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Remember the Growths?

In two previous articles, we met Mr. & Mrs. Growth. They were saving for retirement following common practices, including shooting for “The Number” and planning to withdraw from their nest egg during retirement.
They diligently saved all their lives for retirement, amassing $1,000,000 in assets. With the help of their financial planner, Ms. P, they diversified their wealth into a variety of asset classes that she said created a safe portfolio. Safety is important to them, as they consider themselves conservative and risk-averse when it comes to investing. Plus having saved a million bucks, they did not want to put it at risk by mishandling their retirement.
Ms. P explained to them how they should apply the 4% withdrawal rule to finance the rest of their lives. But it’s trickier than they imagined. She showed them some charts that were outputs of Monte Carlo testing on their portfolio. Under lots of scenarios, they discovered, their money won’t last for 30 years. Not only that, toward the end of their golden years, their portfolio may take a sickening plunge towards zero—even if it makes it to 30 years with some assets left. How could this be? After all, they are millionaires!
There are two culprits. The first is inflation. Their portfolio may get eaten away by annual, tiny-looking increases in their withdrawals that Ms. P says they need to make to keep up with inflation. Those increases are like termites bringing down a building. Ms. P told them that they could start out with a 4% withdrawal the first year ($40,000), then add 3% each year to stay even with inflation. The idea is that the value of their assets will expand over time, covering the extra 3% withdrawal each year. Now, they are shocked to find, it doesn’t always work out. Their initial $40,000 withdrawal in Year 1 of retirement compounds all the way up to a $94,264 withdrawal in Year 30. They had never thought much about compounding before, but now they realize that it produces an exponential result. That Year-30 withdrawal is more than 9% of their entire original million-dollar nest egg.
The second culprit is the withdrawals themselves. By liquidating assets from their portfolio to create income each year, they have fewer assets remaining after each withdrawal. The only way the withdrawal scheme can work is if the value of the remaining assets expands enough to cover the amount sold. That does not need to happen each and every year, but it does need to happen in the aggregate. It’s especially important in the first few years of retirement. If that value expansion fails to happen, the entire withdrawal scheme for funding retirement fails. The technical term for this is blows up. In the first two articles, I ran some scenarios to demonstrate how the Growths’ seemingly well-conceived retirement plan—based on Modern Portfolio Theory and utilizing the “safe” 4% rule—might blow up.
Meet Mr. & Mrs. Income
Down the street, their neighbors Mr. & Mrs. Income are at a similar stage in life. They are both 65 and plan to retire. Like the Growths, they saved diligently. But they took a different approach while they were saving.
About 15 years ago, the Incomes began seriously planning for their retirement. They realized that they would need income, and that their income needs would go up every year because of inflation. So their thought was, why not purchase income-producing assets right now, rather than just shoot for a Number? And if they could, why not seek assets that produce increasing income every year, if such things existed? They felt that if they could get most of their retirement income from such assets, they wouldn’t need to sell as much from their portfolio each year, and they would sleep better.
Feeling their way along (there wasn’t much they could find in Money or The Wall Street Journal about this) they discovered a dizzying array of income-producing assets: US bonds, municipal bonds, corporate bonds, annuities, CDs, stocks. Corporate bonds, they learned, range from “investment grade” (deemed to be very safe) to “junk” (deemed to be very risky). Junk bonds paid higher yields to make up for the risk that they would default, a technical term meaning that they would go down the drain, taking the original investment with them. The couple also learned that bonds have terms—their durations are fixed. When the term ends, a bond stops paying and you get your original money back. Terms also came in a full spectrum, from short-term notes all the way up to 30-year instruments.
Stocks, the Incomes learned, also come in different flavors: Common shares, preferred shares, shares in companies that increase their dividends seemingly every year, others that don’t pay dividends at all. The dividend stocks have a whole range of yields, from 0.1% all the way up to 18-19% per year. The couple also discovered that the ratings agencies, which are all over bonds like white on rice, don’t rate stocks at all. In particular, they don’t rate the safety, sustainability, or growth prospects of the stocks’ dividends—the very feature that the Incomes were interested in. They thought this was curious, but they were getting used to being on their own in their quest.
