Asset Allocation For A Dividend Growth Investor

by: David Van Knapp

For the past couple of years, I have been searching for ways to meld my own beliefs about dividend growth investing with the best ideas I can find about asset allocation. My intent had been to write an article when I had it all figured out. That's looking like it may never happen, so I've decided to write this article about where I am now. Perhaps the article will help readers who have been pondering the same subjects, and the comments will help all of us.

A Typical Allocation Includes Lots of Bonds

I am 65 and my wife is about a decade younger. We are both retired. I have a pension, she does not. I draw Social Security, she does not. I suspect that if I went to a financial planner, he or she would recommend a fairly typical asset allocation of about 40% stocks, 50% bonds, and 10% cash. So my asset allocation model would look like this:

Asset

Allocation

Bonds

50%

Stocks

40%

Cash

10%

I immediately have problems with the bond allocation, so let's discuss that first. With 10 years' retirement experience under my belt, I can state without reservation that income is the name of the game in retirement. As stated by Aaron Katsman in a recent article:

If you can figure out how much money you will need, then you can figure out how much income you will need to generate to supplement your pension, social security and any other income sources you may have.

The most common method to generate income for retirement is by considering retirement to be the "withdrawal" phase of your life. (Building up your nest egg when you were working was the "accumulation" phase.) So we have the well-known 4% rule: Withdraw 4% of your assets in Year 1 of retirement, then bump that amount up by 3% or so annually to cover inflation for the rest of your retirement. The theory is that the remaining assets (after each liquidation) will expand in value enough to cover what was liquidated. Thirty years is often used as the time that your nest egg must last. "Success" is defined as having your assets run out at the end of the 30-year retirement period. That is thought to be both safe (you did not outlive your assets) and efficient (no assets remain when you die).

The problems I have with the bond allocation are these:

  • As fixed-income investments, the income from bonds does not rise with inflation. The exceptions are TIPs and I-bonds.

  • I already have fixed income from my pension and Social Security.

I will use numbers from my own life for illustration. (To protect my privacy, I have adjusted actual dollar figures, but the percentages are representative of our own situation.)

Let's say I have $500k in investable assets (excluding home, etc.). Our expenses are $50k per year, and my pension and SS cover 2/3 ($33k) of our expenses at this moment. I say "at this moment," because our expenses are rising while the pension is fixed. Social Security is indexed to inflation, but for purposes of creating a margin of safety, I will treat SS as fixed also.

Asset allocation is about where to put capital, retirement is about how to generate income. Therefore the basic question always comes back to converting one to the other. Usually the conversion being discussed is capital to income, because capital is what the retiree owns, and income is what he/she needs.

With the pension and SS, I have some income already. The rights to those income streams are definitely valuable assets, but their capital equivalent is not obvious. To figure out asset allocation, I need to determine the approximate capital value of those income streams. In other words, I need to calculate the capital-to-income conversion backwards.

For want of a better alternative, I can use annuities as a conversion device. An annuity allows anyone to convert capital to a fixed income stream that ends at death, just as my pension and SS are fixed income streams that will end at death. Using a calculator at Immediate Annuities (here), you can also make the conversion backward. Here's what I discover:

  • An annuity representing my pension would cost $366k.

  • An annuity representing my SS would cost $142k.

So I already have the rights for my lifetime to fixed income that I could buy for $508k. My ownership rights to those income streams effectively double the investable assets that I have. This framework for thinking allows me to view my pension and SS as if they were fixed income investments. And in fact, I do think of them that way, as if I had used capital to purchase those fixed income rights.

The question begs to be asked: Why do I need more fixed income on top of this? My conclusion is that I do not. I already have 51% of my effective asset total invested in fixed income. I do not need more "bonds." So my model asset allocation looks like this so far:

Asset

Allocation

Bonds

0%

"???"

39%

Pension

37%

Social Security

14%

Cash

10%

Protecting Against Inflation

In a terrific reply to another commenter on his own recent article, Robert Martorana said:

The growth that [the other commenter] noted is KEY, since dividend growth acts as a hedge against inflation. This is a subtle point, and often lost.

The growth they were talking about was growth in the retiree's income, not in assets.

In my view, growing income is the most important growth for a retiree, since as stated above, income to cover expenses is the name of the game when you are retired. (Of course, if you are funding your retirement by selling assets, then growth in the remaining assets would be the key consideration for you.)

So here's where we are so far in this analysis:

  • My pension and SS cover 2/3 of my income needs.

  • But they are fixed income, while my expenses will rise with inflation.

  • So I need to invest in such a way that inflation in all my expenses is covered by my other investments, meaning the investments beyond my pension and SS, designated as "???" in the table above. I want to discover how to invest those assets.

