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There has been a lot of debate on SA about the "4% rule" and how to best use it. As a quick review of what is meant by the 4% rule, from Investopedia:

"A rule of thumb used to determine the amount of funds to withdraw from a retirement account each year. The four percent rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that will allow funds to be withdrawn for a number of years. The 4% rate is considered to be a "safe" rate, with the withdrawals consisting primarily of interest and dividends. The withdraw rate is kept constant, though it can be increased to keep pace with inflation."

The debate, as I see it, has been between proponents of Dividend Growth Investing (DGI) and proponents of (for lack of a better term) Growth and/or Value investing (G&V). The DGI investors have argued that the best way to use the 4% rule is to build a portfolio of blue chip dividend growth stocks, which pay the owner a 4% (or more) yield. By simply withdrawing the dividends from your account, and using them to fund your retirement, you satisfy the goal of the 4% rule without having to sell any of your principle. Your stock portfolio remains intact, available to continue to grow year after year.

G&V investors, although not disagreeing that the DGI method is an effective way to use the 4% rule, also feel that simply selling 4% of your assets each year, while allowing the rest of the portfolio to continue to grow, is just as effective a way to use the 4% rule, and that in the long run the two methods will give similar results. But DGI proponents disagree, arguing that by selling shares of the stocks you own to come up with the 4% withdrawal, those shares are no longer in your portfolio, and therefore can no longer work for you to produce wealth. The G&V investors counter that as long as the rest of the portfolio grows at a rate higher than the 4% withdrawal, that it will over come the loss of shares, and work just as well as the DGI method.

Here is an example of the math the G&V proponents might use to support their argument. Assume both the DGI portfolio and the G&V start with $1,000,000. Also assume that the DGI portfolio pays a 4% yield and grows at a rate of 6% a year, while the G&V portfolio grows at 10% a year, but has to sell 4% of its assets to fund retirement. Both portfolios would end up with $1,060,000 after a year, showing that the two philosophies come out the same.

G&V:

$1,000,000 portfolio

10% growth = $100,000

4% asset sale = $40,000

$1,000,000+$100,000-$40,000 = $1,060,000

DGI:

$1,000,000 portfolio

6% growth = $60,000

4% yield = $40,000 (withdrawn from the account)

$1,000,000 + $60,000 = $1,060,000

But I feel that this does not tell the whole story. To really show if there is a difference between the two philosophies I feel that it is important to carry the math out over a much longer period of time to show the long term affect of the selling of the principle. Therefore I ran a 20 year scenario using the following assumptions:

G&V

-Starting value of $1,000,000

-A portfolio return of 10% a year

-A starting cost of living of 4% of the portfolio ($40,000) and an inflation rate of 3% added to the cost of living every year.

-Assets equal to the cost of living were sold each year to fund the retirement, not just a straight 4% per year.

DGI:

-Starting value of $1,000,000

-Starting yield of 4%, with a dividend growth rate of 6% a year

-A portfolio return of 6% a year

-A starting cost of living of 4% of the portfolio ($40,000) and an inflation rate of 3% added to the cost of living every year

-Any dividends collected that are not needed to fund the cost of living were reinvested back into the portfolio

Note that in both scenarios the total yearly return for each portfolio is 10% (10% market return for G&V, 6% market return plus 4% yield for DGI).

In each scenario, for ease of calculation, the shares of "stock" held in each portfolio are either shares of "G&V" stock or "DGI" stock, two imaginary stocks meant to represent all the stocks of a full portfolio.

