Whenever I ask soon-to-be retirees what the ultimate goal of investing in retirement is, the most common answer I hear is:
I don’t want to run out of money.
Pretty straightforward, right?
Here’s the problem. When I ask many of those same individuals what the primary objective of their retirement portfolio is, this is the typical response:
Preservation of principal.
Whether retirees realize this or not, those two goals run almost exactly counter to one another.
If your goal is to preserve your principal, you are likely to invest primarily in fixed-income assets which, especially at today’s interest rates are barely keeping up with inflation. Making matters worse, it seems likely that interest rates will increase over the next few decades which is a bad thing for bondholders. If the interest your bonds pay doesn’t keep up with inflation, then you are likely digging into your principal every year you need distributions. And if interest rates are rising, your balance may be falling at the same time.
This can result in the exact outcome people fear most - running out of money. Albeit, they may run out of money without the perceived risk of investing in the stock market.
I don’t think the goal of a retirement portfolio should be principal preservation. The goal of a retirement portfolio is to provide a growing income that meets or exceeds inflation and to accrete principal if at all possible.
If your income doesn’t keep up with inflation, you have almost no choice but to dig into principal which is the antithesis of retirement income planning. So, how might you accomplish both goals of growing your income and your portfolio?
Let’s take a dive into the overlooked miracle of dividends and how they did over the last 30 years (the average retirement):
If you had $1,000,000 in 1990 and invested those funds in a pretty standard allocation of 75% equities and 25% fixed income, what would have happened to your dividend income and investment balance of the equity portion since that time?
Using data from NYU Stern[1][2], based on an initial equity investment of $750,000 into the plain-vanilla S&P 500, we can see that the dividend income would have grown about 5x from ~$25,000 per year to ~$125,000 per year. This would happen during a period where inflation increased only 2x!
If that’s not enough, what happened to your portfolio balance of equities? They would have grown quite nicely as well. Assuming your dividends were paid 100% in cash to live on, your underlying principal (remember, this is what everyone is so worried about), would have grown from $750,000 to about $6,800,000 over the same period.
Surely, somebody somewhere is going to accuse me of cherry-picking data. But this is just the last 30 years which includes the 2nd and 3rd largest declines in the history of the U.S. stock market. As I regularly say, I don’t know what the future holds, but I know what has happened historically and that is over the past 60 years, the dividends of the S&P 500 have grown at a compounding rate of close to 6%.
I’ve heard most of the arguments against dividends at this point, but one thing I love about them is that dividends are the only way you can get income from your equity portfolio without having to reduce your ownership in the great companies of America and the world.
In retirement, this little benefit can help from an emotional standpoint knowing that your ownership interest is the same, all the while you continue to collect a paycheck. In other words, you can pay more attention to the share balance (and your paycheck), and less about the dollar balance so to speak.
I believe a portfolio of assets consisting of the great companies of America and the world must be a significant consideration and piece of the portfolio to provide the growth of income that is so desperately needed.
During times of market turmoil, I believe retirees who can maintain a primary focus of the dividend income stream their portfolio is distributing are less apt to react to the all-too-common market downturns that await a 30-year retirement.
To be clear, as I laid out in my example, I am not saying retirees should be 100% equities, but I believe the conventional wisdom of going into retirement with primarily fixed income investments is going to disappoint a lot of retirees. Making matters worse, by the time retirees realize it was the wrong strategy, it will be too late.
At current, the dividend yield is running about three times the 10-year Treasury note at just over 2% versus 0.64% respectively. In other words, based on the current dividend yield, you could get 3x the income and as a bonus, you can participate in the future growth of the underlying companies.
Surely, most retirees should have a percentage of their portfolio allocated to fixed income as a safety net for a variety of reasons, but I think many retirees underestimate how long they’ll live, what inflation will do to their standard of living, and overestimate the negative impact bear markets have on long-term investing.
It’s worth noting that the current landscape of investing and dividends is mired in a bit of uncertainty as we speak. Somewhat recently, we experienced a significant decline during the Great Panic of 2008 when dividends were cut by about 21% due primarily to the financial sector.
At the moment, we are seeing similar dividend cuts in the energy and consumer discretionary sectors. This is why the diversification of your dividend income stream and overall portfolio is so important. It is also one of the primary reasons to keep the safety net of fixed income to account for these types of events. All these tools work together for a reason.
I welcome your thoughts and ideas.
Thanks for reading!
-Ashby
Related Articles:
- Retirement Income in Bull Markets, Bear Markets & Flat Markets
- A Portfolio Strategy for 30-Year Retirements
- Why I Prefer Dividend Income Over Total Return in Retirement
Footnotes:
[1] NYU Stern Data Set 1
[2] NYU Stern Data Set 2
This post is not advice. Please see additional disclaimers.