A Case for Direct Indexing Using Rising Dividend Stocks
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Consumers who are near or in retirement are sailing into a perfect storm in term terms of navigating their investments for current income and lifetime portfolio sustainability.
Soaring inflation paired with sharp declines in the stock and bond markets means that no major asset class is protected, leaving consumer nest eggs exposed to unprecedented sequence-of-returns risk.
While well-conceived retirement spending plans should enable most portfolios to withstand even a severe portfolio shock early in retirement, back-to-back severe downturns, such as the 2000-2002 and 2007-2009 bear markets in stocks, could lay waste to even the best laid plans. [See my previous article, Be Afraid, Very Afraid of Retiring in the 2020s].
What are consumers to do? This is one of the hottest topics in personal finance, and the standard advice includes delay retiring if possible, or, for those recently retired, cut spending and/or restrict spending to non-discretionary expenses. The following articles exemplify this guidance.
- 7 Ways to Handle Retirement With Rising Inflation (U.S. News)
- 'This is not the retirement I envisioned.' How retirees are getting hit by inflation (CNN Business)
- Cut Your Retirement Spending Now, Says Creator of the 4% Rule (Wall Street Journal)
- Inflation will force 25% of o Americans to Delay Retirement (NY Post)
Series I savings bonds and Treasury Inflation Protected Securities (TIPS), particularly in retirement accounts, are routinely touted as tools to help consumers at least keep pace with inflation. Other pundits advocate for consumers to sidestep negative returns in bond-heavy mutual funds, including balanced funds and target-date retirement funds, by selling them and purchasing individual bonds and certificates of deposit. Below are a few of the many articles that make these recommendations.
- There’s a Low-Risk Way for Investors to Earn 9.62% Returns Right Now (Bloomberg)
- Protection for Inflation, With Some Leaks (NY Times)
- Hugely Popular Retirement Investments Flop in Bear Market (AARP)
- This Is Why You Should Ditch Your Bond Funds And Buy Some Bonds Instead (Forbes)
But one investment with the ability to provide current income, inflation protection, and even the potential for capital appreciation has been largely overlooked – rising dividend stocks.
This article addresses the reasons for this oversight and shows that investing in a well-diversified mix of carefully screened companies with a demonstrated proclivity for increasing dividend payments to shareholders at rates well above inflation has distinct advantages over investing in related mutual fund and ETF products. Those advantages are akin to building laddered bond portfolios instead of investing in bond mutual funds. We begin by introducing and countering the common academic rhetoric against dividend investing. Next, we introduce the two largest and most well-known indices of rising dividend stocks and compare their performances to each other and to the S&P 500 Index. In doing so, we explain the distinct disadvantages the indices pose to investors relative to purchasing directly in individual rising dividend stocks. We then present a case for why rising dividend investing is uniquely suited to direct indexing and offer a general investing framework for implementing the strategy. We conclude by explaining how rising dividend stocks may be incorporated into a retirement spending strategy.
The academic research against investing for dividend income
Although we are unabashed disciples of rising dividend investing, the academic research community has not always shared our enthusiasm. Part of our difference in opinion may be attributed to apples-to-oranges strategy comparisons, as the general strategy we introduce in this article is different from the approaches used in most research. The pond of rising dividend stocks in which we fish is far smaller than the ocean of stocks that pay dividends.
However, there are elements of the academic reasoning that are flawed, particularly when applied to retirement spending portfolios. To illustrate this, we offer as exhibit A the video presentation below from Bob French, CFA. Bob is a respected industry thought leader and co-founder of RetirementResearcher.com along with Wade Pfau, Ph.D., CFA, RICP, and Alex Murguia, Ph.D.
- Video: Does Income Investing Make Sense? Why dividends aren't everything (8m, 32s)
French presents the classic academic view of how dividends factor into total return. He reminds listeners that dividends represent earnings that are not reinvested into the company to help it grow.
The basic thesis of the video is that investors who sell shares of stocks to produce $X of income from spending are no worse off than investors who receive the same $X in the form of dividends (and potentially better off after-taxes). He also argues that companies that reinvest their earnings are likely to produce greater profits.
A problem with this logic in a spending portfolio is that selling stocks to generate income exposes the investor to sequence-of-0returns risk in a way that collecting dividend income does not. For example, assume investor A owns a $1,000,000 portfolio of growth stocks that pay no dividends, and investor B owns a $1,000,000 portfolio of dividend stocks that are paying a modest $30,000 in annual dividends and will grow their dividends at 5-7% per year. According to French’s strategy, to keep up, investor A merely needs to sell enough shares to match the dividend income paid from investor B’s portfolio, and, over the long run, his portfolio should appreciate more than investor B’s.