Here are the results:

G&V

Year

Shares of Stock

Price

Value

Removed

Shares Sold

% assets sold

1

10000.00

$100.00

$1,000,000.00

$40,000.00

400.00

4.00%

2

9600.00

$110.00

$1,056,000.00

$41,200.00

374.55

3.90%

3

9225.45

$121.00

$1,116,280.00

$42,436.00

350.71

3.80%

4

8874.74

$133.10

$1,181,228.40

$43,709.08

328.39

3.70%

5

8546.35

$146.41

$1,251,271.25

$45,020.35

307.50

3.60%

6

8238.86

$161.05

$1,326,875.99

$46,370.96

287.93

3.49%

7

7950.93

$177.16

$1,408,555.53

$47,762.09

269.60

3.39%

8

7681.32

$194.87

$1,496,872.78

$49,194.95

252.45

3.29%

9

7428.88

$214.36

$1,592,445.61

$50,670.80

236.38

3.18%

10

7192.49

$235.79

$1,695,952.29

$52,190.93

221.34

3.08%

11

6971.15

$259.37

$1,808,137.50

$53,756.66

207.26

2.97%

12

6763.90

$285.31

$1,929,818.92

$55,369.35

194.07

2.87%

13

6569.83

$313.84

$2,061,894.53

$57,030.44

181.72

2.77%

14

6388.11

$345.23

$2,205,350.50

$58,741.35

170.15

2.66%

15

6217.96

$379.75

$2,361,270.07

$60,503.59

159.32

2.56%

16

6058.64

$417.72

$2,530,843.12

$62,318.70

149.19

2.46%

17

5909.45

$459.50

$2,715,376.87

$64,188.26

139.69

2.36%

18

5769.76

$505.45

$2,916,307.47

$66,113.91

130.80

2.27%

19

5638.96

$555.99

$3,135,212.93

$68,097.32

122.48

2.17%

20

5516.48

$611.59

$3,373,827.16

$70,140.24

114.68

2.08%

DGI

YEAR

SHARES

Price

Value

Divs per Share

Total Divs

Removed

Extra Cash reinvested.

