Most recent college graduates have not put a lot of thought into retirement. This is usually because they believe it to be too far away, or that they don't have any expendable income to invest. What they do not realize is how severely they are hampering their odds of an enjoyable retirement. It is crucial to start investing as soon as possible, even without a substantial initial investment.
There are many different investment options available to investors, each of which has its own benefits. These include 401ks, IRAs, Roth IRAs and defined benefit plans such as pensions. Although it is important to diversify between different plans, I will focus mainly on a do-it-yourself dividend portfolio and the advantages it provides for an enjoyable retirement.
I will explain below why I believe a dividend growth portfolio to be the best possible option for young investors looking to invest for the long-term. The power of compounded returns, coupled with increasing dividend payments, will provide a foundation for an enjoyable retirement. It is not just important to save money, but to invest it in an efficient manner to achieve high returns. Below I will select some stocks that I feel give investors the greatest chance for success in dividend investing.
Let's take a look at fictional character Dave, who has just starting working after graduating college at the age of 22. He has begun to consider putting away a portion of his income into a retirement fund, but does not have any current savings to contribute. Dave's starting salary is $40,000 and needs to pay rent and bills, which he feels does not leave him with much income to invest. Here is how Dave can set himself up for retirement by saving just $3 daily, only 2.5% of his current gross income. By investing this in quality dividend growth stocks, Dave can provide himself with a reliable stream of dividends to draw from in retirement. Here are three qualities to look for in dividend-growth stocks:
1. Payout Ratio - I prefer to see a low payout ratio because it allows a higher margin of safety for the dividend, while at the same time ensuring that the company can focus on growing earnings. Although payout ratio can be deceptive in some cases, I find that in most cases it can be an effective tool for evaluating payouts. Since increasing the payout ratio is one of the few ways to provide dividend increases, it is an important part of this Dividend Growth Scorecard.
2. 1/3/5 Yr Dividend Growth Rates (DGRs) - The rate at which a company has recently been growing its dividend is very important in my decision to invest. Since I look for companies that I can hold long-term, I want to increase my income stream not only with reinvestment, but also dividend growth. Ideally, I like to see annual dividend hikes of greater than 10% over the past 5 years with accelerating increases.
3. Earnings Growth - Sometimes dividend growth rates are not enough information for the investor to act on. If a company is raising its dividend without increasing earnings, it will eventually run out of money for its payouts. Although I like established companies with long track records of dividend increases, I still want to see a good rate of earnings growth.
$3 every day for 365 days per year adds up to $1095 in annual contributions. This means that by the time Dave turns 23 he will have that amount available to invest in his retirement; not a bad start. Dave invests in blue-chip dividend growth stocks, with an average current yield of 4% and annual dividend growth of 7% annually. We will assume that capital growth mirrors dividend growth to keep yield consistent throughout the example. Here are some solid stocks that Dave could invest in long-term to achieve his desired yield and growth:
|Company||Yield||3 Yr DGR|
|Intel Corporation (NASDAQ:INTC)||4.30%||15.8%|
|Lockheed Martin Corp. (NYSE:LMT)||4.88%||19.6%|
|Philip Morris Inc. (NYSE:PM)||3.70%||12.8%|
|AT&T, Inc. (NYSE:T)||4.92%||2.4%|
Intel Corporation - Yield: 4.30%, 3 Yr DGR: 15.8%
Why it is a good retirement stock: High current yield combined with a low payout ratio and solid dividend growth make Intel a solid long-term pick. Current prices offer an attractive entry point as valuation has suffered due to weakness in the PC market. Look for Intel to make a push into the mobile and adapt to the changing industry.
Lockheed Martin Corp. - Yield: 4.88%, 3 Yr DGR: 19.6%
Why it is a good retirement stock: With a yield of almost 5% and very high recent dividend growth, LMT is a very solid income stock. The security and aerospace industry should continue to stay strong in the future, and Lockheed is in a great position to capitalize on this.
McDonald's Corp. - Yield: 3.12%, 3 Yr DGR:11.9%
Why it is a good retirement stock: The fast-food giant is about as safe as they come. During good times and bad, MCD will continue to adjust to the economy and increase earnings. With one of the most recognizable brands in the world and strong margins, McDonald's will continue to thrive for a long time.
Philip Morris International - Yield: 3.70%, 3 Yr DGR: 12.8%
Why it is a good retirement stock: As unhealthy as the tobacco industry is, companies such as PM enjoy great profit margins and relatively inelastic demand. Philip Morris has been increasing its dividend at a rapid pace, and seems to be a good bet for future growth due to the opportunities around the world.
AT&T, Inc. - Yield:4.92%, 3 Yr DGR: 2.4%
Why it is a good retirement stock: The smartphone industry is growing at an incredible pace, and this translates into an increasingly greater need for telecom companies. AT&T is the largest telecom player and generates a tremendous amount of cash flow from operations. Although its dividend does not grow like some of the above companies, the safety and reliability combined with high yield make T a great stock for retirement.
Each one of these companies is in a dominant market position in its respective industry. Although owning only 5 stocks is not enough to be diversified, the high yields and growth rates of these companies make them a solid foundation for the dividend growth portfolio required in this scenario.
That $1095 that Dave has accumulated by the time he turns 23 grows 7% in his first year, to a total of $1172. He also receives $44 in dividend income, which is reinvested along with the annual $1095 in contributions. This gives Dave a total of $2,310 by the time of his 24th birthday. Shown below is the chart of his portfolio up until his retirement age of 65.
This chart makes it very easy to see the power of compounding that was the result of Dave's early start. Although his annual dividend income increases by only $50-$100 initially, it rises by thousands of dollars as he approaches retirement. So by only contributing $3 per day into his account, Dave will accumulate a portfolio with a value of $875,000 and annual dividend income of $35,000. It is important to note that this is 40 years in the future, so the purchasing power of these amounts will not be what it is today, although it is still a respectable amount. Also important to note is that if Dave had waited until age 27 to begin contributing, his portfolio would only be generating about $20,000 annually.
Dave wants to have annual income until he is 100 years old, and calculates that he can now withdraw about $110,000 annually and have his money last for 35 more years. The chart below shows the effect of his withdrawals on his portfolio.
Here is a graph showing the value of the portfolio at each age of Dave's life as he deposits money and then withdraws in retirement.
Dave's Portfolio Value Over His Lifetime
The lesson learned from this example is that it is crucial to begin contributions to your retirement portfolio as early as possible, even if it does not seem like a significant amount. Just by getting the compounding process started, young investors give themselves a significant advantage. The example above shows how just $3 per day can create an investment that can contribute greatly to retirement.
Disclosure: I am long INTC, LMT, MCD, PM, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.