Building A Safe 4.5% Yield Income Portfolio With Inflation Growth In Today's Market - Is This Possible?

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Includes: SPY
by: Bruce Miller

Summary

The Yield on the S&P 500 at about 2.2% is very low.

Many retirees or soon-to-be retirees are rejecting the income approach for lack of reliable yield today.

But by mixing low yield high dividend growth with high yield no-dividend growth may provide sufficient household income AND income growth.

The S&P 500 Price is outpacing Dividend Growth in today's over-heated, yield-starved market, as interest rates have remained depressed, pushing many to dividend paying stocks for relief

Building an inflation growing income portfolio today is a true challenge, but it is doable.

As prices on dividend paying stocks rise faster than dividends are growing, the corresponding yield continues to decline.

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For those coming up on retirement or who are in retirement and considering changing their investing strategy to using an income method for providing reliable household income, it would seem that now is not a good time to be coming into the 'yield market'. But with a balanced use of fixed income preferred stock or Exchange Traded Debt (ETD) in combination with low yield high dividend growth stocks, a 4% to 4 ½ % income portfolio that will grow each year with inflation is certainly possible without having to take excessive income risk

What is INCOME RISK?

Simply put, income risk is the risk that the dividend paid by a stock or fund will not grow at the rate expected, will not grow at all (a 'flat' dividend), will be reduced (CUT) or, worst case, eliminated altogether. Generally, for a dividend growth stock, the higher the current yield, the higher is the income risk or the slower the dividend is expected to grow. The reason for this is the market is pretty efficient for yield. If company A within a given industry has a current yield of 4% and another stock B within that industry carries a current yield of 3%, stock A will either have a higher income risk or its dividend is not expected to grow at the rate of company B.

Defining the income need: Setting Goals

Step one in this process is establishing income need. It does no good to select dividend paying stocks if one has no idea of what the income requirement is and if the collective dividends will meet this need. This is done by listing the existing sources of household income and subtracting from this the household expenses. Here is a simple example:

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With today's yields continuing to shrink, is it possible to construct an income portfolio that will provide a current yield in the mid 4% range without taking too much income risk? This couple is risk averse and would like the income stream to be low risk of disruption of expected future dividends. The answer is yes, this is possible, but will require some work to find the right income securities.

Income Portfolio Construction

This income portfolio will require a mix of lower yielding but higher dividend growth stocks with long reliable dividend histories and strong current cash flows to adequately cover the dividend and high yielding low/no dividend growth to provide for the higher yield the portfolio will require. Dividend reliability is a high priority, while for this couple, liquidity is a secondary consideration due to household cash flow security. Preservation of capital is also a minor need and more of a 'nice-to-have'.

David Fish's listing of Dividend CCC Spread Sheet provides a ready source of reliable dividend payers. Note that for brevity I am foregoing my normal income diversification of no more than 3% of portfolio income from any single security and no more than 20% of portfolio income from any single income group (usually an industry). Otherwise, this article would be a bit too long.

From this list for dividend growing stocks, I've selected 5 stocks that have been paying a growing dividend for at least 15 years, have at least a 2.5% current yield with previous 5 year average dividend growth rates of greater than 3% but less than 10%. The latter requirement may seem odd to some, but 'explosive' dividend growth is generally not sustainable and is usually associated with an over-bought stock with a very low dividend current yield. Dividend growth sustainability is more important than short term high dividend growth.

For high yield/no dividend growth securities, I used LordXot's Google-Docs list of all preferred stock and Exchange Traded Debt (ETD) available. I would normally choose only those fixed income preferreds/ETDs currently trading near or below issue/redemption price so I don't have to include Yield-To-Redemption calculations, but I've had to reach up a bit higher for price due to the historically inflated prices of these securities in today's marketplace. I screen and select from those who have at least 2 years until first possible redemption, are preferably cumulative (preferred stock), the issuer pays a common stock dividend that has not historically been cut to zero and is currently covering their dividend with Cash Flow from Operations.

Here is the list I've come up with. Prices and dividends are as of July 28 close of business (COB). Note, that there are many, many combinations of C-Corporation dividend growing stocks and fixed income stocks that could be used, and it's important not to get too hung up on these names vs. other stocks that could/should be used….but rather to focus on how an income portfolio is constructed to meet household income requirements.

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As can be seen, the allocation of common stock to preferred stock/ETD is about 60%/40% based on today's valuation, but is the reverse…about 40%/60% of portfolio income. The number of shares to be purchased of each security affects the portfolio income yield and the expected portfolio income growth rate: The higher the proportion of dividend growth stocks the higher the portfolio income growth rate to sustain purchasing power (inflation) but the lower the overall portfolio yield. To get expected dividend growth rate for each dividend growth stock being considered requires calculating a previous 5 year average dividend growth history and then from this taking a "best-guess" on how the dividend will grow over the next several years based on the recent dividend growth trend and how the industry is headed.

From these expected growth rates, a table of expected total dividend payments can be constructed for the next several years and the Compound Annual Income Growth determined.

The expected portfolio income growth rate is a bit shy of the projected 2.5% target, but I consider this within the error range of assumptions made.

Conclusion

In the many years I've been doing this, I don't think I've ever seen current yields this low…even in 2006 when I didn't think they could get any lower. Over the last many years, constructing a 5.5% yielding income portfolio growing at 3% to 4% each year was easy. Today, a 4.5% yielding income portfolio with an expected 2.5% inflation growth rate is pushing the income-risk envelope for many retirees for whom income reliability is the top investment goal. But as I said earlier, there are many, many combinations of reliable dividend paying stocks available to choose from and also a somewhat lesser selection of affordable preferred stock and ETDs. The combination of these holdings can be adjusted to provide the desired portfolio yield and expected portfolio income growth the household requires.

So for those so interested, now its just a case of building your own income portfolio. Hopefully, this approach will provide some guidance in doing this. For those wishing to take the income approach to providing reliable income during retirement years, it's a bit of work, but in the long run, it is well worth it.

Disclosure: I am/we are long SO, XOM, MO, KMB, JNJ, O.

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.