When I build a retirement income portfolio for a client I always factor in inflation. If the income must grow to keep up with rising prices without re-investments (you are living off the income) then dividend growth is essential. Companies with a long history of dividend growth are typically involved with products and services that can command increased prices. The nature of these products is simple and they have in-elastic demand, like medical, food and energy. These will work well for inflation protection.
Now the best of these dividend growth companies trade at strong price premiums. It's a factor of investor perception of safety. Not many of my clients want to live off of the 2.7% yield of some of these companies like Coca-Cola (NYSE:KO). Don't get me wrong, I love KO and own lots of shares.
Investors who are looking for strong current income will need to start adding quality high-yield investments. This creates a mix of dividend growth and high yield. This is were the fun starts.
For current income I add high yield until a portfolio is paying out about 6% APY. I do not advise my clients to go above that cumulative yield level in order to protect capital. I want to see the cumulative yield rising by at least the inflation rate each year. I want the portfolio to exist forever, so the return of capital is not considered yield. Many high yielding CEFs are returning capital to shareholders and that cannot be sustained over a long time frame.
An example would look like this for a $50,000 portfolio designed for maximum sustainable current income and still be protected from inflation.
AT&T (NYSE:T): $20,000 Annual Dividend: $980.00
Johnson & Johnson (NYSE:JNJ): $5,000 Annual Dividend: $185
Microsoft (NASDAQ:MSFT): $5,000 Annual Dividend: $135.00
Linn Energy (LINE): $15,000 Annual Dividend: $1215.00
Altria (NYSE:MO): $5,000 Annual Dividend: $245.00
Total Dividends: $2760 Yield: 5.52%
*Dividend growth rate: 5-year average is 11%
* Data from Morningstar.com
A look into the future is best done conservatively, so let's take half the 5-year average dividend growth rate and check in on the payments growing by 5.5 percent each year.
|1st Year||$2760||YOP: 5.52%|
|2nd Year||$2911||YOP: 5.8%|
|3rd Year||$3071||YOP: 6.1%|
|4th Year||$3239||YOP: 6.4%|
|5th Year||$3417||YOP: 6.8%|
|6th Year||$3604||YOP: 7.2%|
|7th Year||$3802||YOP: 7.6%|
|8th Year||$4011||YOP: 8.0%|
This chart is shown with no re-investment of your dividends. You took the money from the dividends and spent it on groceries and the grand kids. Now the stock market is risky for sure, so this could all fall apart. I would like to mention that AT&T has raised its dividends for 28 years, and JNJ has raised for 49 years, MSFT has raised for 9 years. Linn and Altria have traditionally been good dividend companies as well and much has been written of both.
If the inflation rate stays the same round 3% per year then your income from this portfolio is staying well ahead of the erosion of your purchasing power. If an investor can wait for several years to take the income then re-investment would be appropriate and it would benefit greatly to find a dividend growth rate even higher than 5.5% even at the sacrifice of lower starting yield percentage.