Where this fails is if this hypothetical scenario begins immediately prior to a prolonged down period in the stock market, such as the back-to-back bear markets of the 2000s. By being forced to sell stocks when the portfolio value is down, investor A may be faced with very real shortfall risk as he is forced to sell more and more shares when the market is down to meet the ever-growing income requirement. While the stock market will eventually recover, investor A may not be left with enough remaining shares to meet the growing income needs over a 30-year standard retirement horizon. In contrast, investor B never has to sell shares and can collect a rising income stream while he waits for the portfolio valuation to recover for the benefit of his heirs.
As for the assertion that dividend-paying companies experience lower growth rates and total returns than non-dividend paying growth stocks, the academic argument likely holds up in comparing the broad universe of dividend stocks to the universe of profitable growth stocks. But within a narrower subset of rising dividend stocks, we see that for every high-flying non-paying growth stock, such as Alphabet, Amazon, Berkshire Hathaway, Meta, and Tesla, there is a formidable rising dividend counterpart such as Apple, Costco, Intuit, Microsoft, Nvidia, and Visa.
The U.S. dividend growers and the high-yield dividend aristocrats indices
Dimensional Fund Advisors published a study in April 2022 comparing the performance of all dividend stocks with those that had high or low dividend yields, as well as companies that paid no dividends at all.
- Should you chase dividend stocks to Combat Inflation and Rate Hikes? (Dimensional Fund Advisors)
The authors found no evidence suggesting that dividends are an effective inflation hedge as non-payers provided better nominal and real returns. However, the study did not consider the susbset of the dividend-payer universe comprised exclusively of rising dividend stocks.
In a similar vein, leading retirement researcher, Wade Pfau has expressed skepticism about investing for dividend income because dividends aren’t guaranteed. As he pointed out in a recent Barron’s interview, the S&P 500’s dividends declined in seven of the 12 U.S. recessions since World War II, but again, the relative performance of rising dividend stocks was not addressed.
A counter perspective to this position was presented in an August 2022 Barron’s article, “Dividend Stocks Can Help During Recession. Here’s What to Look For ,” which made a distinction between screening for companies with high dividend yields and those with high dividend growth rates. The latter tend to be well-managed, well-capitalized companies healthy enough to maintain their dividends even through recessions. To shine further light on this concept, we compared the performance of the two largest rising dividend ETFs and the S&P 500 ETF (SPY).
Launched in 2006, the Vanguard Dividend Appreciation ETF (VIG) tracks the S&P U.S. Dividend Growers Index which measures “the performance of U.S. companies that have followed a policy of consistently increasing dividends every year for at least 10 consecutive years. The index specifically excludes the top 25% highest-yielding eligible companies from the index.” VIG holds nearly 300 companies, with its top 10 holdings featuring faster-growing dividend payers such as UnitedHealth Group, Microsoft, Visa, and Mastercard. With only a 10-year minimum dividend growth streak required, VIG can own companies that may have longer runways for meaningful growth compared to mature businesses with lengthier dividend streaks.
We compared VIG to the SPDR S&P Dividend ETF (SDY) which tracks the S&P Global High Yield Dividend Aristocrats Index. The index screens for companies that have raised their dividends for at least 20 straight years. SDY’s holdings, which number around 120 stocks, are then weighted by yield, with higher-yielding stocks rewarded larger position sizes. Beginning with total returns, we observed that from January 2007 through June 2022, VIG delivered the highest annualized return and the smallest maximum drawdowns during the two recessions that took place. The figures below assume dividends were withdrawn rather than reinvested. However, had dividends been reinvested, the performance ranks of each ETF would have remained the same.
