When I look to add dividend-paying stocks to my retirement portfolio I always look for companies that have a long history of paying dividends as well as a history of solid growth in those dividends. It's even better if the company has shown it can weather recessions by not cutting its dividend when the economy goes south.
When Microsoft (MSFT) announced a 22% increase in its dividend last week I decided that it was now time to add this stock to my retirement portfolio. Its dividend growth has been 18% annually for the past five years and it has plenty of cash on hand and free cash flow to keep this dividend growth going. With a low payout ratio of only 34%, a 2.8% dividend yield and resilient dividend growth, this stock is now a wonderful candidate for retirement portfolios.
This article is not going to recommend that people invest heavily in stock funds or ETFs for the rest of their lives. This strategy has gotten too many people into way too much trouble over the past 15 years. What I want to discuss today is how carefully selecting and investing in dividend-paying stocks that will have solid dividend growth for the next 20 years, such as Microsoft, can pay off big time in the long run and reduce stress immensely as movements in the stock price eventually barely matter.
Although I will focus on Microsoft in this discussion, the strategy here applies to many companies that have a solid history of increasing (or at least not cutting) their dividends over time, even during recessions. Other companies that fit this mold are Johnson & Johnson (JNJ), Exxon (XOM), Coca-Cola (KO), Intel (INTC), 3M (MMM), Chevron (CVX), Procter & Gamble (PG) and Wal-Mart (WMT).
What I want to show today is how a dividend-paying stock like Microsoft can change a person's entire retirement situation. I want to take a look at a 45-year old couple that has been scared out of the stock market and currently has everything invested in long-term Treasury bonds at 2.9%. They currently have $400,000 saved. Let's also apply an inflation rate of 2% for each year. They plan on retiring when they are 65. How much money can they expect to have when they retire if we take into account inflation? For this example I assumed half of their money was in a qualified, non-taxable account such as an IRA. They pay taxes at a 30% rate on their investment income and dividends are taxed at a 15% rate.
Here are the results for this couple if they keep all of their money invested in low-yielding Treasuries:
Real Annual Return After Taxes
In 20 years their investments have only grown by a mere $55,890 if we reduce everything by the inflation rate. That is only 0.60% per year in real terms. I plugged in these numbers into our Retirement Planner and found that this couple would only have a 17% chance of not running out of money if they save $10,000 a year for the next 20 years, spend $45,000 a year in retirement and receive $35,000 a year in social security payments. This couple is headed for serious trouble.
Now let's look at the case where they invest in a basket of solid dividend payers such as Microsoft. It is important to note that I am not recommending investing in just one stock. I am recommending investing in a basket of solid dividend-paying stocks that have characteristics similar to Microsoft.
In this example I assumed a dividend yield of 2.8% (Microsoft's current dividend yield). I was also somewhat conservative about the long-term annual dividend growth assumption. I chose 12% even though the five-year annual dividend growth rate is 18%. I also assumed no increase in the stock price at all. I ran these numbers in our free online calculator called Dividend Yield And Growth.
Real Annual Return After Taxes
Now we're talking some real money when they retire. They will have over $1 million (in today's dollar terms) when they retire. Plugging these numbers into our Retirement Planner I found that they now have an 85% chance of never running out of money in retirement. It is important to keep in mind that I assumed no change in the stock price in this example. I wanted to show how just collecting the dividends from strong dividend growth stocks can have such a large impact. If we assume the price of the stock increases by just 2% per year over this time frame the ending real value of the account is over $1.5 million and the probability of never running out of money in retirement jumps up to over 95%.
Because of the time factor involved with dividend-growth stocks it is of utmost importance to begin investing wisely when you're relatively young. For those who are already in their 60s this strategy will not be as useful, although it can still be a significant part of their overall strategy.