Dividend Growth Baselines

What is the absolute worst case withdrawal rate when you own TIPS and high quality dividend stocks?

Between 3.5% and 3.6% of the original balance (plus inflation). It lasts indefinitely, far into the future.

You may choose an initially high stock allocation that emphasizes a growing dividend income stream. You may prefer to start with a lower initial stock allocation, which leaves you with the ability to pick up bargains in the future. All tradeoffs are attractive.

Worst Case Baselines

I constructed baselines of dividend stocks and 2% (real interest rate) TIPS. I assumed an initial dividend yield of 3.0%. I assumed a real dividend growth rate of only 1%.

To maintain a constant withdrawal rate, I supplemented dividend income with TIPS interest and principal. I assumed that stocks never become attractive enough to purchase with the existing TIPS balance.

The 1% real growth rate is less than the dividend growth rate of the S&P500 index. A dividend yield of 3.0% is readily available from dividend focused exchange traded funds (ETF). The notion that stocks will never become attractive enough to buy implies continuing high valuations since P/E10=13 or 14 is enough to double the yield of dividend payers.

High Stock Alternative

Assuming an initial balance of $100000, withdrawing $3500 initially:

With 80% stocks and 20% TIPS at 2% (real) interest, the initial dividend amount is $2400. We can withdraw enough from TIPS interest plus principal to bring the total withdrawal amount to $3500.

The dividend amount at Year 10 is $2625. The dividend amount at Year 20 is $2899. The dividend amount at Year 30 is $3203. The dividend amount at Year 40 is $3538.

The TIPS balance hits a minimum Year 36. It increases after Year 36.

Assuming an initial balance of $100000, withdrawing $3600 initially:

With 80% stocks and 20% TIPS at 2% (real) interest, the initial dividend amount is $2400. We can withdraw enough from TIPS interest plus principal to bring the total withdrawal amount to $3600.

The dividend amount at Year 10 is $2625. The dividend amount at Year 20 is $2899. The dividend amount at Year 30 is $3203. The dividend amount at Year 40 is $3538.

The TIPS balance lasts through Year 36. In Year 37, the dividends are $3434. They grow above $3600 (to $3609) in Year 42.

Lower Stock Alternatives

Individuals may prefer lower stock allocations in case they need cash to exploit buying opportunities and/or to handle emergencies. A substantial percentage of the TIPS balance remains at Year 20 in all instances. Year 30 TIPS balances are small, about one-half of Year 20 balances.

Assuming an initial balance of $100000, withdrawing $3600 initially:

With 20% stocks, the Year 20 TIPS balance is $49241.
With 30% stocks, the Year 20 TIPS balance is $42134.
With 40% stocks, the Year 20 TIPS balance is $35027.
With 50% stocks, the Year 20 TIPS balance is $27920.
With 60% stocks, the Year 20 TIPS balance is $20813.
With 70% stocks, the Year 20 TIPS balance is $13706.
With 80% stocks, the Year 20 TIPS balance is $ 6599.

Assuming an initial balance of $100000, withdrawing $3500 initially:

With 80% stocks, the Year 20 TIPS balance is $ 8883.

We already know the (real) dividend amounts in later years with an 80% stock allocation. They are unchanged:

The dividend amount at Year 10 is $2625. The dividend amount at Year 20 is $2899. The dividend amount at Year 30 is $3203. The dividend amount at Year 40 is $3538.

We do not know the dividend yields in later years. The initial dividend yield is 3.0%. Most likely, dividend yields will increase as valuations return to normal.

Dividend Amounts in Year 30

Assuming an initial balance of $100000, withdrawing $3600 initially:

With 20% stocks, the Year 30 dividend amount is $ 801.
With 30% stocks, the Year 30 dividend amount is $1201.
With 40% stocks, the Year 30 dividend amount is $1601.
With 50% stocks, the Year 30 dividend amount is $2002.
With 60% stocks, the Year 30 dividend amount is $2175.
With 70% stocks, the Year 30 dividend amount is $2537.
With 80% stocks, the Year 30 dividend amount is $3203.

Summary

Under absolute worst case conditions, starting with $100000:

In terms of maintaining an income stream, a high dividend stock allocation makes sense. An 80% allocation can supply $3500+ indefinitely without any reductions. It can supply $3600 for 36 years, with a temporary reduction to $3434. It recovers completely by Year 42.

However, stock prices are volatile. If a retiree depends on TIPS to supply cash to exploit opportunities and/or to handle emergencies, starting with a TIPS allocation of 60% (and 40% stocks) supplies him with a TIPS balance of $35027 in Year 20. His stock holdings remain small. His dividend amount is only $1601 in Year 30.

Higher stock allocations produce higher dividend amounts, which grow faster than inflation. Lower stock allocations allow a retiree to take advantage of major stock price reductions for up to 20 years. All of these tradeoffs are attractive.

Have fun.

John Walter Russell
December 21, 2006