Another thing they found odd was that universally bonds were considered safer than stocks. They came to understand that this was because—with investment-grade bonds anyway—the principal was practically guaranteed to be returned at the end of the bond’s term. Well, that made sense—everybody knows that stock prices go up and down all the time, so getting all your principal back seemed like a very good thing. Not only that, but in corporate financial structures, bonds come ahead of stocks in terms of any payouts.
But the reason that the Incomes found the “bonds are safer than stocks” mantra strange was that they were looking at bonds from the income angle, and they could see some flaws. The biggest flaw by far was the fixed nature of bond payments. Except for a couple of curiosities like TIPS (inflation-protected bonds from the US), bonds were not safe from the most obvious risk: Inflation. Fixed payments do not, by definition, keep up with inflation. The Incomes wondered why this was not talked about more.
The couple also wondered about the fixed-term nature of bonds. Whereas stocks, like the companies they represented, had potentially perpetual lives, at some point every bond runs out its term, and you have to figure out what to do with the money returned to you. Can you find something that will replace the income of the expired bond? Complicating this difficulty was the fact that, in real terms, the money you got back would be worth less than what you put in to buy the bond. The couple began to feel that the common wisdom that bonds are safe because you get all your money back was disingenuous. Using the back of an envelope and a cheap calculator, the Incomes figured out that at 3%-per-year inflation, $10,000 invested in a 10-year bond would be worth just $7,374 when you got it “all” back. Then they would have to find another bond to invest that money in. Wouldn’t they be permanently behind at that point? What was so safe about that scenario?
By now, the Incomes were seeing a pattern: Everybody focused on principal, on sheer wealth. That’s why bonds, for example were considered safer than stocks: You got all your principal back. Hardly anybody focused on income. But, the Incomes thought, their main need in retirement 15 years down the road would be income that kept up with inflation. Wasn’t this obvious, or were they way off base?
They didn’t learn much when they talked to their friends and neighbors. To the extent anyone talked about retirement at all, everyone was focused on how much they needed to retire. People got all excited when they bragged about their latest 3-bagger in the stock market, which was booming back in 1996. When the Incomes tried to talk about an income approach, nobody was interested. Too boring, they were told. They began to keep to themselves about the subject. They were not necessarily feeling that other people were wrong, but they could not see where they were wrong either. Investing for income rather than for sheer wealth still made sense, even if others scoffed. They did have to admit, it was fun listening to Jones talk about the killing he made in Netscape. Jones tended to exaggerate sometimes, and he drank a little too much, but he was the life of the party. The Incomes, well, were not.
But they plodded on. In their research, the Incomes found themselves drawn to dividend-growth stocks. They seemed to have all the qualities they were looking for: They produced income on their own. Their dividends went up each year, and from what they could tell, the dividend increases surpassed inflation most years. They wondered, Is it possible to build a portfolio of the best dividend-growth stocks whose income, by itself, is enough in Year 1 of retirement, and whose income growth—through annual dividend increases—would not only keep up with but would actually surpass inflation while they were retired?
They thought that might be possible. Yet they still found it difficult to simply shake off all the common wisdom around them: Accumulate a high Number; go for big scores; you can convert to income assets when you retire; you’ll “just sell a few shares” to create income in retirement; and so on. After all, if so many investment experts believed in this approach, who were they to think they could go in a different direction? They weren’t investment experts. They were just as conservative as the Growths, and they certainly did not want to get this wrong. They would only have one shot at it.
So they decided to consult a financial planner themselves. They explained what they were thinking.
“No, no, no, you’ve got it all wrong,” Mr. A said. “Here, I have some new software. Let’s assume you can save $1,000,000 by the end of 2000. I’ll show you how to allocate your assets when you get there to make them safe. Meanwhile, you’ll just shoot for the million dollars. Let’s plug the assets into my software, and it will show you how you can withdraw 4% each year, add 3% for inflation each year, and still have money left over after 30 years.”
“How does this work?” they asked.
“It takes samples of how these assets have performed historically, mixes them all together, and runs thousands of scenarios. It doesn’t miss a thing. In the end, I’ll get you a graph that shows how your portfolio will last. I just love this software, it is way cool.
So they ran the samples. Mr. A showed them a chart with three lines on it, labeled Best Case (green), Likely Case (blue), and Worst Case (red). The horizontal axis was time, running from 0 to 30 years. The vertical axis was dollars, with $0 at the bottom and $1,000,000 centered halfway up. All three lines started at $1,000,000.
