Wednesday, November 17, 2010
How much money do you really need to retire with dividend stocks?
Many investors are being told that in order to retire, one needs to accumulate a minimum nest egg of $1,000,000. Some advisers do recommend that even one million dollars might not be enough to ensure comfortable retirement to individuals, given higher life expectancies or variability of investment returns. This is discouraging many investors, who are starting to believe that they would be working forever. Instead of focusing on the amount of money one needs to accumulate however, I think that a much better way should be to focus on the income from your investments.
After all, a million dollar investment in your home would most likely lead to thousands of dollars in annual property taxes, but no income. Thus, having even a million dollars invested in the wrong asset might not be enough to ensure a comfortable retirement. If that same investor purchased dividend stocks. which increase distributions regularly, they would be able to generate and inflation adjusted stream of income, which would be sustainable for extended periods of time.
If our dividend investor built a portfolio consisting of stocks which yield 10% on average, they should be able to generate $100,000 in annual pre-tax income on that $1,000,000 nest egg. Companies which yield more than 10% include American Capital Agency Corp. (AGNC), Hatteras Financial Corp. (HTS) or Annaly Capital Management, Inc. (NLY).
If our dividend investor build a portfolio consisting of dividend stocks yielding 6% on average, they should be able to generate a $60,000 annual pre-tax dividend income on the $1,000,000 nest egg. Companies yielding more than 6% include Universal Health Realty Income Trust(UHT) and Kinder Morgan Energy Partners, L.P. (KMP).
While it is possible to find companies yielding much more than 6% in today’s market, investors have to look at those investments with a questioning mind. It is highly unlikely that a company which pays a 10% dividend is able to reinvest anything back into growing the business. In addition to that, chances are that such a company is also using a special corporate tax form, which might add in further to the risk of income depletion provided that this income tax form is disallowed. Many investors in the Canadian income trusts have suffered huge losses in income and principal since 2006, when Canadian government announced that it would be phasing out the tax advantaged income trust structure in 2011. Many US investors have allocated excess amounts into Master Limited Partnerships. Business Development Companies or Real Estate Investment trusts. all of which pass through all of their income to the individual holders. A change in the tax code could certainly jeopardize these investors. In addition to that, most of those corporate structures have not been around for as long as common stocks, which makes it difficult to backtest their performance during various market conditions.
Common stocks on the other hand, have been around for several hundred years. Some studies suggest that spending 4% from your portfolio annually should ensure maximum longevity for you. Given the fact that dividend yields were typically around 4% during the time of the studies, I have concluded that a starting 4% average portfolio yield should be sustainable for at least four decades. A portfolio yielding 4% could include high yielding stocks with low or average dividend growth such as Kinder Morgan (KMP), Realty Income (O) or Royad Dutch (RDS.B). It could also include low yielding stocks with high dividend growth such as Archer Daniels Midland (ADM) or Family Dollar (FDO). The portfolio could also include stocks in the sweet spot such as Coca Cola (KO),McDonald's (MCD) or Johnson & Johnson (JNJ). As a result, a $1,000,000 investment could result in $40,000 in annual dividend income.
Truth however is that investors do not truly need $1,000,000 in order to retire. If you focus on companies which regularly raise distributions, it is possible to construct a portfolio with much less than $1 million dollars. For example, let assume that one wants to retire in 24 years and assumes a 3% inflation rate. Let’s also assume that this individual also requires $40,000 in dividend income in 2010. Using the rule of 72. a 3% inflation rate would erode the purchasing power of $40,000 in 2010 dollars by half by the year 2034. As a result the investor would need to generate $80,000 in 2034. Let’s assume that this investor is able to purchase a well rounded portfolio of dividend growth stocks. which currently yield 4%, but which will increase distributions
by 6% for the next 24 years. This is not an unreasonable dividend growth rate, since it slightly exceeds the 5.4% average dividend growth rates achieved by Dow Jones Industrials average for the 85 year period ending in 2005. This means that our investor needs only $500,000 to invest at 4%, which would generate income of $20,000 in year one, $40,000 in year 12 and $80,000 in year 24.
Of course if our investor decides to reinvest dividends for 24 years they would need much less in start up costs in order to generate sufficient dividend income. Most strong brand names which sell consumer products have been able to generate such returns over time.
The type of stocks that enterprising dividend growth investors should be focusing on include:
Johnson & Johnson (JNJ) engages in the research and development, manufacture, and sale of various products in the health care field worldwide. The company operates in three segments: Consumer, Pharmaceutical, and Medical Devices and Diagnostics. The company yields 3.40%, but has managed to grow dividends at 13.50% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 29.10%. (analysis )
The Procter & Gamble Company (PG) provides consumer packaged goods in the United States and internationally. The company operates in three global business units (GBUs): Beauty and Grooming, Health and Well-Being, and Household Care. The company yields 3.00%, but has managed to grow dividends at 10.70% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 22%. (analysis )
Chevron Corporation (CVX) operates as an integrated energy company worldwide. The company yields 3.30%, but has managed to grow dividends at 7.90% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 17%. (analysis )
McDonald’s (MCD) franchises and operates McDonald's restaurants that offer various food items, soft drinks, coffee, and other beverages. The company yields 3.10%, but has managed to grow dividends at 26.50% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 28.30%. (analysis )
Abbott Labs (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. It operates in four segments: Pharmaceutical Products, Diagnostic Products, Nutritional Products, and Vascular Products. The company yields 3.50%, but has managed to grow dividends at 9% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 20.70%. (analysis )
Coca Cola (KO) manufactures, distributes, and markets nonalcoholic beverage concentrates and syrups worldwide. The company yields 2.80%, but has managed to grow dividends at 9.90% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 18.20%. (analysis )
Pepsi Co (PEP) manufactures, markets, and sells various foods, snacks, and carbonated and non-carbonated beverages worldwide. The company yields 3.00%, but has managed to grow dividends at 12.70% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 18%. (analysis )
Clorox (CLX) engages in the production, marketing, and sales of consumer products in the United States and internationally. The company operates through four segments: Cleaning, Lifestyle, Household, and International. The company yields 3.50%, but has managed to grow dividends at 9.70% annually over the past decade. The yield on cost of a 1989 investment in the company would be a staggering 21%. (analysis )
Colgate Palmolive (CL) manufactures and markets consumer products worldwide. The company yields 2.80% t has managed to grow dividends at 11.30% annually over the past decade. The yield on cost ofa 1989 investment in the company would be a staggering 34.40%. (analysis )
At the end of the day those dividend machines would not only generate substantial yields on cost but they would most likely generate substantial capital gains as well. Dividends are typically taxable in the year they have been received, whereas capital gains are only taxable when you sell your stocks. If someone inherits company stock, their basis is increases to the fair value at the time of the transfer. As a result investing in these dividend growth stocks is similar to planting a tree, and then harvesting its fruit for decades, without having the necessity to cut the branches you are sitting on.
Full Disclosure: Long ABT, CL, CLX, CVX, FDO, JNJ, KMP, KO, MCD, O, PEP ,PG, RDS.B, UHT,