The 4% Plan: Updating Your 2014 Equity Position

by: Morgan Myrmo

"Strength and wisdom are not opposing values." - President William J. Clinton

Regardless of interest rates, geopolitical turbulence or economic growth rates, equities that pay dividends are investments that income investors have favored for years.

Under the premise of The 4% Plan, which is to achieve a permanent income stream solution of 4% annually through simple investment strategies, an asset allocation of equities, bonds, commodities and cash is recommended for portfolio diversification and income safety.

The Asset Allocation

While there are four types of assets in the 4% plan, equities play a critical role. As Bill Clinton stated, "strength and wisdom are not opposing values." Income investors looking at equities may use this concept to prove the value of dividend growth stocks in the balanced income portfolio.

To begin, equities provide strength. This asset class rises in value with the tide of economic growth. Income-producing equities are wise choices for income investors, as shareholders are rewarded with cash according to a percentage of company profits that are expected to grow over time.

At a 75% weighting, equities provide the largest weighting of the portfolio. For a explanation of 2014 allocations for the 4% plan, please read The 4% Plan: Adjusting Your Sails For 2014, published December 18, 2013.

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Focusing On The First Goal - A 4% Annual Income Stream

As the goal of the investment portfolio is to earn 4% annually in the form of dividends, both equities and bonds play a critical role. For safety, a target yield of 4.2% to 4.5% is recommended to ensure the 4% stream.

For an explanation of this target range and why a 2% cash level is imperative, please read Part 1: Creating A Target Portfolio Yield in The 4% Plan: Building Your Bond Position Now.

Part 1: Determining The Target Equity Allocation Yield

To review, there are four asset types in the portfolio. Of these four, only the equities and bonds will be producing reliable income. With hard-asset commodities such as silver and gold owned, that asset class is a hedge that produces no income. In a low interest rate environment, cash produces hardly any income as well. In this portfolio, cash is only a buffer to enforce the income stream.

When removing cash and commodities from the equation, the investor is left with equities and bonds to produce income. In aggregate, both positions equate to 93% of the portfolio (18% bonds plus 75% equities).

As such, to discover the target yield average of bonds and equities with a 93% weighting, one must divide the total portfolio target yield by 93%.

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To summarize, a 4.2% to 4.5% total portfolio yield is desired for two reasons: to protect the distributions from dividend risk and to maintain a minimum of 2% cash. With a 93% bond and equity allocation, the aggregate bond and equity yield should fall between 4.52% and 4.84% to hit the 4.2% to 4.5% total portfolio yield range.

In the bond portfolio, an investor may choose funds that on average yield north of 6% in this environment. If bond yields are 6% in the 4% portfolio, then the following yield targets will give 4% investors their target portfolio yield.

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Building Up The Equity Portfolio

The equity portion of the portfolio is key to keeping ahead of inflation, as equities serve a combination growing dividends and capital appreciation. Fluctuations in price may lead to allocations that are over or under the target area, however yearly adjustments can be made to keep the asset allocation close to this target range.

Within any general asset class, an investor reduces risk through diversification. Using funds rather than individual stocks, the investor is able to diversify however this comes at the cost of generally lower yields and fund management costs. In each category of the equity allocation the costs and benefits of funds will be explored.

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The equity portion of the portfolio is divided into five categories. These are a mix of traditional asset classes that in combination provide excellent exposure to equities in accordance with a lower risk/higher income profile.

These categories have been modified from the original 4% plan article, where U.S. value is updated to U.S. dividend growth, energy is updated to earth resources, global growth and value is combined as global dividend growth and utilities are expanded to included telecom and other stock types. The categories and definitions are as follows:

  • U.S. Dividend Growth - All U.S. stocks that provide dividend income and are not resources, real estate or utility stocks.
  • Earth Resources - All stocks that provide exposure to energy, energy-related companies and other companies that offer exposure to resources such as precious metals and other commodities.
  • Real Estate - Real estate investment trusts (REITs)
  • Global Dividend Growth - Same as U.S. dividend growth category but companies that are based outside the U.S., regardless of the origin of profits.
  • Utilities - Utilities, telecom, toll roads, airports, railways and ports.

1. U.S. Dividend Growth (20% of Portfolio)

The U.S. dividend growth category may be compromised of funds as well as stable and growing dividend players. Such stocks include large-cap companies that hold a low risk profile, such as Wal-Mart Stores, Inc. (NYSE:WMT) and The Coca-Cola Company (NYSE:KO). An excellent guide to research such stocks is the Dividend Champions list by David Fish.

The category may be complimented with secular-growth companies, defined as companies that may or may not pay a dividend however are viewed as long-term growth options. One area that has demographic headwinds lifting demand is healthcare. The aging demographic, limited supply, government sponsorship and economic expansion all play a role in supporting healthcare as an excellent long-term domestic growth story.

To invest in healthcare, an easy, low-cost strategy is to purchase the Health Care Sector SPDR (NYSEARCA:XLV), which tracks a U.S. healthcare index that included companies ranging from pharmaceuticals to biotech, healthcare supplies and healthcare technology. The fund expense ratio is .18% and yields 1.54% as of the close of trading on 12-20-13 and the two-year compound annual dividend growth rate is 11.41%.

