I determined when I first started investing back in early 2010 that the dividend growth investing strategy was extremely robust for my goals. And I’ve relentlessly pursued it, building up the six-figure portfolio I now control.
I wanted to be in a position to where I could retire by 40 years old, and live solely off of the passive income my portfolio generated. And I wanted to make sure that the income would never stop flowing, forcing me back into the workforce. Furthermore, the income had to increase over time, keeping up with inflation and making sure my purchasing power stayed intact.
I’ve already shared my reasons why I believe dividend growth investing is such a great strategy for those seeking retirement or financial independence very early in life. But let’s take a look at a major alternative out there.
The Trinity Study
The Trinity Study, affectionately referred to many as “The 4% Rule” or “4% Safe Withdrawal Rate Rule Of Thumb”, is an informal name referring to a paper released by three professors of finance at Trinity University.
The paper studied withdrawal rates, and how much an investor could theoretically withdraw from a portfolio on a yearly basis with a low likelihood of running out of assets.
It concluded that during a 30-year retirement, there was a high chance of success if one were to withdraw 4% per year of assets in stock-dominated portfolios at the outset, and adjust annually for inflation. If one were to simply withdraw a static 4% year after year, the probability of success was also quite high in portfolios with a more conservative mix of stocks and bonds.
The professors used information provided from Ibbotson Associates covering the 1925-1995 period, which includes the Great Depression, but not some of the more recent issues, like the recent financial crisis and Great Recession. Of course, that 70-year period also had many years where fixed-income rates were significantly higher than they are right now.
Thus, to many people investing for retirement is quite simple. You invest a sizable portion of your assets in index funds and withdraw 4% per year, adjusting for inflation or not based on your asset mix.
However, there are two major hangups to this strategy for me:
- The study was based on a 30-year retirement. I plan to retire by 40, which means I’d have to make sure my investment income could potentially last twice that time frame.
- The strategy requires the selling of assets, which potentially increases your chance of failure with every subsequent withdrawal. And every withdrawal further limits the earnings and income power of the underlying asset base.
The 4% Rule For Early Retirees?
My main issue with the idea of investing in index funds and then just withdrawing 4% per year means that there’s a chance that I’d eventually run out of income since I’m going to be living off of my investment income for much longer than the time frame used in the Trinity Study. Especially so if I start to adjust for inflation and increase my withdrawal rate.
Of course, there are many other reasons I’m not an index investor, but this is one of my primary reasons. For those that are anticipating a much shorter, traditional retirement, then investing in a couple of index funds and withdrawing 4% per year would most likely suffice just fine.
But what about those with much longer time horizons, where living off of passive investment income needs to be realistic for 3-4 decades or longer?
I propose for these people that investing in a collection of wonderful businesses that regularly and reliably pay and raise dividends is a better solution, and I’ll discuss why.
Sell Off Assets Piece By Piece
When reading about the merits of investing in funds and then selling off pieces of the portfolio to compensate for the spread between any dividends they may pay and the amount of income you need to pay your bills, I cringe a little. And that’s simply because every sale of underlying assets means you have a smaller asset base with which to generate future income. Sure, the broader market may compensate for this for periods of time, awarding each share in your funds a higher price, thus buoying your overall net worth. However, the percentage actual equity you own in real companies is declining with every subsequent asset sale, and the amount of income these ownership positions can possibly generate is declining as well.
You can’t start with 1,000 shares of Johnson & Johnson (JNJ) and sell 50 shares per year, hoping that the market will continue to value each share more and more over time to compensate the difference. Not only is that unlikely as the stock market rarely moves up in such a linear fashion, but you’ll still end year one with 950 shares, year two with 900 shares, year three with 850 shares, etc.
You can see where that’s going. Each share may be worth more if things go just right both with the company and the stock, but you’ll still own less equity in the company. And less equity will reduce your dividend income year after year, meaning you may have to accelerate your sales over time, further reducing your income-producing asset base.
Now, Johnson & Johnson has a 52-year streak of raising its dividend. And the strong likelihood of this continuing far into the future is one of the big reasons it’s currently my largest position by value. So dividend raises by the company will, to a degree, counteract stock sales, meaning each share left should produce more income than it did the previous year. But this counteracting effect will be reduced and eventually eliminated as time goes on for two reasons:
- The amount of shares you own continuously decreases. As time passes, even static asset sales in terms of the number of shares sold increases the percentage of equity lost, and dividend raises will not be able to keep pace.
- Inflation reduces the real value of money over time. This means your asset sales will likely have to increase as time goes on just to keep your purchasing power intact. So those asset sales will likely not stay static over time, thus accelerating the loss of organic income.
And eventually, you run out of assets to sell.
Furthermore, if the broader market has a major correction this can have a substantial impact on your ability to sell off parts of your portfolio. For instance, the S&P 500 index experienced a -38.47% change in 2008. Investors in a broad S&P 500 index fund would have had a rough year. At that point, not only is your asset base then generating less income with every sale, but the actual value of your assets have plunged. That can leave one in an awfully precarious position.
