For many investors approaching retirement, income planning has become extremely difficult, if not downright impossible. So many people had hoped to live off of income generated by relatively safe treasury bonds and high-quality corporate bonds, but that strategy is out the window for most given where interest rates are today. Even with interest rates rising over the past few months, they are still well below historical norms.
In this article I want to show just how difficult it has become to cover expenses with fixed income alone in retirement. I also want to show what might surprise some investors: A relatively low dividend yield stock such as Apple (NASDAQ:AAPL) can be used for income planning.
Even though Apple's dividend yield is relatively low at 1.6%, it is the potential growth of that dividend that makes it a great candidate for income generation in retirement, especially after several years of compounded dividend growth.
Let's first start off by looking at how much easier it was to live off of bonds in retirement in 2007 when the ten-year treasury yield was 5%. I want to look at a couple that is currently 50 years old and will retire in 15 years. My assumptions are below.
First note that this couple plans on switching completely to treasuries when they retire at age 65. If treasury yields were at the level they were in 2007, this couple would not have any problems. I generated the analysis and graph below using our Retirement Planner. I assumed they invested all of their money at retirement in 10-year treasury bonds yielding 5%, which was the 10-year yield in 2007.
Notice how expenses are covered by income every year in retirement. Not only are expenses covered by income, but this couple will have nearly $900,000 left at the end of their plan. That is a very large safety buffer, and it is obvious this couple will have no problem meeting their retirement goals.
But this was before treasury yields fell to below 3%. Using today's yields, we see the following:
It now becomes painfully obvious that there is no way this couple can use income for their retirement expenses. Not only that, but their safety buffer (the amount left at the end of their plan) falls to less than $200,000. Also, their probability of success using Monte Carlo analysis falls to 60% from 97% when yields were higher.
Now that we know the problem, what is the solution? Let's look at a company like Apple whose dividend yield is 1.6% and whose dividend growth rate has been averaging about 10% for the past three years. If this growth rate holds, over a 10-year period, the Yield On Cost would jump to nearly 4.5%, and over 20 years, the Yield On Cost would be over 10%. With Apple's income and cash holdings and their extremely low payout ratio of 23%, it is very possible for them to continue this dividend growth rate for years to come.
I propose using a combination of high-quality dividend-growth stocks and treasury bonds to generate income in retirement. The types of dividend-growth stocks I am referring to are those that consistently raise their dividends and have shown that they can raise their dividends even during recessions. I am also most definitely not recommending that people invest in only one dividend-growth stock. Investors should diversify among many dividend-growth stocks that have shown they will increase their dividends over time.
Let's take a look at what happens if they move half of their money into a basket of dividend-growth stocks that have an average dividend yield of 1.6%, an average dividend growth rate of 10%, and average stock price growth of 3%.
We now see that this couple easily covers their expenses with income (thanks to their dividend payments). They will also now have a safety buffer of over $850,000 at the end of their plan and the probability of plan success jumps to more than 90%.
As many investors know, the dividend yield is not the only way to generate income from dividend paying stocks. Dividend growth can be an even bigger factor over time, so it is important to find stocks that have the capability of increasing their dividends into an investor's retirement.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.