Dividends and Constant Terminal Value Rates

Constant Terminal Value Rates (CTVR) are withdrawal rates that leave the balance at the end of a period identical to the initial balance plus inflation. Constant Terminal Value Rates are especially useful for young retirees because withdrawals continue indefinitely.

CTVR withdrawals allow for the selling of shares. Most dividend-based strategies do not. This makes for an interesting comparison.

Keep in mind that dividend amounts almost always grow faster than inflation, especially over a 30 year timeframe.

Portfolios

CTVR Calculator A calculates 30-Year Constant Terminal Value Rates. I have made it available for downloading from my Yahoo Briefcase. It is in the Big Project folder, listed as CTVR Calc A.

I have included fixed allocations of 20%, 50% and 80% stocks and TIPS in CTVR Calculator A. I renamed portfolios SwAT and SwOptT to CSwAT and CSwOptT to make it clear that the final balance is other than zero.

With portfolios CSwAT and CSwOptT, I vary allocations (switching) between stocks (S&P500) and TIPS in accordance with P/E10. (P/E10 is a measure of valuation.) CSwAT has constraint A which limits both stocks and TIPS allocations to 25% to 75%. This follows Benjamin Graham’s advice. It has stood the test of time very well. CSwOptT has no such constraint.

Both CSwAT and CSwOptT outperform fixed allocation portfolios when valuations are high, but not always. Under favorable conditions, fixed allocation portfolios do better because they lock in stocks purchased at bargain prices. CSwAT and CSOptT algorithms act without memory, varying allocations without regard to past purchases and current balances.

NOTE: It is possible to exploit such advantages. Simply preserve capital (possibly using TIPS) until stock prices become attractive.

CTVR with Fixed Allocations

At today’s valuations (P/E10 = 27.5) and today’s 2.4% TIPS (real) interest rates, the best stock allocation is closer to 50% than 80%. The coin toss rate (with 50%-50% odds) is 2.99%. The Safe Withdrawal Rate (while maintaining today’s buying power at year 30) is 2.41%.

Higher TIPS interest rates and/or higher degrees of safety shift the best stock allocation lower. It is less than 50% with 3% TIPS and/or at the Safe Withdrawal Rate with today’s 2.4% TIPS.

At typical valuations (P/E10 = 14), all conditions favor the highest stock allocation. An 80% fixed stock allocation does better than both CSwAT and CSwOptT. The Safe Withdrawal Rate with today’s 2.4% TIPS and 80% stocks is 4.68%. The coin toss rate is 5.48%.

At bargain prices (P/E10 = 7), high stock fixed allocations do exceptionally well. An 80% fixed stock allocation does substantially better than CSwAT and CSwOptT. The Safe Withdrawal Rate with today’s 2.4% TIPS and 80% stocks is 9.86%. The coin toss rate is 10.66%.

Comparisons with Dividend Strategies

Most dividend investors are confident that they can withdraw 3% plus inflation from dividends alone even in today’s market. To see why, glance at DVY, an exchange traded fund, and its holdings.

The issue is whether it makes sense to sell stocks to make up the S&P500’s income deficit (its dividend is less than 2%). Assuming a fixed stock allocation and today’s valuations, selling stocks introduces an unnecessary risk. Dividends alone can match the coin toss (50%-50% odds) constant terminal value rate associated with the S&P500. There is no need to introduce any element of risk. The S&P500 fixed allocation Safe Withdrawal Rate is 2.41%.

Looking at SwAT and SwOptT portfolios at today’s allocations and today’s 2.4% TIPS, we see that a dividend strategy falls behind at the coin toss rate. SwAT currently has a 3.47% coin toss rate. SwOptT currently has a 3.80% coin toss rate. A dividend strategy matches SwAT at the reasonably safe rate (80% confidence level for success). A dividend strategy matches SwOptT if we demand a slightly higher level of safety (between 80% and 95%).

Today’s stock allocations for SwAT and SwOptT are at their minimums: 25% and 0%, respectively. What these results really tell us is to stand on the sidelines. Today’s S&P500 portfolio can be helped by waiting for bargains. Today’s dividend focused portfolio can be helped as well.

Have fun.

John Walter Russell
May 11, 2006