Real Estate Example
Let’s look at this from another angle. This example is a little tongue-in-cheek, but I’m trying to extrapolate my point.
Imagine you’re a real estate investor. You have a few rental properties netting you $1,500 per month from rental income, which puts you in a pretty good spot. Unfortunately, your bills are $2,000 per month. You’re now retired and not interested in getting a part-time job, so where do you come up with the extra $500 per month?
Well, you simply sell off part of your real estate portfolio, in a piecemeal manner every single month: First goes a little siding here. Then it’s roof shingling there. Then the plumbing has to be sold.
What’s happening here as you sell off your rental properties in pieces?
Well, the amount of rent you can possibly collect from these properties is going down, rather than up. Instead of having a portfolio of high-quality assets generating rental income that will likely rise with inflation, you’re slowly turning your properties into shoddy homes, thus limiting the chances of attracting tenants that will rent from you at all. And any that do rent from you certainly aren’t going to be paying what you were charging before you started selling off pieces of the homes.
My Dividend Growth Portfolio
Instead of selling off assets, I’d prefer to keep my equity intact and collect the rising income those intact assets can produce over time. Why would I want to sell off chunks of The Coca-Cola Company (KO) when I believe they’re going to generate more profit and dividends over the next 10 years? Why would I want to own less and less of the company?
I have 49 individual equity investments right now. These are all what I believe to be high-quality companies that are well-positioned to grow their revenue, earnings, and dividend payments to shareholders over the next 10 years and beyond.
If I would have had this same exact portfolio through the Great Recession I would have faced only two dividend cuts – General Electric Company (GE) and Wells Fargo & Co. (WFC) both cut their dividends in 2009.
I’d like to think I would have seen these dividend cuts coming and appropriately reacted, but there’s also a very good chance I wouldn’t have. As such, I would have seen income reduction from these two particular investments (neither completely eliminated their respective dividend). But the majority of the other companies that were paying a dividend back then kept right on increasing their payout right through the financial crisis, and I would have experienced an overall income boost. And that was during what very well may be the greatest economic calamity I’ll see in my lifetime! Not too shabby.
Is Dividend Growth Investing The New 4%?
It’s funny, but I think these two strategies aren’t really that far apart.
For instance, I’ve noticed that the overall yield of my entire portfolio has oscillated between ~3% and ~4% since its inception. For much of the last couple years, my portfolio’s yield has been steadily declining from around 3.8% to below 3.5%. And that makes sense as I shift from investing in Stage 1 stocks to Stage 3 stocks, and as the value of the stocks I’m invested in increases, advancing with the broader market. Rising stock prices causes their yields to fall, as the two are inversely correlated.
But if you can construct a diversified portfolio chock-full of equity in fantastic businesses that can also generate a yield for you that’s in the 3.5% or so range, you’re coming pretty close to the 4% safe withdrawal rate without actually trying to. However, you’ll be in even better shape if you’re solely living off of the dividend income your portfolio generates. Because at that point your dividend income will surely rise over time while the value of the underlying businesses also rise in kind. Your income and your wealth grows, and your odds of actually running out of either are extremely low.
You would be living off of the organic income your portfolio generates with this strategy. No asset sales are necessary.
And it wouldn’t be impossible to construct a portfolio with a 4%+ yield, meaning you have reached the same yield level of the 4% SWR without needing to sell off assets. Shares in companies like AT&T Inc. (T),Realty Income Corp. (O), Kinder Morgan Inc. (KMI), and Philip Morris International Inc. (PM) all yield more than 4%, and all of these companies have histories of regularly rewarding shareholders with annual dividend raises.
Conclusion
I don’t think investors should be looking at the 4% safe withdrawal rate as a panacea to retirement income planning. Furthermore, if you are planning on following this strategy by building up a sizable base of assets and then selling off pieces in retirement, carefully consider this aspect of income planning that the professors behind the Trinity Study qualified their findings with:
The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.
However, I think most would be better off looking at planning for (early) retirement with the mindset of permanent wealth protection. That is, one shouldn’t be interested in selling any assets at all, unless a major emergency required such. Selling assets has a kind of reverse compounding effect, where the income that your investments can possibly generate declines over time, requiring every subsequent asset sale to be potentially larger than the last, depending on market conditions.
Dividend growth investing, in my opinion, offers the best of both worlds. You can customize your overall portfolio yield, and very likely get the aggregate yield of your entire portfolio near 4%. Thus, you’d be collecting your 4% yield in income without having to sell any of the underlying assets, allowing them to grow along with the dividend income they provide to you. By living solely off of the organic income your portfolio produces, you can allow your wealth to continue compounding. That could provide an extra layer of safety as you age, and potential medical problems increase the likelihood of having to tap assets. Furthermore, it could provide a legacy to pass on to others, if you so choose. You can actually have your cake and eat it too!
Full Disclosure: Long JNJ, KO, GE, WFC, T, O, KMI, PM.
What’s your opinion? A fan of the 4% SWR? Think dividend growth investing allows you to have your cake and eat it too?
Thanks for reading.This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]