2. Earth Resources (20% of Portfolio)

The earth resources category of equities refers to dividend-players in the energy and commodities sectors of the U.S. and global economy.

The most obvious play here is to purchase oil and gas majors and related exploration and production (E&P) companies. A couple of ideas here are BP PLC (NYSE:BP) which yields 4.87% and ConocoPhillips (NYSE:COP) which is yielding 3.95%. BP is a newly minted, smaller version of the old company as many assets were sold due to the aftermath of the Deepwater Horizon oil spill. COP is the largest domestic E&P company and has a diversified, lower risk strategy that also includes assets in the central U.S. shale rock formations.

An easy and recommended way to diversify here is with the ALPS Trust MLP ETF (NYSEARCA:AMLP), which invests alongside an index of limited and master-limited partnerships in the U.S. energy sector and offers a healthy distribution of 6.18% with an expense ratio of .85%. Companies represented here are engaged in the production, distribution and transformation of commodities and are exempt from corporate taxes like REITs.

As gold and mining stocks fall into the category, a small portion of the energy allocation of funds, perhaps 15%, can be used to engage in this area of investing. Keep in mind that the yields are low, however with AMLP yielding over 6% and oil-majors producing stable income this field can be legitimately explored.

Although commodities have their own place in this portfolio, a small holding here will serve as another portfolio hedge as well as potential gold-mine for growth when the next commodity cycle hits.

3. Real Estate (REITS - 19% of Portfolio)

A great high-income stock option for income investors to take advantage of is the real estate investment trust (REIT) category, as those firms must pay at least 90% of their income to shareholders by law. Dividends are taxed as ordinary income however, which lowers the effective yield of the REIT portion of the portfolio in accordance to the investor's tax bracket.

REITs that are over $20 billion in market capitalization and yield less than 4% may be avoided, as most mid-cap and small-cap REITs have yields north of 5%, while several also showcase a strong case for long-term secular growth. To learn more about secular-growth REITs in this area, I highlighted seven in another article here.

The total REIT portion of the portfolio can easily remain north of 5% by leaning more heavily on a team of stable 5-6% yield players such as HCP, Inc. (NYSE:HCP) at 5.82%, Realty Income Corp. (NYSE:O) at 5.81%, Camden Property Trust (NYSE:CPT) at 4.43% and Chambers Street Properties (NYSE:CSG) at 6.42%.

4. Global Dividend Growth (8% of Portfolio)

Global Value stocks are defined here as non-energy, real estate and utility companies that offer dividend stability, an ex-U.S. headquarters and a global reach that is dominant and hard to compete with. A little global exposure is good to balance out the portfolio.

Diversified funds may play a role in this portion of the portfolio. Remember that with index funds, a portion of assets will likely be held in earth resources, utilities and real estate.

For a stock recommendation, Diageo PLC (NYSE:DEO) is based in the U.K., is yielding 2.3% and controls a high-quality portfolio of alcohol assets that are distributed world-wide. Alcohol consumption continues to grow and is recession-proof as people drink regardless of the business cycle.

5. Utilities (8% of Portfolio)

The ultimate low-growth, stable-dividend companies are utilities. They are legal monopolies that are allowed to increase pricing to customers. Also, unlike credit cards or other bills, utilities must be paid and therefore are just as an important human staple (in our industrialized country) as is food and shelter.

In addition to utilities there are several other categories that should be added to this portion of the portfolio due to the nature of their businesses. Such areas include telecom, railroads, toll roads, airports and marine ports.

The Utilities Select Sector SPDR ETF (NYSEARCA:XLU) is a low-cost method of investing in tradition gas and electric utilities. The volatility in this fund is low and will help provide both income and stability to the total portfolio.

A great fund option is the Cohen & Steers Infrastructure Fund (NYSE:UTF), which would be divided here as 64.1% weighting in utilities, 22.1% earth resources and 6.9% global dividend growth. At toll roads, airports and marine ports are largely international plays and do not trade in the U.S. with sponsored-ADRs (American Depository Receipts), the fund manager buys these stocks on foreign exchanges. The fund pays quarterly distributions, is a closed-end fund that may trade at a premium or discount and yields 7.3%.

For telecoms, Vodaphone Group PLC (NASDAQ:VOD), which yields 4.2%, is one example of a diversified player with major international reach. Investors who own VOD will be distributed shares of Verizon Communications Inc. (NYSE:VZ) as a dividend next year. VZ currently yields 4.4%.

Caution is advised when looking at telecom plays however, as many firms have huge debt levels that may be increasingly harder to service as bond rates inch upward.


When building a portfolio designed for permanent income, bonds play a bodyguard-type role to maintain income distribution and lower overall risk while equities offer market exposure that offsets inflation through growing dividends and capital appreciation.

By creating an equity portfolio that is wrapped in the five categories noted here, diversification is easily achieved along with a target yield rate above the 4% permanent income requirement.

Remember that diversification in equities is strength, while investing in dividend achievers is wise. Together, strength and wisdom may work together to provide a long-term solution to the income investor's needs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.