A New Take On The 4% Rule

Includes: CVX, INTC, JNJ, MCD, T
by: David Van Knapp

For about a year, I have been fascinated by the symmetry of dividend growth investing's typical 4 percent current yield with the familiar retirement strategy of withdrawing 4 percent of your assets in Year 1 of retirement.

They are the same number! In other words, if you have saved $X for retirement, then withdrawing 4 percent of it in Year 1 produces the same amount of "income" as a 4 percent yield. If you've saved $1,000,000, then a 4 percent withdrawal is $40,000. If your assets consist of income generators, a 4 percent current yield (which is typical) also generates $40,000. The equality of amounts holds true no matter how much X is.

That fact has lead me to write a few comments in reply to other commenters who criticized dividend growth investing by stating that it only works if you have a lot of money saved. They seem to think that living off of income is only for rich people. They overlooked the fact that the 4 percent withdrawal rule generates the same dollars in Year 1 of retirement.

A couple of weeks ago, I realized the blindingly obvious. In a comment exchange with fellow dividend growth investor Bob Wells, I stated the following:

Bob, You know what, if your portfolio yields 4% and that income grows with inflation, and you simply take your dividends out, it could be said that you ARE following a 4% rule. Of course, as we know, it's a different route, but the fact is that each year you are getting as cash your Year 1's 4% adjusted to the current year for inflation. (Actually, your yearly income will increase faster than inflation most years, but we'll just keep that our little secret.)

What about Years 2 through 30 or 40? Dividend growth investing appears to have an edge. Under the traditional 4 percent rule, you increment that first year's withdrawal amount by 3 percent (or another number) selected to represent inflation. So a $40,000 withdrawal in Year 1 becomes a $41,200 withdrawal in Year 2, and so on. In more flexible approaches, you might increment the next year's amount by the actual level of inflation (the government-calculated rate or your own home-calculated rate), or you might adjust your withdrawal by the actual performance of your portfolio. The point is, in Years 2 and beyond, inflation is accounted for in some fashion.

If the assets you own when you retire are income generators, the inflation adjustment may happen automatically. If you own a lot of dividend growth stocks, it has been shown that the dividend stream from your portfolio will increase faster than inflation most years. (A typical dividend growth rate across an entire portfolio of stocks selected with an eye on their dividend growth qualities is 6-8 percent per year. See "Has Dividend Growth Kept Up With Inflation?") In my public Dividend Growth Portfolio, the annual dividend increases have been 15 percent in 2010, 9 percent in 2011, and 10 percent so far in 2012, all well beyond inflation rates. The portfolio contains such well-known dividend growth stocks as AT&T (NYSE:T), Chevron (NYSE:CVX), Intel (NASDAQ:INTC), Johnson & Johnson (NYSE:JNJ), and McDonald's (NYSE:MCD).

As with the traditional 4 percent rule, you can be flexible about how you use the annual income increases. You can just take them as income and spend them. Or you can take just enough to cover inflation and reinvest the rest. Or you can take the excess beyond inflation and start a separate mad-money fund just for fun. (To see how an excess of available cash can build up beyond what is needed for living expenses, see "Retirement's 4% Rule: Why Mr. & Mrs. Income Don t Need It.")

The big difference, of course, between a retirement funding plan based on the traditional 4 percent rule and a "4 percent rule" derived from income generating assets is that in the traditional model, you must liquidate assets to produce the income you need in retirement. That is, you convert capital assets that you saved during your accumulation years into income by selling them. When you retire with income generating assets, the assets produce your income organically. It is a natural function of the type of assets that they are. Not needing to sell them means that you take Mr. Market's bipolar disease out of your retirement model.

Those of us who are attracted to the dividend growth model cite benefits such as:

  • Your income stream will generally increase faster than inflation.
  • You may sleep better at night knowing that your retirement lifestyle is not affected by market-driven fluctuations in your assets' value. The income generated by your assets is usually quite independent of their price volatility.

To those benefits we can now add this one: It doesn't take any more savings during your accumulation years to live off of income than to liquidate assets. That is because 4% of X equals 4% of X.

Disclosure: I am long CVX, T, INTC, JNJ, MCD. 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.