Retirees: Do The Math And Combine The Strategy Of 'Homemade Dividends' With High-Quality Dividend Stocks

by: Antonio Carradinha

Summary

Only a small minority of retirees may live with dividends and capital gains without touching the principal.

A strategy of "homemade dividends" is often the solution for a stream of income.

Naturally, income from guaranteed sources such as social security and pensions (if any) will add to the portfolio's income at some point in time.

Given that only 25% of Americans aged 55 and over have saved more than $300,000, it is worth considering ways to better manage the money at retirement.

It is clear that only a small minority of retirees may live with dividends and capital gains without touching the principal. Even in this situation, I think that the money has to be invested mainly in top-notch dividend stocks because it should be taken into account that stocks sharply beaten down are left with misleading high yields.

But if the level of capital involved is small, retirees need to have a stream of income in accordance with their specific lifestyle. So, what should be done?

To begin with, I'm going to consider a retiree with a stable life, no debt and medium-to-low needs of annual cash flow. Thus, I will consider a portfolio of $300,000 that can lead to an annual income of almost $40,000, which may be acceptable for the day-to-day running expenses of an average retiree under the conditions described above. Of course, this should always be complemented with other income from guaranteed sources such as, for example, social security and pensions (if any).

The table below is an exercise that may have a lot of meaning for many retirees as it demonstrates that different ways of managing a portfolio will be possible in these cases. It is here that within the framework of a strategy to sell stocks annually ("homemade dividends") the portfolio can become the key to a favorable financial scheme. Either way, for different lifestyles, we may scale up or down as needed, and I will present the results of different levels of investment.

It is more suitable that a substantial part of the portfolio will include non-dividend paying stocks providing more flexibility and fiscal efficiency. Thus, the small $300,000 portfolio can be divided into two parts as follows:

  1. $150,000 - high-quality dividend stocks with a dividend yield of around 3%. Expected capital increase of 5% per year. Generation of cash through the sale of shares in the annual amount of 12% of total - putting in place the so-called strategy of "homemade dividends".
  2. $150,000 - non-dividend paying stocks with growth potential and expected annual appreciation of 15%. Generation of cash flow through the sale of shares ("homemade dividends") in the amount of 12% of total (15% after year 10).

It's clear that this portfolio has simple assumptions, but it is not safe from sharp falls in difficult times. Let's see in detail what the results with the above expectations are:

  1. On the table above, we can see that with the mentioned assumptions, after 20 years, we still have $66,000 from the first portion and $196,000 from the second one.
  2. It is extremely important to note that over these 20 years, the investor sold sufficient shares to obtain an amount of "homemade dividends" which was never lower than ~$36,000 on an annual basis (with an average of $38,000).
  3. If the strategy can be accomplished over time, in year 21, the retiree's portfolio may still be worth $262,000, still a very significant amount.

With everything else being equal, we have the following results for higher levels of initial portfolio:

Of course, the biggest risk lies in the appreciation of the portion of shares without dividend for which an annual increase of 15% is foreseen. It is implicit in this strategy that annual sales of shares should adapt to market cycles. Thus, if there is a high risk of running out of money in the future, retirees should reduce withdrawals and expenses so that after 20 years they can always have a capital of around $200,000, using the financial projections of the model above. In any case, there is always the possibility of choosing which of the two groups should have more or less shares sold according to their performance throughout the year. This flexibility will hopefully allow good years to make up for worse years. In addition, the dividend yield has a conservative forecast of 3%, which may present a much higher record.

One last point: The 5% annual increase in high-quality stocks may be higher given that we are looking at a 20-year period. While knowing that past performance is no guarantee of future results, we are aware that the historical CAGR of the S&P 500 is much higher than 5%.

This is an exercise meant to include the generation of cash flow through the sale of shares of the portfolio putting in place the so-called strategy of "homemade dividends". Even for larger portfolios, it's always crucial to pay the utmost attention to the high-quality of shares chosen (included in the first group) and the growth potential of shares covered in the second group.

My goal was to present a flexible method of managing retirees' portfolios that could be of effective help allowing wide application according to the abilities of each investor. This is especially directed to those retirees who like to research stocks and have the knowledge and interest to pursue ways to find new sustainable paths for their investments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: The author of this article is not an investment adviser and gives only his personal view and opinion, never making any investment advice or recommendation to buy or sell specific securities. Investors in financial assets must do so at their own responsibility and with due caution as they involve a significant degree of risk. Before investing in financial assets, investors should do their own research and consult a professional investment adviser.