The Delayed Purchase Concept

Dividend based strategies provide a continual, growing income stream. They start at a low percentage of the original portfolio balance. The failure mechanism is gentle.

Liquidation strategies provide a higher initial income stream. They can run out of money in a finite number of years. Studies usually report 30-year withdrawal rates. The failure mechanism is abrupt: portfolio bankruptcy.

The delayed purchase concept is to start with a liquidation strategy and later switch to a dividend based strategy when conditions are right.

Various Strategies

A portfolio of high quality, dividend paying stocks can produce a steady income stream that grows at least as fast as inflation. Starting from today’s low payout ratios, such growth is almost certain. It is never necessary to liquidate any shares.

The problem of living off this income stream is that it starts at a low level, typically in the neighborhood of 3% of the original balance (plus inflation).

You can boost the initial income by adding a TIPS ladder and slowly liquidating the principal. If the dividend payments grow fast enough, they will make up the difference well before the TIPS ladder runs out of money.

Using this method boosts the minimum payout to 3.5% to 3.6% of the original balance (plus inflation) under extreme worst-case conditions. It boosts the payout to 4.0% of the original balance (plus inflation) under a more reasonable choice of worst-case conditions.

Through a series of sensitivity studies, I found that these payout percentages work with almost any combination of TIPS and stock allocations. These findings hold up through Year 20 and, sometimes, longer.

This concept becomes more aggressive as the initial TIPS allocation increases to 50% or more.

Exploiting Valuation Changes

In spite of the bursting of the bubble in 2000, today’s valuations are sky high. The S&P500 index yield is 1.8%, far below historical norms. The P/E10 of the S&P500 is close to 28. The historic norm is 13 or 14. At stock market bottoms, P/E10 = 5 to 8.

If we start with a high initial TIPS allocation, we can boost our income dramatically. We should be able to purchase many more shares when buy our dividend paying stocks. If stock prices return to normal, dividend yields will double. If stock prices fall to the bargain levels seen at bottoms, dividend yields with quadruple.

Under a reasonable set of conditions, this increases the payout to 5.6% of the original balance (plus inflation). Payouts eventually rise even more through sustained dividend growth.

Notice that prices do not have to remain low. They need only to fall momentarily, at which time you buy shares.

Here are some objective criteria for purchase:

P/E10 is a good indicator. It makes sense to buy a few shares when P/E10 falls below 20. It makes sense to add more shares when P/E10 falls to 13 or 14. It makes sense to buy heavily when P/E10 falls below 8. The corresponding S&P500 dividend yields are 2.5%, 3.6% and 6.3%. High quality, dividend paying stocks should be yielding 4.2%, 6.1% and 10.7%, respectively.

Making Comparisons

Notice that I state results in terms of a steady income stream, which is a percentage of the original balance (plus inflation). The income is removed each year. The only other difference is the portfolio lifetime. The most commonly reported portfolio lifetimes are 30-years and indefinite (i.e., lasting far into the future).

Most of my comparisons are based on the S&P500 because that is my primary source of information. For dividend based strategies, I scale the S&P500 dividend yield (1.8%) by the yield of DVY (3.0%), an exchange traded fund. The scale factor is 1.7. I assume a dividend growth rate at least equal to that of the S&P500 index, which is 1% faster than inflation.

Here are some comparisons that I can make:

1) Safe Withdrawal Rates as a constant percentage of a portfolio’s original balance (plus inflation) over a specified number of years.
2) TIPS withdrawal rates at a specified interest rate and number of years.
3) TIPS interest rate, corresponding to a long lasting income stream.
4) Dividend based strategies mixed with TIPS to provide a constant income stream lasting indefinitely, far into the future.
5) Dividend based strategies with a growing income stream, in the sense that I can identify when the income stream grows beyond a specified percentage of the original portfolio balance (plus inflation).

I find it meaningful to talk about 2% TIPS. They have a 30-year Safe Withdrawal Rate of 4.46%, a 35-year Safe Withdrawal Rate of 4.0%, a 40-year Safe Withdrawal Rate of 3.66%, but an indefinite withdrawal rate of only 2.0%.

A simple portfolio with a delayed purchase income boost can extend the 35- and 40-year portfolio lifetimes into the indefinite future (under two different sets of worst-case conditions).

My most aggressive, but reasonable, delayed purchase approach increases the income stream to 5.6% of the original balance (plus inflation) and lasts indefinitely. The risk is that my underlying assumptions fail.

There are a variety of comparisons that I cannot currently make. I have not characterized REITS, Master Limited Partnerships and the other high yield investments that show up in many high income portfolios.

I can see a strong case for using the 5.6% (plus inflation) income stream as a standard for comparison.

I can envision a stronger case for combining approaches, using a traditional high income component, a straightforward dividend growth component and a delayed purchase component. Each component would have its own failure mechanisms and consequences.

Have fun.

John Walter Russell
January 14, 2007