% (plus inflation) in Year 33 and decreased gradually to 4.3% (plus inflation) in Year 40.

I returned the Stock A dividend growth rate to 8% per year. I reduced the Investment B dividend growth rate from 2% to 0% per year.

I stayed with the 15% Stock A – 85% Investment B initial allocation. I made deposits into and then withdrawals from the TIPS account to manage the income stream.

I was only able to maintain a withdrawal rate of 4.6% (plus inflation).

Failure Mechanism

Because there are no sales, the failure mechanism would be a drop in the purchasing power of dividends. The worse case for the S&P500 index after 1950 (using January values) was a drop from $16.606 in 1967 to $12.567 in 1976. This was a drop to 75.7% of the original buying power. It took until 1990 to gain a full recovery.

Conclusions

A retiree should focus on the higher yielding Investment B (Harvest) portfolio. I used a value of 2% per year in my basic investigation. I used 0% per year in my sensitivity study.

This portfolio is likely to meet its 2% per year dividend growth baseline. Its individual holdings have dividend growth rate forecasts of 2% to 8% per year.

Similarly, the individual holdings of the Stock A (Builder) portfolio have a history of exceeding the 8% per year dividend growth rate that I assumed.

Taken at face value, the Morningstar Dividend Investor portfolios allow you to withdraw at least 5.54% of the original balance (plus inflation) on a continuing basis.

Applying the worst case dividend cut of the S&P500 index since 1950, the buying power could fall to a 4.2%. Treat this as an absolute worst case outcome.

Recommendation

I recommend that the cautious plan on a withdrawal rate of 4.6% to 5.1% (plus inflation) as indicated by the sensitivity study. They can reinvest any excess to guard against a widespread reduction of dividends.

Have fun.

John Walter Russell
March 25, 2007