Originally posted at Portfolioist.com.
I came across a very highly commented article on Seeking Alpha today called With The Right Dividend Stocks, How Much Money Would You Really Need to Retire?
The focus of this article is to ask whether you can get away with a smaller portfolio value and still retire comfortably if you invest in stocks that have high dividends.
This is an interesting question, and one that I examined in a recent article for Advisor Perspectives.
A rule of thumb for retirement income is that you can expect to draw an annual income equal to 4% of the value of your portfolio at retirement. If you retire with $1 million, you can plan to draw an inflation-adjusted $40,000 per year. So, you will draw $40,000 the first year, and escalate this with inflation in each year thereafter. The typical assumption is that the portfolio is invested in a simple mix of stocks and bonds--say 60% stocks and 40% bonds. This type of portfolio typically is projected to have a total return of about 7% per year.
Why can you only draw 4% when your portfolio is expected to grow at 7%? Two reasons. The first is inflation--part of the return on the portfolio goes to make sure you keep up. The second reason is investment risk. You may average 7%, but the ups and downs mean that you can count on drawing only 4% or so if you want to be confident that you will not run out of money.
The Seeking Alpha article suggests that you can, in fact, draw considerably more than the 4% rule suggests if you invest in dividend stocks. The article seems to be positing that the key is to invest in stocks with high dividend growth rates and that dividend growth is the key. The problem that I have with the analysis is that it seems to be assuming that the dividend growth rates and returns on dividend stocks are, in essence, risk free. If we could be certain that companies we invest in will be able to maintain and raise their dividends every year, we'd be fine---but that is not the case.
In my article, I was inspired by a study by Vanguard that suggests that income-oriented strategies don't make sense and that a 'total return' approach is the best solution for funding sustainable retirement income. My article was essentially a counter-argument, and I used Monte Carlo simulation (which explicitly accounts for investment risk) to compare some income-oriented strategies to total-return strategies. My simulation results suggest that neither approach is inherently superior from a statistical standpoint.
I am still inclined towards dividend-focused investing on the basis of behavioral issues, however. There is a broad and growing literature that suggests that low beta stocks tend to out-perform high beta stocks. Low beta stocks tend to be the dividend payers, for example. Low beta stocks are not glamour stocks--to the contrary, they tend to be the 'boring' firms that don't get all that much attention. There is also evidence that dividend-paying stocks tend to be less susceptible to management playing games with accounting (aka 'earnings management') and thus their earnings statements are more meaningful as the basis for investment decisions. Companies that focus on stock buybacks rather than dividends often use these buybacks for the benefit of management rather than for the benefit of investors.
I am all for investing in quality dividend stocks, but I think that it would be a terrible mistake to assume that you can plan to save less during your working career because you are investing in dividend stocks. We may hope that this is the case, but as the saying goes 'hope is not a strategy.'
So, when we want to answer the basic question of how much money you need to have in invested assets at retirement, I believe that we come back to estimating something on the order of $40K-$50K for $1 million.
Disclosure: No positions