Dividend Growth versus Liquidation

Early retirees should adopt dividend strategies. They are vastly superior to the traditional, fixed allocation, liquidation strategies that depend on capital appreciation.

Traditional Liquidation Strategies

The traditional liquidation strategy uses a fixed allocation between the stocks and bonds, as represented here by the S&P500 and 2% (real interest rate) TIPS. Withdrawals consist of a constant percentage of the initial balance (plus inflation). Withdrawals consist of interest and dividend income and the sale of stocks.

Most often, the Safe Withdrawal Rate is specified at Year 30. There is a non-trivial probability (greater than 5%) of running out of money in Year 31. Most often, if a portfolio survives beyond Year 30, it succeeds spectacularly well.

I used my Super SVTVR Calculator L to determine the P/E10 levels that would produce specified Year 30 Safe Withdrawal Rates at stock allocations of 20%, 50%, 80% and 100%. Here are those results:

For a 4% Safe Withdrawal Rate (2% TIPS) at Year 30:
20%, P/E10=23.0.
50%, P/E10=21.4.
80%, P/E10=19.5.
100%, P/E10=17.3.

For a 6% Safe Withdrawal Rate (2% TIPS) at Year 30:
20%, P/E10=5.9.
50%, P/E10=10.5.
80%, P/E10=12.5.
100%, P/E10=12.4.

For an 8% Safe Withdrawal Rate (2% TIPS) at Year 30:
20%, P/E10=3.3.
50%, P/E10=7.0.
80%, P/E10=9.2.
100%, P/E10=9.7.

I used my Super SVTVR Calculator L to determine the P/E10 levels that would preserve the buying power of the initial portfolio at Year 30 (at a 95% confidence level). This produces Continuing Withdrawal Rates at Year 30. [I also refer to these as Year 30 Constant Terminal Value Rates.] I examined stock allocations of 20%, 50%, 80% and 100%. Here are those results:

For a 4% Continuing Withdrawal Rate (2% TIPS) at Year 30:
20%, P/E10=5.7.
50%, P/E10=12.6.
80%, P/E10=15.9.
100%, P/E10=15.9.

For a 6% Continuing Withdrawal Rate (2% TIPS) at Year 30:
20%, P/E10=3.2.
50%, P/E10=7.8.
80%, P/E10=11.0.
100%, P/E10=11.8.

For an 8% Continuing Withdrawal Rate (2% TIPS) at Year 30:
20%, P/E10=2.2.
50%, P/E10=5.7.
80%, P/E10=8.4.
100%, P/E10=9.4.

Dividend Growth

Since 1950 (actually, since the 1940s), S&P500 dividends have had a remarkably steady nominal growth rate of 5% per year. Today’s S&P500 dividend yield is just under 2%. The oldest dividend focused ETF (exchange traded fund) DVY currently has a dividend yield of 3%. With care, today’s investor should be able to obtain an initial dividend yield of 4%.

It should be straightforward to match the 5% per year nominal dividend growth rate of the S&P500. Simply eliminating those companies that pay zero dividends would increase the initial yield. [I am ignoring companies that begin to pay dividends or that discontinue paying dividends.]

I used my TIPS Income Stream Allocator B to see what initial dividend yields of 3% through 7% would provide in income. I allocated 20% initially to TIPS (at a 2% real interest rate). I allocated 80% initially to Stock A. I allocated nothing to Investment B. I neither sold nor purchased any shares of stock. I varied withdrawals from the TIPS account to produce a steady (real) income stream (after adjusting for inflation).

This is what I found:

If the initial dividend yield is 3% and the nominal dividend growth rate is 5% per year AND if the Stock A allocation is 80% and the TIPS allocation is 20%, the Continuing Withdrawal Rate is 3.95%.

If the initial dividend yield is 4% and the nominal dividend growth rate is 5% per year AND if the Stock A allocation is 80% and the TIPS allocation is 20%, the Continuing Withdrawal Rate is 4.95%.

If the initial dividend yield is 5% and the nominal dividend growth rate is 5% per year AND if the Stock A allocation is 80% and the TIPS allocation is 20%, the Continuing Withdrawal Rate is 5.9%.

If the initial dividend yield is 6% and the nominal dividend growth rate is 5% per year AND if the Stock A allocation is 80% and the TIPS allocation is 20%, the Continuing Withdrawal Rate is 6.9%.

If the initial dividend yield is 7% and the nominal dividend growth rate is 5% per year AND if the Stock A allocation is 80% and the TIPS allocation is 20%, the Continuing Withdrawal Rate is 7.8%.

If the initial dividend yield is 8% and the nominal dividend growth rate is 5% per year AND if the Stock A allocation is 80% and the TIPS allocation is 20%, the Continuing Withdrawal Rate is 8.7%.

Comparisons

Today’s P/E10 is 28. None of the liquidation strategies can provide an income stream of 4% of the original balance (plus inflation) safely. In contrast, a dividend strategy that starts with a 3% initial dividend yield produces a continuing income stream of 3.95%. With care, a dividend investor should be able to withdraw 4.95% (plus inflation) continually and safely.

When stock valuations return to their normal levels, which is about one-half of today’s levels, the initial dividend yield of the S&P500 will double to just under 4%. Dividend stocks will start out yielding 6% to 8%.

At P/E10=14, with an 80% to 100% stock allocation, the traditional Year 30 Safe Withdrawal Rate is below 6%. The Year 30 Continuing Withdrawal Rate is a little bit higher than 4% with a liquidation strategy.

In contrast, the S&P500 should deliver a continuing income stream close to 4.95% with a TIPS/dividend growth strategy. A dividend investor should be able to achieve a 6.9% to 8.7% continuing income stream.

Failure Mechanisms

Liquidation strategies result in bankruptcy when they fail. More often, they succeed spectacularly well.

Dividend strategies fail to keep up with inflation when they fail. Based on the S&P500 during hyperinflation, real dividend amounts can fall by as much as 24% (cumulative). [I have set the Income Stream Allocator’s inflation rate at 3%, which is typical, not an extreme.] Real stock prices fell to 42% of their peak (peak to valley, 58% loss) in the same period.

Conclusion

Dividend strategies perform spectacularly well when compared to traditional liquidation strategies.

These numbers are lower bounds. I do not have good data for the dividend growth rate of dividend focused portfolios. I have used S&P500 numbers by default. I believe that careful retirees can do much better.

Have fun.

John Walter Russell
February 21, 2007