Dividend-Based Design Outline

1. I use S&P500 data for detailed analysis simply because they are available.

2. I use DVY for scaling. DVY is a high dividend exchange-traded fund. Dividend investors should be able to purchase stocks from high quality companies that yield as much as DVY when compared to the S&P500. DVY yields just under 3.0%. Today’s scale factor is 1.725.

Dividend Growth

3. I determined the growth of (real) dividends as a function of the payout ratio (dividends/earnings) in terms of E10, the average of a decade of trailing (real) earnings. I calculated E10 from Professor Robert Shiller’s data by dividing the real price by P/E10. I used Excel to calculate regression equations (i.e., linear curve fits) of the moving average of dividends at years 4, 8 and 12.

4. NOTE: My breakthrough was to use the payout ratio (based on E10) instead of the percentage earnings yield 100E10/P. The payout ratio based on a decade of smoothed earnings tells us about the sustainability of dividends and the likelihood of their growth.

5. Using today’s payout ratio of 40% to 45%, the (real) dividend growth [without reinvestment] is most likely to be 10% at year 4 with a range of –10% to +40% (rounded). The (real) dividend growth is most likely to be 40% at year 8 with a range of 5% to 100% (rounded). The (real) dividend growth is most likely to be 50% at year 12 with a range of 0% to +150%.

Dividend Availability

6. Based on Professor Robert Shiller’s historical data, I anticipate that P/E10 will fall to 15 in 3 to 7 years. I expect P/E10 to fall to 10 by 2015. Assuming that payout ratios based on E10 remain between 40% and 60% (as they have throughout the last half-century), the S&P500 dividend yields should be between 2.7% and 4.0% within 3 to 7 years and between 4.0% and 6.0% within 9 years. Scaling by the 1.725 factor (which is the dividend yield of DVY divided by the dividend yield of the S&P500): dividend investors should be able to get yields of 4.7% to 6.0% from good companies in 3 to 7 years. Dividend investors should be able to get yields of 6.9% to 10.4% from good companies in 9 years.

The TIPS Alternative

7. I use TIPS at today’s 2.0% (real) interest rate as an alternative investment.

8. If you draw down principal, TIPS at 2.0% would allow you to withdraw 4.00% (plus inflation) for 35 years, 4.46% (plus inflation) for 30 years or 5.12% (plus inflation) for 25 years.

9. After a decade, withdrawing 4.0% from 2% TIPS reduces the principal to 78.1% of its original value. Withdrawing 4.4% from 2% TIPS reduces the principal to 73.7% of its original value. Withdrawing 4.8% from 2% TIPS reduces the principal to 69.3% of its original value. Withdrawing 5.0% from 2% TIPS reduces the principal to 67.1% of its original value.

10. NOTE: See Equations for Design for the formulas.

Equations for Design

Strategy

11. My strategy is to buy dividend stocks and TIPS. I withdraw the stock dividends and TIPS interest. I consume enough TIPS principal to maintain the desired withdrawal rate.

12. The downside risk from dividend cuts is 10% over four years based on today’s payout ratio. After year 4, the downside risk is 0%. [There can be fluctuations. These numbers are based upon 4-year moving averages.] That is, after year 4, the (real) dividend amount will have grown or, at worst, it will be only as much as it was initially.

13. I assume that dividend stocks will yield 6.9% by year 10. [This assumes a 40% payout ratio for the S&P500 index, similar to today’s, when using E10 instead of one-year earnings and it assumes the 1.725 scale factor.] The upside potential for dividend stocks is 10.4% yield (based on a 60% payout ratio).

Trade-offs

14. Without consuming TIPS principal, we would be stuck with the yields from dividend stocks: around 3.0%. Payments would increase. Typically, the payments would be up by 40% to 50% after a decade: around 4.2% to 4.5% (plus inflation). The payments could be up to as high as 6.0% to 9.0% (times the initial balance plus inflation).

15. If we were to buy TIPS alone and if we never bought any dividend stocks, we could withdraw 4.00% (plus inflation) for 35 years, 4.46% (plus inflation) for 30 years or 5.12% for 25 years (plus inflation). But our final balance would be zero.

16. If we were to start with 100% TIPS, we could withdraw 4.8% for up to ten years, waiting for dividend stocks to yield 6.9%. If we had to wait the full ten years, we would still have 69.3% of our original principal when we bought our dividend stocks. The dividend payments would be 0.693*6.9% times our original balance. That is, we could continue to withdraw 4.8% of our original balance (plus inflation), but now perpetually. We would no longer consume principal.

17. Our downside after conversion would be a 10% decline over a period of four years, after which our payments would grow back to their full value (plus inflation) or even larger.

18. You can consider alternative allocations as well. For example, in my example, I looked at a 50%-50% initial allocation between dividend stocks and TIPS.

19. The income stream from dividend stocks is (close to) permanent. The income stream from TIPS is not. The risk from investing in TIPS is that dividend stocks never become attractive enough to purchase.

20. This approach avoids the need to sell dividend stocks when their yields are not sufficient.

Have fun.

John Walter Russell
January 18, 2006