The green line looked great: It rose practically every year, running right off the top of the chart some time around Year 20. Clearly the best case was very successful. It was exciting to think of having all that money. They would never have a financial care in their lives.
The blue line was OK. It rose in the early years, then flattened out, then dropped steadily the last few years. At Year 30, it was at about $50,000 and going almost straight down. Despite that steep plunge at the end, Mr. A told them that this blue line represented success: Their portfolio funded their full 30-year retirement. That was the most likely case: That their million-dollar portfolio would succeed.
The red line was ugly. It went down right from the beginning. Mr. A surmised that there must have been an awful bear market right at the beginning of that scenario. The red line sort of held its own in the middle years, even getting back above $1,000,000 a couple of times. But like the blue line, it was going nearly straight down at the end. And unfortunately, the end of the line was not at Year 30. It was at Year 23 when it crashed into the $0 horizontal axis.
The Incomes stared at the red line. “How likely is this to happen?” they asked. Mr. A said reassuringly, “There’s only a 7% chance of that happening.” They nodded politely. But they were horrified.
Then they asked, “In the middle blue line, there’s only $50,000 left after 30 years. Are we reading that right? If we live one extra year, what’s that year’s withdrawal?”
“Well, let’s see, it’s about $97,000.”
“Does that mean there would not be enough money to make that withdrawal?”
“Yes,” said Mr. A.
Mr. & Mrs. Income got up, thanked the planner for his time, paid him, and left the office. As soon as they got outside, they said simultaneously, “Let’s do this ourselves.” They agreed that they did not want to live their last few years running out of money at a frighteningly fast rate, even if it did just barely make it to the 30-year finish line.
What the Incomes Did
Mr. & Mrs. Income decided that they would shoot for a Number too, but instead of a sheer-wealth number, they would shoot for an Income Number. They called that Target A. They also decided to shoot for Target B: Annual growth in income that would overcome inflation.
Having reached that decision, the next decision was easy: Instead of shooting for a maximum-wealth portfolio in their remaining years before retirement, they would build their retirement income portfolio as they went along. They discovered some good news here. They found a couple of studies that concluded that over long periods of time, stocks that raise their dividends, as a group, deliver the best total returns too, when compared to stocks in general! So even though they were not shooting for a traditional high Number in total wealth, they might get one anyway.
That gave them a lot of confidence, but they still couldn’t shake their doubts about the conventional wisdom. Mr. A had talked a lot about asset classes and diversification. “Don’t put all your eggs in one basket,” he told them. So they decided to diversify as best they could without taking their eyes off Targets A and B. Looking ahead as best they could, they estimated that in Year 1 of retirement, they would need $40,000 of income in 2011. That was Target A. For target B, they decided to use the common 3% annual estimate of inflation. So these were their two targets: Accumulate assets that would yield $40,000 in 2011 with an estimated growth rate of at least 3% annually through 30 years of retirement.
They decided on this allocation of their assets to get to those two targets :
  • 60% of their money in common stocks. All of that would go into the best dividend-growth stocks they could identify. They would not shoot for Netscapes, despite the raging bull market in 1996. They would not consider a stock unless it paid a decent yield to begin with, had a history of growing that dividend, and seemed that it had a solid, non-faddish business. As the years went by, they became better and better at identifying such stocks, and they averaged only about one failure per year—failure being a stock that cut its dividend or delivered only paltry increases.
  • 40% of their money into bonds. They decided they would not be able to learn about bonds and stocks too, and their hearts were with the stocks, so they just used mutual funds for their bond allocation. Actually, they just used one fund, Vanguard’s Total Bond Market Index Investor Shares (VBMFX).
Mr. & Mrs. Income realized that this gave them a 60/40 stock/bond allocation, which they kept reading was some sort of standard allocation used by many financial planners. Indeed, Mr. A had discussed it. That helped assuage some of the trepidation about going on their own. But nevertheless, they realized that there was something really unique about their portfolio. Everything in it produced income, even the stocks. They were not shooting for high-growth capital maximization. They were shooting for Target A, income to live on in retirement, and Target B, income that would grow at least as fast as inflation.