Let's do the calculations required by the third bullet point. Assuming 3% annual inflation, my "???" investments must cover inflation on all $50k of my expenses. Here's a table of the first 10 years of total income that I need, showing how my expenses rise at the presumed rate of inflation.

Year Number

Total Income Needed

Percentage Increase

Dollar Increase

1

50,000

2

51,500

3%

1,500

3

53,045

3%

1,545

4

54,636

3%

1,591

5

56,275

3%

1,639

6

57,964

3%

1,689

7

59,703

3%

1,739

8

61,494

3%

1,791

9

63,339

3%

1,845

10

65,239

3%

1,900

I need to get the dollar growth shown in the last column from my $450k in investable assets ($500k less the 10% in cash), because I will get no growth from my pension or (by conservative assumption) from Social Security. So the income from my $450k must meet or beat:

Year Number

Income Needed from "???"

Dollar Increase (Same as Above)

Percent Increase in Income from "???"

1

$17,000

2

$18,500

1,500

8.8%

3

$20,045

1,545

8.4%

4

$21,636

1,591

7.9%

5

$23,275

1,639

7.6%

6

$24,964

1,689

7.3%

7

$26,703

1,739

7.0%

8

$28,494

1,791

6.7%

9

$30,339

1,845

6.5%

10

$32,239

1,900

6.3%

The first table in this article showed a baseline standard asset allocation for someone my age. But we now know that "???" represents just 39% of my effective total assets after monetizing my pension and SS income rights. I will keep the 10% allocation to cash, so that 10% is removed from the calculations. Applying the conventional allocation model to my investable assets would produce the following result.

Asset

Allocation

How Calculated

Bonds

22%

5/9 * 39%

Stocks

17%

4/9 * 39%

Pension

37%

Previously computed

Social Security

14%

Previously computed

Cash

10%

Standard allocation

What's wrong with this picture? Fixed income is far over-represented (73% of the total) and stocks are way under-represented (17%). I've already stated that given the value of the fixed-income rights that I own, I'm inclined to own no further bonds at all. And given my belief in the efficacy of dividend-growth stocks, I am inclined just to put all of my remaining investable assets into dividend growth stocks. That gives me this allocation.

Asset

Allocation

Bonds

0%

Dividend Growth Stocks

39%

Pension

37%

Social Security

14%

Cash

10%

In other words, "???" represents dividend growth stocks such as Intel (NASDAQ:INTC), Johnson & Johnson (NYSE:JNJ), and Procter & Gamble (NYSE:PG) in a self-directed and actively monitored portfolio. I expect that portfolio to deliver 3.8% cash yield in Year 1 of retirement and also to grow that cash flow steadily to keep up with or surpass inflation. A certain margin of safety is built into the scheme by the fact that the Social Security income stream will grow also, as it is indexed to inflation under current law.

Sneaky

Perhaps you have noticed that along the way in this article, I changed the framework of the discussion. It began as an examination of how I should allocate capital assets. But now it has become an examination of where my retirement income will come from. I am comfortable with that paradigm shift, because income, not wealth, is my goal for funding retirement. Wealth is a means to an end, not the end itself.

I believe that the outcome is very realistic. For one thing, in Year 1 I need to receive $17,000 income from $450k worth of dividend growth stocks. That requires a 3.8% yield. That's a typical-indeed conservative-current yield for a well selected portfolio of dividend growth stocks.

For another thing, the annual growth in income from the dividend growth stocks is 9% at the start of retirement, with the percentage slowly declining as the years go by. That 9% is a typical rate of growth in the income of a well selected dividend growth portfolio. It is independent of the prices of the stocks. That said, typically the prices rise roughly in line with the dividend increases over long periods. That keeps the current yield more-or-less constant even as the dividends increase annually. It also builds another margin of safety into the whole scheme via probable capital increases over long periods of time.

Conclusion

As I said at the beginning, this is a first cut at asset allocation for a dividend growth investor. It's a hypothesis. There are a couple of interesting propositions on the table.

  1. What at first looks like a risky allocation- all assets in stocks- appears pretty normal once I "capitalize" the income rights that I already own through my pension and Social Security. That brings my stock allocation down to 39%.

  2. Viewing stocks as an income asset rather than a capital growth asset makes sense to me. I know that it does not make sense to lots of folks, who reflexively equate income with bonds or annuities. But dividend stocks yield income too, and that is their role in this asset allocation scheme.

  3. Under the figures here, I would never have to sell anything from my assets, as the dividends from the stock allocation not only cover my current income needs beyond my pension and SS, but they also cover the annual inflation that will reduce the purchasing power of all of my income. In fact, I will probably receive an excess of dividend income over the years when compared to my expenses, even after inflation is accounted for.

Disclosure: I am long INTC, JNJ, PG.