The one constructive response I received on the article, A Portfolio Strategy for 30-Year Retirements, was the preference for total return versus dividend income. If you haven’t read it, I’d encourage you to do so now as what follows will make much more sense.
Before we dive in, let’s first define total return investing. Total return investing is the idea that there is no preference for investment gains, whether via dividends or growth of underlying capital. The thought process here is that the client should be agnostic to where the return is coming from and should focus on “maximizing” return which in turn could/should yield higher overall growth and by extension a higher overall income.
Let me first say, I agree with this philosophy. I’ve been a long-time advocate for total return investing – and still am today.
Personally, I abide by the total return approach in my own portfolio – but I am thirty-five years old with thirty years to go before retirement. So, naturally, I want to maximize my overall growth potential and I hold no preference for dividends or capital growth. I just want my portfolio to compound at the highest rate possible.
But I don’t believe it’s the best way to approach retirement income because when you get to retirement, things change – not in the sense that your portfolio should become overly conservative (bond heavy) as conventional wisdom dictates, but your appetite for risk changes and your views on the markets are likely to change. Retirees can often become apprehensive about the volatility of their overall portfolio. Maybe this is true for you as well.
When it comes to generating income from a retirement portfolio, I am looking to balance two things – the need for long term income growth and to minimize portfolio mistakes in retirement if at all possible.
If you have an increasing stream of dividends paying out, let’s say 2.5% – 3%(ish) for year one in retirement, you’ve already generated between 60%-75% of the income you might need based on a 4% withdrawal rate with little regard for portfolio volatility. If you’re like many of my clients, that 2.5%-3% dividend stream may be all the income you need.
Even if you need the full 4%, you would only need to withdraw capital (sell principal) to create another 1%-1.5% to round out your required income. From here, a bucket approach that provides the flexibility of where to withdraw the income can offer an additional lever to pull to fend off any emotional issues that could arise due to market volatility and the need to sell assets for income purposes.
For example, let’s say you have a $1,000,000 portfolio (75% equities / 25% fixed) and need $40,000 per year from your portfolio. Let’s assume the equity portion of your portfolio has a 2.75% initial dividend yield as a middle ground. Your income stream might look like this:
Equity Dividend Income: $750,000 x 2.75% = $20,625
Remaining Income Needed From Your Portfolio: $40,000 – $20,625 = $19,375
In good markets, where your underlying equity capital is increasing, you might choose to withdraw the remainder from equities. In poor markets, you might choose to withdraw from your fixed income portfolio. Even assuming 0% growth, the $250,000 in fixed income could support 12+ years of the income shortfall assuming the dividend income is stable. (Please reference the subsection “Goal #1: A sustainable and growing income that keeps up with inflation” of this post for the historical stability and income growth of this assumption.)
I willingly admit that this is an oversimplified example because we’ve omitted a variety of variables, but I think it’s valuable to see how this could play out in a real-world scenario in year one of retirement.
Disclaimer: This is a hypothetical example for illustration purposes only. Actual investor results will vary.
If we were relying solely on a total return portfolio, the yield almost certainly would be lower as the overall dividend yield for the past year has been hovering around 1.9% for the S&P 500. And if you carry a “growth-oriented” portfolio into retirement, your initial yield may be lower still. In either case, the stressful decision of what to sell and when is greater.
And, perhaps most importantly for people retiring today, if you were taking a total return approach, what would you do in prolonged down or flat markets as we experienced from 2000-2010 where 100% of market returns were due to dividends? (see below.)
This is the exact stress I am attempting to minimize by utilizing a dividend growth portfolio. While there are no fool-proof strategies that can eliminate all stresses associated with portfolio withdrawals, it hopefully becomes a much smaller factor to deal with when people can see that a significant portion of their income is generated from a consistently (historically) increasing dividend income.
In fact, the further along in retirement you are, you may very well see a concurrent reduction of sequence of return risk as well as a dividend income stream that has grown significantly further reducing the need to liquidate additional principal.
These factors, coupled with maintaining a consistent paycheck similar to what you experienced during your working years, might provide the comfort you need to make better retirement decisions overall and allow you to find more enjoyment in the process.
Thanks for reading!
Disclaimers: Opinions expressed are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Any information provided is for informational purposes only and does not constitute a recommendation. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Keep in mind that there is no assurance that any strategy will ultimately be successful or profitable nor protect against a loss. Investments mentioned may not be suitable for all investors.
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I am a Financial Advisor in Pittsburgh and a CERTIFIED FINANCIAL PLANNER™ professional with Shorebridge Wealth Management. I enjoy helping clients and readers find sensible answers to retirement’s big questions. If I can answer any questions for you, feel free to Contact Me or if you think you might be a fit for our practice, see Who We Serve.