Extra shares bought

1

10000.00

$100.00

$1,000,000.00

$4.00

$40,000.00

$40,000.00

$0.00

0.00

2

10000.00

$106.00

$1,060,000.00

$4.24

$42,400.00

$41,200.00

$1,200.00

11.32

3

10011.32

$112.36

$1,124,872.00

$4.49

$44,994.88

$42,436.00

$2,558.88

22.77

4

10034.09

$119.10

$1,195,076.73

$4.76

$47,803.07

$43,709.08

$4,093.99

34.37

5

10068.47

$126.25

$1,271,120.97

$5.05

$50,844.84

$45,020.35

$5,824.49

46.14

6

10114.60

$133.82

$1,353,562.18

$5.35

$54,142.49

$46,370.96

$7,771.52

58.07

7

10172.68

$141.85

$1,443,013.73

$5.67

$57,720.55

$47,762.09

$9,958.46

70.20

8

10242.88

$150.36

$1,540,150.51

$6.01

$61,606.02

$49,194.95

$12,411.07

82.54

9

10325.42

$159.38

$1,645,715.27

$6.38

$65,828.61

$50,670.80

$15,157.81

95.10

10

10420.52

$168.95

$1,760,525.47

$6.76

$70,421.02

$52,190.93

$18,230.09

107.90

11

10528.43

$179.08

$1,885,480.89

$7.16

$75,419.24

$53,756.66

$21,662.58

120.96

12

10649.39

$189.83

$2,021,572.08

$7.59

$80,862.88

$55,369.35

$25,493.53

134.30

13

10783.69

$201.22

$2,169,889.54

$8.05

$86,795.58

$57,030.44

$29,765.15

147.92

14

10931.61

$213.29

$2,331,633.97

$8.53

$93,265.36

$58,741.35

$34,524.01

161.86

15

11093.47

$226.09

$2,508,127.46

$9.04

$100,325.10

$60,503.59

$39,821.51

176.13

16

11269.60

$239.66

$2,700,825.91

$9.59

$108,033.04

$62,318.70

$45,714.34

190.75

17

11460.35

$254.04

$2,911,332.66

$10.16

$116,453.31

$64,188.26

$52,265.05

205.74

18

11666.09

$269.28

$3,141,413.58

$10.77

$125,656.54

$66,113.91

$59,542.64

221.12

19

11887.21

$285.43

$3,393,013.59

$11.42

$135,720.54

$68,097.32

$67,623.22

236.91

20

12124.13

$302.56

$3,668,275.02

$12.10

$146,731.00

$70,140.24

$76,590.76

253.14

These results show that at the end of the 20 years the DGI portfolio was worth $3.6 million, while the G&V portfolio was worth $3.3 million. In large part this was because the G&V portfolio, starting with 10,000 shares, only had 5,516 shares at the end. In contrast the DGI portfolio had increased its number of shares to over 12,000. However, the G&V stock had increased in value to $611, due to the higher growth rate, helping to keep the final results closer. The annual return for the G&V portfolio was 12.92% and for the DGI portfolio was 13.87%

This supports the contention that, due to assets being sold, and therefore unable to contribute to future growth, in the long run, when deciding how to execute the 4% rule, the G&V philosophy will under perform the DGI philosophy. But this does not tell the whole story, because in the above scenario the stock values continued to increase year after year. This is, of course, not realistic. And one of the main arguments that DGI proponents use against the G&V philosophy is that during down markets you have to sell assets when they are depressed, exactly when you don't want to sell them. So to show what affect this would have on the two portfolios, I ran two more scenarios.

The following charts show what would happen if the situations were exactly the same as in the previous scenarios, but twice during the 20 year period, in years 6 and 16, the market suffered a 10% decrease.

G&V

YEAR

SHARES

Price

Value

Removed

Shares Sold

% removed

1

10000.00

$100.00

$1,000,000.00

$40,000.00

400.00

4.00%

2

9600.00

$110.00

$1,056,000.00

$41,200.00

374.55

3.90%

3

9225.45

$121.00

$1,116,280.00

$42,436.00

350.71

3.80%

4

8874.74

$133.10

$1,181,228.40

$43,709.08

328.39

3.70%

5

8546.35

$146.41

$1,251,271.25

$45,020.35

307.50

3.60%

6

8238.86

$131.77

$1,085,625.81

$46,370.96

351.91

4.27%

7

7886.94

$144.95

$1,143,180.33

$47,762.09

329.52

4.18%

8

7557.43

$159.44

$1,204,960.06

$49,194.95

308.55

4.08%

9

7248.88

$175.38

$1,271,341.62

$50,670.80

288.91

3.99%

10

6959.97

$192.92

$1,342,737.90

$52,190.93

270.53

3.89%

11

6689.44

$212.22

$1,419,601.67

$53,756.66

253.31

3.79%

12

6436.13

$233.44

$1,502,429.51

$55,369.35

237.19

3.69%

13

6198.94

$256.78

$1,591,766.17

$57,030.44

222.10

3.58%

14

5976.84

$282.46

$1,688,209.31

$58,741.35

207.96

3.48%

15

5768.87

$310.70

$1,792,414.76

$60,503.59

194.73

3.38%

16

5574.14

$279.63

$1,558,720.06

$62,318.70

222.86

4.00%

17

5351.29

$307.60

$1,646,041.49

$64,188.26

208.68

3.90%

18

5142.61

$338.36

$1,740,038.56

$66,113.91

195.40

3.80%

19

4947.21

$372.19

$1,841,317.12

$68,097.32

182.96

3.70%

20

4764.25

$409.41

$1,950,541.78

$70,140.24

171.32

3.60%

DGI

YEAR

SHARES

Price

Value

Divs per Share

Divs.

Removed

Extra Cash reinvested.

