Dividend Growth and The 4 Percent Rule

[Kerim]

I wasn't planning to post much this weekend, but glanced over at SA and ended up leaving a long comment that I thought would make an excellent topic here.

In this article, Eli Inkrot argues that you needn't choose between dividend growth investing and building a portfolio to live off of using the "4 percent rule" (selling off 4 percent of your assets annually). I agree that the concepts can (and in many cases should) be married, but that the solution presented in the article is not a solution at all. The article argues that you join the concepts by targeting a 4 percent yield from your dividend growth portfolio.

Here's the comment I left in response:

I always love your thoughtful articles, but have to disagree here. Achieving a 4 percent yield from your dividend growth portfolio isn't (in any way that I can see) "marrying" the concepts of living off your dividend stream and selling off 4 percent of your assets annually. That you target "4 percent" in the different cases doesn't mean you've combined the ideas.

It is true that people incorrectly assume they need to choose one or the other, but the combination of the two ideas is different from what you've presented here. The problem in my mind with the "pure" dividend growth approach is that many people will never be able to get their income stream high enough to cover all of their expenses. If you are fortunate enough to start young and have sufficient capital to put to work over time, DG will work, but otherwise, you may not reach that magical point of independence.

The important feature of the "selling 4 percent of your assets" every year that is easy to overlook for dividend growth adherents is that it allows you to get through your retirement with less than you would have to save in a pure DG approach. This is an obvious point -- a "pure" DG approach says you'll never need to touch your capital. A "sell your assets" approach" acknowledges that your capital is a perfectly valid source to tap to get through retirement in that manner you'd like.

With all of that understood, the right way to think about combining the two approaches is to build the best possible income stream you can, and to nonetheless be open to selling off some of your assets through retirement. Perhaps you've got enough income flowing from your portfolio that you only need to sell off 1 or 2 percent annually to make ends meet, while still having high confidence that your portfolio will outlive you. This will allow you to survive through retirement on a smaller nest egg than needed using only the income from your dividend growth portfolio, which may be much more realistic for many.

[cannew]

Agree completely.

One of the advantages of DG is that you know what your income stream is and see it growing over time, regardless of the market. As you get towards retirement you'll know what you income will be from dividends and be able to determine if you will need to sell capital to meet your needs. You'll also have a good idea of the dividend growth expectations you can expect from the stocks (because you should have a history of past growth).

[NilesMike]

(11-29-2013, 04:30 PM)cannew Wrote: Agree completely.

One of the advantages of DG is that you know what your income stream is and see it growing over time, regardless of the market. As you get towards retirement you'll know what you income will be from dividends and be able to determine if you will need to sell capital to meet your needs. You'll also have a good idea of the dividend growth expectations you can expect from the stocks (because you should have a history of past growth).

I'm not a big fan of selling assets, especially income producing assets, for additional income. Most of my retirement is in apartment buildings and I was told long ago... the hardest part is getting them and don't ever sell them. There are always better solutions than selling.

[Kerim]

(11-29-2013, 05:46 PM)NilesMike Wrote: I'm not a big fan of selling assets, especially income producing assets, for additional income.

I agree, but that may not be possible for everyone, and it assumes that you've decided to die leaving your whole pile of income-producing assets intact. That's fine, but may not be everyone's choice.

A corollary of this discussion is that while we usually focus on the risk of not saving enough, there is a risk of saving too much. It is great if you happen to love your job and would keep working to generate more assets regardless of need, but if you would rather be doing other things -- time with friends and family, travel, volunteering -- then leaving tons of assets to your heirs or to charity represents an economic loss. The time you spent generating those assets in excess of what you needed to get through your life was time you did not spend pursuing your passions.

If the choice is between: (1) working until 68 to have enough income-producing assets to live off of without selling any of those assets (and leaving those assets to my heirs or charity when I die); or (2) only working until 62 and living off my assets through a combination of income and selling -- to maintain the exact same lifestyle as option (1) -- but leaving a lot less to my heirs or charity, I may well choose option (2).

And for many, option (1) may not even be an option at all. If you cannot save enough to generate the income stream you need, then you must consider using the capital itself as well as the income to fund retirement.

[NilesMike]

I am fortunate that prior generations did choose plan 1 and then some. This will allow me to make a hybrid of 1 and 2.

Part of my reason for being is to make it easier for the generations of my family to follow a successful path. My wife and I think leaving a legacy is important.

I've found we have more than enough time to do all the things we would like to do. Prioritizing makes it much easier to accomplish.

I understand each situation is unique.

[Dan Mac @DGSInvesting]

My plan is to try to build a large enough nest egg where I am able to live off of the dividend income in retirement and not have to sell any of my shares(assets).

However, if I for some reason do fall short but still close, I will most likely take a hybrid approach. I will first use the dividend income stream but will be forced to close any gap by selling off a portion of my portfolio each year. As I continue through my retirement phase, I will be required to sell more and more each year because I will be earning less and less income on fewer and fewer assets.

I'm still ok with that approach as long as I'm comfortable not to run out of money. However, it does leave less of an inheritence behind which I'm sure will displease my heirs. But they can take the lessons I've taught them along the way to do the same thing.

So, first goal is to live completely off the dividend income. If for some reason I fall short I will turn to strategy two.