What Do I Really Think About Dividends?

Dividends raise today’s Safe Withdrawal Rate to 5.4% (plus inflation) of the portfolio’s initial balance.

Dividends extend the portfolio lifetime indefinitely, well beyond 40 or 50 years.

Background Material

I have extracted the following paragraphs from my Dividend-Based Design Outline article. We start by investing entirely in TIPS and switching to high quality, high dividend stocks later when they become attractive enough. We never sell any shares for income.

Dividend-Based Design Outline

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.

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.

New Calculations

I have determined that withdrawing 5.4% (plus inflation) from 2% TIPS leaves you with 62.8% of your original principal after a decade.

As relevant side information, I calculated that you can continue to make 5.4% withdrawals through year 23 (but not year 24) before running out of money.

From the article, we can expect dividend yields to be within the range of 6.9% and 10.4% (8.65% typical) at year 10, possibly earlier.

Taking 62.8% of the dividend yields, your initial dividend income should be between 4.3% and 6.5% of your initial portfolio balance at year 10. Your dividend income is most likely to start at 5.4%.

The danger is that the income stream might drop to 4.3%.

Investors with little time on their hands should be able to match my calculated results by selecting suitable, low cost index and exchange traded funds. They need to check on dividend yields and overall market conditions as they approach year 10.

Careful, active investors can do better. First, today’s TIPS yield more than 2.0% (plus inflation). Second, careful investors can buy stocks at better prices than I have modeled. Simply use price discipline (limit orders) instead of mechanically timed purchases. Third, investors can do better through better security selection.

Purchases should extend over a period of two or three years. To help with security selection, I recommend Lowell Miller’s The Single Best Investment and David Dreman’s Contrarian Investment Strategies: The Next Generation.

I believe that careful, active investors will avoid the drop in the income stream at year 10. Even if they decide to take a cut because of unexpectedly poor market conditions and a need for income security, I expect them to do much better than 4.3% (plus inflation) after year 10.

Have fun.

John Walter Russell
April 2, 2006