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There is a raging debate regarding the best way to live off your portfolio. Young adults are told, by those older and wiser, to save and invest for retirement. There is never a shortage of ideas and suggestions on how to build a nest egg. For those lucky enough to have accumulated a nest egg large enough to meet their financial needs, the dilemma is determining the best way to tap that egg.

When it comes to defining the best solution for this task, there are two major camps – and they rarely see eye-to-eye. In one corner are the total return proponents. They believe the optimum approach is to manage the portfolio for total return. They assume the income generated by the portfolio will not be sufficient to cover retirees’ annual financial needs and therefore some holdings will need to be sold to make up the shortfall.

In the other corner is the dividend income camp. That camp believes the optimum approach is to invest strictly in dividend generating securities that kick out the required income without ever having to sell any holdings. The dividend camp makes some compelling arguments, but that is a subject for another article.

Today, I want to focus on what I see as the single largest flaw of the dividend crowd: They do not acknowledge the fact that dividends can and do experience declines. This failure results in not having a thoughtful plan for those occurrences.

Let’s take some real-life examples. We need some basic assumptions, so we’ll start with the widely accepted 4% rule for first year withdrawal. If you are not familiar with the rule, it puts forth that to minimize the chance of outliving your nest egg the most you can withdraw from your portfolio balance the first year is 4% and that amount can be adjusted upward each year for inflation. There are numerous variables and it won’t work for every situation, but it is a good starting point. If you start with $1 million and assume a 3% inflation rate, then the 4% rule says you can withdraw $40,000 the first year, $41,200 the second year, and so on. The withdrawal amount is independent of your portfolio balance in subsequent years.

The total return investor probably holds a mixture of stocks and bonds, and the portfolio may only throw off about 2% in dividends. The total return investor is counting on portfolio growth to stay ahead of inflation and to cover the shortfall in annual income needed versus dividends received.

The dividend investor requires a 4% initial portfolio yield. This approach requires sufficient dividend growth to allow future distributions to keep pace with inflation. The major flaw with this approach is that there is nothing sacred about dividends and they can be decreased, thereby creating the necessity for the devout dividend investor to convert to a total return investor at an inconvenient time.

I have prepared the following table as a case study. It clearly illustrates that dividend investment strategies can and do experience severe declines in dividend payouts. The largest dividend ETF, iShares Dow Jones Select Dividend ETF (NYSEARCA:DVY), had a 31.4% reduction in dividends from 2008 to 2009. The 2010 per share distribution amount was 29.8% below the 2008 level.

Income From Largest Dividend ETFs 2008-2010

Ticker Name Current Yield 2008 Div Pmts 2009 Div Pmts 2010 Div Pmts % Chg 2008-2009 % Chg 2008-2010
DVY iShares Dow Jones Select Dividend 3.6% $2.42 $1.66 $1.70 -31.4% -29.8%
VIG Vanguard Dividend Appreciation 2.2% $1.03 $0.98 $1.05 -4.9% 1.9%
SDY SPDR S&P Dividends 3.5% $2.21 $1.73 $1.74 -21.7% -21.3%
VYM Vanguard High Dividend Yield ETF 3.0% $1.44 $1.17 $1.09 -18.8% -24.3%
IDV iShares DJ International Select Div 4.9% $2.82 $1.06 $1.32 -62.4% -53.2%
DWX SPDR S&P International Dividend 5.7% $4.64 $1.89 $2.36 -59.3% -49.1%
PID PowerShares Int'l Div Achievers 3.9% $0.72 $0.47 $0.42 -34.7% -41.7%
PFM PowerShares Dividend Achievers 2.5% $0.36 $0.30 $0.28 -16.7% -22.2%
DTD WisdomTree Total Dividend 3.0% $1.64 $1.14 $1.34 -30.5% -18.3%
FGD First Trust DJ Global Select Div 4.5% $1.40 $0.69 $1.00 -50.7% -28.6%

Table sorted by assets under management. Annual ETF dividend income data from Morningstar. Current yield data from Ned Davis Research. Data compilation by

Let’s assume a person embarked on a dividend-based withdrawal plan in 2007 or 2008 and bought enough shares of DVY to supply $20,000 in annual dividends in 2008. That person planned on dividends rising by 3% to $20,600 in 2009 to offset inflation. Instead, they received only $13,719 from DVY. They couldn’t make up the difference with other dividend ETFs because, as the table clearly shows, most of the others were just as bad, if not worse.

Our dividend investor is left with no choice but to sell some holdings to make up for the income shortfall. To add insult to injury, the dividend streams still have not returned to their prior levels, forcing the dividend investor to sell again in 2010 and 2011. Even if dividends remarkably return to 2008 levels in 2012, our dividend investor has sold off a portion of the portfolio plus experienced four years of inflation, and therefore portfolio level dividends will still be insufficient.

One argument I expect to receive is that these ETFs are not good examples because they don’t own the best list of dividend stocks. My counter argument would be that the underlying indexes are created by knowledgeable experts. Any list that you generate today, consisting only of companies that have never cut their dividends, is a list that suffers from extreme survivor bias.

Another argument might be to put it all in the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) since it had a smaller decline and has already fully recovered. However, VIG and similar strategies only generate about a 2% yield – far short of the 4% needed.

If you are going to point out that the yields on these ETFs actually increased in 2009 (their prices fell more than their dividends), my counter argument will be that it doesn’t matter to our 2008 retiree. Current yield only matters to new money being invested. By definition, our investor is in withdrawal mode and not accumulation mode. He has no money to invest at these new lower prices and higher yields.

Disclosure: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.