It is nearing year end and my wife and I have set aside time this weekend to review our 2011 financial results and 2012 financial plans. To this purpose, years ago I set up a spreadsheet that projects our financial future out to age 90. I have updated it, modified it and added to it over the years so that it has become quite detailed and complex. Through those changes though, the primary purpose has always remained having a tool available to track whether we are on target to have sufficient money available should we be fortunate enough to live to such a ripe old age or, looking at a less rosy view, if we live to this age but need significant assistance in the process.
Now I am an asset allocator targeting wealth, not a dividend growth investor targeting income. Nonetheless, in case you haven't noticed, I am fascinated by dividend mechanics. One of the nice things about being a strict dividend growth investor targeting a level of retirement income and not wealth, is that there are relatively fewer variables to your investing style mathematically speaking. As a result, you can more easily and accurately project how much income your portfolio might yield at a particular point in time and then alter the few assumptions involved to estimate how sensitive it is to such changes.
Now I know that my hypothetical models have been wildly popular but, since I am going to try to deal with the future, I have no choice but to use this type of model. However, in this case, I will ground it in a bit more of a real-life foundation including real stocks as a starting point and the regular addition of fresh capital to the portfolio.
Here's the set-up: Larry, 55 years old, has saved well for retirement having an IRA that has a $400,000 current value. It is comprised of roughly equal amounts of four stocks: Procter & Gamble (NYSE:PG), Johnson & Johnson (NYSE:JNJ), McDonald's (NYSE:MCD) and Exxon Mobil (NYSE:XOM). Combined, these stocks have an average current yield of about 3% and, over the past three years, the combined average dividend growth rate has been about 10%. I have converted these four stocks into "Larry's ETF" and have assigned a hypothetical number of shares at 10,000 and current share price of $40 per share (this is essentially what I do with my own portfolio of individual stocks). I have fixed the annual anticipated stock price appreciation on the portfolio at 3%, but this only serves to determine the number of shares bought when dividends or new contributions are invested as I am targeting an income level not a portfolio value. * (see note below)
Larry wants to retire in 10 years at age 65 and is expecting that he will need $40,000 of income from his dividend growth portfolio in current, 2011 dollars. He is estimating that inflation will average about 2.5% over the next ten years so inflating the $40,000 at this rate for ten years grows the required level of income to almost exactly $50,000. Over the next ten years, Larry plans to continue to contribute to his IRA but wants to plan how much he might need to contribute annually to reach his goal of $50,000 of income in ten years.
First, let's say that Larry believes the 10% dividend growth rate of the past three years is a good estimate for the growth rate for the next ten years. Using the "Goal Seek" function in Excel, I set the required income in 2021 to $50,000 and solved for the annual contribution. As the spreadsheet shows, Larry would need to contribute $4,876 per annum to achieve his goal. Click to enlarge:
Now let's say that Larry feels that the dividend growth rate for his personal ETF for the past few years has been extraordinary and cannot be sustained. Instead he feels that an 8% dividend growth rate is more appropriate. Again using the "Goal Seek" function, we solve for the required annual contribution to achieve the $50,000 income goal. The result is, he would need to contribute $19,435 per annum to his IRA to reach his goal...more than a $14,500 increase per annum over the result from the 10% dividend growth portfolio! Click to enlarge:
Finally, let's say Larry really feels his portfolio has really overachieved the past few years and believes that a 6% dividend growth rate is a safer, more conservative assumption. The result is that he would need to contribute $37,275 per annum to his IRA (might exceed Larry's contribution limits)...an almost $18,000 increase per annum over the 8% dividend growth assumption and more than a $32,000 increase per annum over the amount required in the 10% dividend growth scenario! Click to enlarge:
Conclusion: A dividend growth portfolio targeted to produce a specific level of income is extremely sensitive to changes in the dividend growth rate. If you are adding annual contributions to your IRA to reach your income target, you will need to add significantly more money as the dividend growth rate falls (and vice versa). If this is your style of investing and your goal, you should closely monitor your assumption of future dividend growth to make sure that you are on track to achieve your goals.
In my next article on this topic, I will talk more about each of the variables in the model and then run some additional sensitivities to see what combinations would allow Larry to achieve his goal of $50,000 of first year retirement income.
* As discussed in my article here, changes in price appreciation have an effect on the number of shares accumulated when reinvesting dividends and will therefore alter the final dividend level. I have attempted to reduce the effect of this variable as much as possible by setting the price appreciation at a modest level (3% per annum) and keeping all the scenarios the same. Should we, for example, enter a sustained bull market where price appreciation is substantially above this level, it will have a negative impact on the income producing potential of the portfolio.