Dividend Growth Investing: Retiring On Dividend Income (Part 2)

Includes: CL, JNJ, JPM, KMB, KO, PG, WFC
by: David Crosetti


There are many ways to fund retirement besides being invested in stocks and bonds.

Every investor is different and every investor needs a retirement plan that accounts for their own situation.

One approach to retirement, using stocks is Dividend Growth Investing.


In my previous article, "Dividend Growth Investing: Creating Your Own Dividend By Selling Shares (Part 1)", we took a look at a hypothetical investor who over the years had amassed a portfolio with a value of 1 million dollars. This investor decided that he was going to sell 4% of his portfolio in retirement and increase his annual income from sales by 4% a year, in order to account for inflation.

Some of the concerns voiced in comments made centered around portfolio makeup. That's a valid concern as many investors have portfolios that include other investments besides stocks. Some investors have a mix of stocks and bonds. Others have EFT's, REIT's, MLP's and all sorts of investment vehicles within their portfolio. Trying to find a one size fits all is a little like trying to fit into a "one size fits all" bathrobe provided at many luxury hotels. When you're 300 pounds, trust me, one size does not "fit all."

There are also a number of different strategies, beyond the stock market, to fund the retirement years. As some readers pointed out, there are annuities that might be appropriate for those approaching or into retirement; for some who have paid for their homes, perhaps a reverse mortgage might be an opportunity.

Social Security plays into the picture as well and depending on your personal situation, there are a number of different strategies to use in determining your own best time to elect Social Security benefits.

Recapping the 4% Rule (Investopedia)

A rule of thumb used to determine the amount of funds to withdraw from a retirement account each year. The four percent rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that will allow funds to be withdrawn for a number of years. The 4% rate is considered to be a "safe" rate, with the withdrawals consisting primarily of interest and dividends. The withdraw rate is kept constant, though it can be increased to keep pace with inflation.

The four percent rule helps financial planners and retirees set a portfolio's withdrawal rate. Life expectancy plays and important role in determining if this rate is going to be sustainable, as retirees who live longer will need their portfolios to last a longer period of time and medical costs and other expenses can increase as the retiree ages.

So, again, there are different strategies that can be employed with the 4% Rule and these can be as varied as any investor might choose to employ them.

Dividend Growth Investing:

As there are many potential nuances to the 4% Rule, there are just as many potential variables to the strategy of funding retirement using the Dividend Growth model. Looking at commentary from different investors at Seeking Alpha, there is no shortage of varying strategies within the DG model.

Some investors using the strategy will select stocks from the Dividend Champions, Contenders, and Challenger lists that are available for your review here.

This is a universe of stocks that have increased dividends annually for at least 5 years and is broken down into three categories that reflect the length of time that a particular company has been increasing dividends annually. The lists include not only traditional equities, but MLP's and Reit's. Something for everyone.

There are DGI's like myself, who trim their holdings to keep their portfolio holdings in a "balance" of the total portfolio value. There are some who will sell entire positions with a large price run up, taking capital appreciation. There are some that "buy and monitor." There are some that look at the dividend yield and focus on that. Again, as varied as there are people who invest in the market.

Regardless of the many nuances to your own DGI strategy, there are some factors which stick out as "constants." For example, a Dividend Growth stock, by definition needs to being growing the dividend. If a company pays a dividend, but does not increase the dividend, then it is a "dividend paying stock" and not a "dividend growth stock."

Some dividend growth stocks have a Dividend Growth Rate that is greater than inflation and some do not. The DGR should not always prevent you from investing in the companies increase dividends at a rate that is less than inflation, if those companies have a larger yield or are attractive from a value position. The overall portfolio yield is just as important a consideration as any individual stock in the portfolio.

Some Suggested Points of Focus For DGI's:

1. Make regular contributions to your retirement portfolio. As long as you have the opportunity to fund your retirement portfolio, make every effort to do so.

2. Focus on creating a diversified portfolio. An investor does not want to load up on only one or two sectors, but instead invest in the "best" company within each sector.

3. Purchase stock in companies when they are priced at a value. Pay particular attention to fundamentals and be comfortable with not adding additional shares of a stock when it is overpriced.

4. Look for companies with a track record of increasing dividends for a long period of time. While I try to find companies that grow dividends at a rate that is larger than inflation, the DGR does not keep me from purchasing any company that is priced at a value.

