Marrying The 4% Rule With Dividend Growth Investing

by: Eli Inkrot

For my long-time readers out there, you know that I frequently use this forum as a means to counteract otherwise "common" financial wisdom. For instance, in my last article I detailed why savings accounts provide a losing proposition in today's environment. Prior to that, I've developed rational arguments against using aggregation vehicles instead of individual stocks, not relying on standard deviation or beta as risk measures and even offsetting the idea that portfolios should be arbitrarily shifted as one ages. It's amazing how certain financial ideas become widespread, despite the common sense notion that nearly everyone has varied if not unique circumstances.

In developing theses ideologies, I believe it's important to underscore the idea that I'm not walking around looking for viewpoints to criticize. There's a bevy of possible solutions out there; not a single sure fire path to success. Rather, I use these critiques as a means to bring balanced thought to the table.

Recently it occurred to me that one of my more fundamental ideas about "common" financial wisdom could be misguided. If you glanced at the title of this article, you know what I'm talking about: the "4% rule." I used to believe that this "rule" was imprudent at best and especially hazardous for a great deal of investors. My thinking went something like this: an individual has saved diligently for decades - delaying gratification today for greater future benefits - by partnering with wonderful companies. In turn, I argued that many investors rather enjoy these partnerships whereby they can eventually "enjoy the fruits of their dividend labor" - by living off the dividend income stream.

On the other hand, the "4% rule" works on the premise that an investor can continuously sell these partnerships in the expectation of future growth - nearly allowing their "last check to bounce." Your portfolio went down 30% this year? Tough luck, because you still need something to live on so you can just sell at the bottom. Rather than maintaining their financial fortress, it seemed that the "4% rule" allows an investor to slowly sell away their financial castle's cornerstone bricks in a race to portfolio depletion or ruin.

However, it dawned on me that these two ideas - dividend growth investing and the "4% rule" - aren't necessarily all that different. My previous thinking was binary. With dividend growth investing, one builds up a collection of companies that not only pay but also have a high propensity to increase their payouts every year. Once your dividend income trumps your living expenses, you've reached financial satisfaction. With the "4% rule," you invest until you reached "your number" and then began periodically selling away 4% of that invested heap over your retirement. In the first scenario, the wealth is perpetual, in the latter it's dwindling. Yet this doesn't have to be the case.

I'm certain that this occurred to others sooner than it occurred to me, but my esteem for DGI and distaste for the 4% rule is actually a bit hypocritical. What I was talking about - living off dividends - and what this "rule" was talking about - living off investment growth - is effectively the same idea. Allow me to explain.

Numerous Dividend Growth Portfolios happen to hover around the 2.5 - 3.5% current yield mark or thereabouts. And the reasoning is relatively simply: most DGI portfolios have a similar core of well-known payout stalwarts like Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), Kimberly-Clark (NYSE:KMB) and PepsiCo (NYSE:PEP). Sure the current yields move about, but in general you're not going to see Coca-Cola with an 8% current yield or JNJ yielding less than 1%. Thus with DGI - once one has reached financial independence - they would take income from the portfolio that roughly equates to a 3% current yield.

Alternatively, the "4% rule" takes away - you guessed it - 4% of the portfolio each year. Well, 3% and 4% aren't all that different really. With a little bit of effort and a touch of yield seeking, it's quite possible to construct a DGI portfolio that has a current yield of 4%. In fact, I'll provide an example to illustrate my point.

Click to enlarge

Here I used the Portfolio Review feature of F.A.S.T. Graphs to demonstrate a sample group of holdings. Note that I simply picked 10 well-known dividend companies - with 5 of them yielding above 4% and the other 5 yielding below 4%. An obvious criticism is that this "portfolio" is skewed towards utilities and large oil companies - but that's not the point. The idea was that it's not especially difficult to come up with a group of dividend companies that have a collective current yield around 4%. Furthermore, I would argue that these companies in particular have a reasonable shot of keeping up with inflation as well. Here's a look at the historical annual dividend growth rates over the last 10 years for these selected companies:

AT&T (NYSE:T) 5.2%
Southern Company (NYSE:SO) 3.7%
BP (NYSE:BP) 3.3%
Consolidated Edison (NYSE:ED) 0.9%
ConocoPhillips (NYSE:COP) 15.1%
McDonald's (NYSE:MCD) 28.4%
Chevron (NYSE:CVX) 9.6%
Kimberly-Clark 9.5%
General Mills (NYSE:GIS) 8.7%
Click to enlarge

During the past decade these 10 companies grew their payouts by an average of just under 9% a year. Granted McDonald's rate tilts the average a bit, but even if the companies are only capable of growing their aggregated payouts by half or even a third of that moving forward, this would still indicate a solid chance of keeping up with inflation.

Expressed differently, while the concepts of DGI - not selling any partnerships - and the "4% rule" - always selling partnerships - seem to be worlds apart they in fact can be precisely married. In this particular example, there's a pretty solid chance that one could withdraw a 4% current yield without touching principal. You get the benefit of extracting 4% of your portfolio without the hangover of losing your equity stake interest - it doesn't violate either strategy. Moreover, this income stream would be expected to grow rather than vary with the size of the portfolio. And of course the numbers get more interesting if you dabble in the REIT, MLP or Preferred Equity universe.

Overall, I find it interesting that you can have the "best of both worlds" by marrying the two concepts. To be clear I still prefer the DGI side of the table; however, too often we cast away ideologies that aren't perfectly similar to our own. There are a variety of ways to approach this investing game and to be frank most of them will work out just fine. Habitually, investors get caught up in definitional terms rather than the possibilities for general application. While I certainly don't agree with selling my wonderful partnerships, I do agree with the idea of living off the rewards that they provide. In reality, these two streams of thought are more alike than they are different; whether you live off dividends or create a "sell-off" approach a la Warren Buffett's most recent shareholder letter we're getting at the same concept. Perhaps you too have overlooked some "common" financial insight along the way.

Disclosure: I am long GIS, MCD, SO, COP, PEP, JNJ, T, CVX, PG, KO. 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.