Over the years, the Incomes became pretty sophisticated about their dividend-growth stocks, learning how to identify duds, swap some of them out for better yields, and keep their eyes out for better opportunities. If a stock cut its dividend, they sold it immediately. They sometimes even successfully anticipated dividend cuts before they happened and got out before there was any damage. A few times they got stung; for example, a bank got them in 2008. They came, over time, to pay less attention to diversifying their stocks into all sectors, as they came to realize that the business models of some companies (such as energy and various consumer stocks) lent themselves to robust dividends and dividend growth, while others (such as technology) did not.
As dividends came in, they reinvested them. They sat down and spent several hours twice per year examining their portfolio. They made events out of their Portfolio Reviews, taking a day off, doing the review, and then going out for a nice dinner. They used those reviews to evaluate how things were going, to identify potential new stocks for purchase, and decide if they ought to sell anything in favor of a better opportunity.
Mr. & Mrs. Income retired at the end of 2010. By the time they retired, they had held some stocks for the entire 15 years, while others were more recent purchases. Here is their 15-stock portfolio as of the time they retired:

The Incomes’ Dividend-Growth Portfolio 1/1/2011
Stock
Projected Yield
Years of Consecutive Dividend Increases
Least of 1, 3, 5, and 10-Year Dividend Growth Rates
Abbott Labs (NYSE:ABT)
3.8%
39
9%
Alliant Energy (NYSE:LNT)
4.3%
8
5%
Altria (NYSE:MO)
5.7%
42
9%
AT&T (NYSE:T)
5.8%
27
2%
Chevron (NYSE:CVX)
3.2%
24
7%
Coca-Cola (NYSE:KO)
2.7%
49
7%
ConocoPhillips (NYSE:COP)
4.0%
11
9%
Intel (NASDAQ:INTC)
4.2%
8
12%
Johnson & Johnson (NYSE:JNJ)
3.5%
49
9%
Kimberly-Clark (NYSE:KMB)
4.1%
39
7%
McDonald's (NYSE:MCD)
2.7%
34
10%
Pepsi-Cola (NYSE:PEP)
3.2%
39
6%
Procter & Gamble (NYSE:PG)
3.3%
55
10%
Shaw Communications (NYSE:SJR)
4.2%
9
16%
Southern (NYSE:SO)
4.6%
10
3%
Simple Average
4.0%
8%
Weighted Average
4.5%
6%
[Data sources: Projected yields—Morningstar. Years of dividend increases and dividend growth rates—Dividend Champions document dated 7/29/2011, produced by The Drip Investing Resource Center. Weighted averages are as calculated by the author and explained in Part II.]
The Incomes’ Bonds
As the years passed, the Incomes became less enamored of regular bonds and their total-bond fund. They were never that enthused anyway, but when they realized that Mrs. Income would have a pension from her job, plus they would both get Social Security, they began to wonder why they needed additional fixed income.
So in 2000, when Vanguard introduced the fund Inflation-Protected Securities Investor Shares (VIPSX), they stopped putting new money into the total bond fund, although they kept re-investing the fund’s payouts back into it. They redirected the new money that would have gone into the bond fund and sent it half into stocks and half into their new TIPS fund. As a result, as they hit retirement at the end of 2010, this is their asset allocation:
  • 70% dividend-growth stocks
  • 5% total bond-market fund
  • 25% TIPS fund
As they enter retirement, the Incomes are pretty sophisticated investors. They understand that the pension and Social Security amount to phantom allocations in bonds, being fixed-income equivalents. (Actually, Social Security is indexed to inflation and therefore not fixed, but on the other hand its future is in doubt politically, so they consider that a wash.) They also realize that their heavy reliance on dividends for retirement income creates a wide gulf between themselves and the recommendations of most financial planners. But they have gained great confidence in their strategy after seeing it in action for more than a decade. They have observed how their stocks’ prices tend to keep up with or surpass the market over long time periods, in fact generally displaying less volatility than the market as a whole. Their dividend income has gone up every year since they started. They have come to understand the technical term for what they have become: Dividend Zealots.
For an in-depth analysis of how the Income's investment choices panned out, see part 2.

Disclosure: I am long ABT, LNT, T, CVX, INTC, JNJ, KMB, MCD, PEP, PG.
Source: Retirement's 4% Rule: Why Mr. & Mrs. Income Don't Need It (Part 1)