5. Reinvest dividends with your brokerage. While there are many reasons why DGI do not reinvest dividends, what I've found is that over long periods of time, the accelerated effect of compounding makes the practice a profitable one.

A Dividend Growth Investor's Retirement:

Our DGI has amassed a portfolio with a current value of 1 million dollars. His current portfolio yield is 4% which means that in his first year of retirement, he can expect to have $40k of dividend income from which to fund his retirement.

In our example, we are focused only on the income from dividends and not Social Security, annuities, or any other form of income. For both the investor who uses the 4% rule and for the DGI, those additional sources of income do come in handy, but again for our purposes here, we are looking at the income from dividends.

Assuming the 4% yield and a 4% Dividend Growth Rate, our portfolio income should look like this over the years:

Notice that there is no portfolio value in the second column. If the starting point is a 4% yield and a 4% DGR, then the value of the portfolio moving forward does not impact the income growth from dividends moving forward.

When we consider a portfolio with a value of 1 million dollars, a yield of 4% and a DGR of 6% our results would look like this:

Again, once the portfolio is established, the value of the portfolio is of less importance as the value of the portfolio does not change the dividend income stream. If the DGR increases by 6% a year, then the dollars generated as dividend income will do the same.

Reasonable Expectations:

Some of my favorite holdings are Coca-Cola (NYSE:KO), Johnson and Johnson (NYSE:JNJ), Kimberly Clark (NYSE:KMB), Colgate Palmolive (NYSE:CL), and Procter and Gamble (NYSE:PG). While these 5 companies have been in my portfolio longer than my other holdings, they have prospered quite well and over the years have increased in position size due to additional purchases made, stock splits, and reinvested dividends.

When we look at the CCC list of stocks, we find that there are 105 Dividend Champions. The stocks that make up the Champions currently have an average dividend yield of 2.52% with a DGR for the 1-3-5-10 year periods of 8.5%, 7.6%, 6.7%, and 8.0%. These companies have been increasing dividends for at least 25 straight years.

In the Dividend Contenders, we find a universe of 229 companies that have an average dividend yield of 2.69% and an average DGR of 9,9%, 10.1%, 9.0% and 11.7%. These companies have been increasing dividends annually for at least 10 straight years.

In the Dividend Challengers, we find a universe of 192 companies with an average yield of 3.06%. The average DGR for the group is 13.6%, 17.3%, and 15.5%. These companies have been increasing dividends for at least 5 straight years.

Summary and Conclusion:

Creating a DGI portfolio to fund retirement, whether you have a 1 million dollar portfolio or less than that, is a viable alternative to the 4% Rule. The advantage to a DGI portfolio is that income from dividends can increase year over year, without the portfolio owner having to concern himself with portfolio value. Now, I am not saying that portfolio value is not something to be concerned about, but the endless fretting over the day to day, month to month or year to year fluctuations becomes of less concern.

Market corrections present opportunities for additional purchases of existing positions and/or the addition of new positions to your portfolio. As the price of a stock pulls back, the dividend yield advances, giving investors a better starting yield point for their additional share purchase.

DGI investors who accumulate a large enough portfolio for their needs in retirement do not have to sell any shares of their portfolio to fund their retirement years. They might choose to sell shares, but since it is not required to generate income, the decision to sell can be made at the most appropriate times to make a sale.

DGI investors participate in an active management role. As companies no longer meet the definition of DGI companies, decisions as to hold/sell have to be made. For investors who held financials in the 2008 market correction, there were decisions that had to be made, relative to hold/sell.

By the same token, as financials recovered and began to increase dividends (while not achieving Dividend Challenger status yet, companies like Wells Fargo (NYSE:WFC) and JP Morgan (NYSE:JPM) have rewarded investors who purchased those companies back in 2011.

DGI is a relatively simple concept. It requires that investors look at long term results, rather than short term trades. It means that stock performance, relative to income growth needs to be monitored. It means that being focused on a diversified portfolio of stocks (and whatever else one might choose to add to their investing world).

While I can acknowledge that having all your net worth only in US stocks is probably not a good idea, I know that having a stake in dividend paying stocks has been very rewarding for me.

Disclosure: I am long WFC, JPM, KO, PG, CL, KMB, JNJ. 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.