Extra shares bought

1

10000.00

$100.00

$1,000,000.00

$4.00

$40,000.00

$40,000.00

$0.00

0.00

2

10000.00

$106.00

$1,060,000.00

$4.24

$42,400.00

$41,200.00

$1,200.00

11.32

3

10011.32

$112.36

$1,124,872.00

$4.49

$44,994.88

$42,436.00

$2,558.88

22.77

4

10034.09

$119.10

$1,195,076.73

$4.76

$47,803.07

$43,709.08

$4,093.99

34.37

5

10068.47

$126.25

$1,271,120.97

$5.05

$50,844.84

$45,020.35

$5,824.49

46.14

6

10114.60

$113.62

$1,149,250.91

$5.35

$54,142.49

$46,370.96

$7,771.52

68.40

7

10183.00

$120.44

$1,226,443.78

$5.67

$57,779.13

$47,762.09

$10,017.04

83.17

8

10266.17

$127.67

$1,310,648.46

$6.01

$61,746.11

$49,194.95

$12,551.15

98.31

9

10364.48

$135.33

$1,402,591.59

$6.38

$66,077.65

$50,670.80

$15,406.84

113.85

10

10478.33

$143.45

$1,503,078.34

$6.76

$70,811.69

$52,190.93

$18,620.76

129.81

11

10608.14

$152.05

$1,613,001.05

$7.16

$75,990.27

$53,756.66

$22,233.62

146.22

12

10754.37

$161.18

$1,733,348.75

$7.59

$81,659.99

$55,369.35

$26,290.63

163.12

13

10917.48

$170.85

$1,865,217.74

$8.05

$87,872.48

$57,030.44

$30,842.04

180.52

14

11098.01

$181.10

$2,009,823.37

$8.53

$94,685.01

$58,741.35

$35,943.66

198.48

15

11296.48

$191.96

$2,168,513.06

$9.04

$102,161.06

$60,503.59

$41,657.47

217.01

16

11513.49

$172.77

$1,989,153.48

$9.59

$110,371.00

$62,318.70

$48,052.31

278.13

17

11791.62

$183.13

$2,159,438.13

$10.16

$119,819.49

$64,188.26

$55,631.23

303.77

18

12095.40

$194.12

$2,347,973.53

$10.77

$130,280.64

$66,113.91

$64,166.74

330.55

19

12425.95

$205.77

$2,556,868.68

$11.42

$141,871.49

$68,097.32

$73,774.17

358.53

20

12784.48

$218.11

$2,788,481.42

$12.10

$154,722.85

$70,140.24

$84,582.61

387.79

With the two down market years included in the scenarios the results are striking. The number of shares left in the G&V portfolio has fallen even further, from 10,000 to 4,764, and the ending value is only $1.95 million. Conversely, the DGI portfolio has even more shares then the previous scenario, 12,784.48, and is worth $2.78 million. Far more than the G&V portfolio. The annual return for these two scenarios, with the two down years, is 6.91% for G&V and 10.79% for DGI. This shows the power of dividend reinvestment. Whereas in the G&V portfolio you lose even more shares during down markets, in the DGI portfolio you actually accumulate even more! And in the ensuing years these extra shares produce even more dividends for you.

CONCLUSION

I'm sure this won't be the end of the argument, but I think it's pretty strong evidence that using DGI to take the 4% out of your retirement account, in the long run, will serve you better than selling assets. And the reasons for this are pretty obvious from the data. By having to sell shares of stock you continuously, year after year, decrease your share count, and therefore decrease the ability of your portfolio to increase your wealth. This affect is magnified during down years in the market, when you have to sell even more of the lower priced shares, to come up with your living expenses. Instead, by using DGI, and by funding your retirement completely through your dividends, you are able to keep all your principle, ie. your stocks, and they will continue to work for you. In fact, as your dividends continue to grow, and you are able to reinvest the dividends not needed for your living expenses, you can actually increase your principle and shares of stock, increasing your wealth prospects even more.

Thank you for reading my article. I welcome your comments and criticisms.

Source: Dividend Growth Investing: A Better Way To Carry Out The 4% Rule