Annualized total return from 1/3/07 to 6/30/22:
- VIG: 7.7%
- SDY: 6.4%
- SPY: 7.6%
Max drawdown during 2007-09 financial crisis:
- VIG: -46% (10/9/07 – 3/9/09)
- SDY: -52% (6/1/07 – 3/9/09)
- SPY: -54% (10/9/07 – 3/9/09)
Max drawdown during 2020 pandemic:
- VIG: -32% (2/14/20 – 3/23/20)
- SDY: -37% (2/14/20 – 3/23/20)
- SPY: -34% (2/14/20 – 3/23/20)
Besides delivering similar, if not superior, risk-adjusted returns to SDY and the S&P 500 over this period, VIG’s dividend income stream remained more resilient. The chart below plots the trailing 12-month dividend income generated by each ETF, assuming $100,000 was invested in each fund at the start of 2007 with no additional contributions or dividend reinvestments. Capital gains distributions were excluded from the chart to keep the focus on regular, recurring payouts. The 2007-09 financial crisis marked the largest reduction in S&P 500 dividends going back to the end of World War II, according to Goldman Sach’s data cited by Barron’s. During this period, VIG’s maximum trailing 12-month income drawdown was -14% compared to -25% for SPY and -24% for SDY, per analysis by Simply Safe Dividends. VIG’s smaller dividend drawdown and ownership of companies with generally faster and more consistent dividend growth helped its trailing annual income rebound to a record high by March 2011. For comparison, SPY took until September 2012, and SDY’s income did not fully recover to pre-crisis levels until March 2017.
Focusing on rising dividends rather than yield demonstrates the power of compounding in other ways, too. At the onset of our study above, SDY generated over twice as much annual income as VIG. However, VIG’s focus on relatively younger, faster-growing businesses enabled its dividend income to compound by 8.8% annually – a hair faster than August 2022’s inflation reading – compared to 4.0% for SDY and 5.8% for SPY.
Even in 2022, when financial markets have broadly deflated, Simply Safe Dividends estimated VIG’s holdings are tracking to pay approximately 10% more in dividends this year than in 2021. Thanks to this steady compounding, VIG’s trailing 12-month income as of June 2022 had practically closed the gap with SDY and pulled well ahead of SPY’s annual dividend income.
S&P Dow Jones Indices published a study in June 2022 that reached similar conclusions. The authors found that dividend growers may provide some downside protection during bearish markets and when market volatility rises. The subset of rising dividend stocks analyzed also recorded fewer dividend cuts during the pandemic than a broader index of high dividend payers.
The case for direct indexing
Overall, data suggests that high-dividend yield is not a compelling screening criterion for either growth of income or total return. But screening for companies with lower yields that pay rising dividends may be a valid strategy for both. However, this finding does not lead us to conclude that income-oriented consumers should purchase VIG for retirement income and inflation protection. In fact, there are three reasons why VIG is unsuited for this task. The ETF is capital-weighted, which means that even if all the companies in the portfolio increase their dividends from one year to the next, the total dividend income paid to VIG shareholders may still fall if the price appreciation of lower yielding companies causes their weighting in the portfolio to grow disproportionately. As of September 23, 2022, VIG’s 30-day SEC portfolio yield was just 1.89%. This is not enough passive income to support most consumers without having to spend down principal. Third, there is no obvious reason to conclude that changing the rising dividend period from 20 years to 10 years and eliminating the highest yielding 25% of the companies represents an optimal screening methodology.
Although VIG ($73 billion) and SDY ($21 billion) are the largest rising dividend ETFs, they are not the only ones. For instance, the Pro Shares S&P 500 Dividend Aristocrats ETF (NOBL) ($9.6 billion) tracks the eponymous index of companies in the S&P 500 that have increased their dividends for at least 25 years in a row. In contrast to SDY’s peculiar yield-weighted construction, NOBL’s index follows an equal-weighted strategy that leads to broader industry diversification than SDY. NOBL’s index also states that no single industry sector may comprise more than 30% of portfolio assets. There are currently 64 companies in the index. The ETF has an SEC 30-day yield of 2.04%
The First Trust Rising Dividend Achievers ETF (RDVY) ($7.8 billion) tracks another like-named equal-weighted index that offers an even more refined set of screening criteria. To be included in the index, companies must meet four screening criteria:
- Paid a dividend in the trailing 12-month period greater than the dividend paid in the trailing 12-month period three and five years prior;
- Positive earnings per share in the most recent fiscal year greater than the earnings per share three fiscal years prior;
- A cash to debt ratio greater than 50%; and
- A trailing 12-month period payout ratio no greater than 65%.
Notably, the index does not include consecutive years of dividend increases among its screening criteria. Instead of sampling from a larger dividend-oriented index, the companies are selected from the 1,000 largest companies in the Nasdaq index. A ranking formula is then applied with the 50 companies with the best scores receiving equal weighting in the index. The ETF has a 30-day SEC yield of 2.0%.
NOBL and RDVY have much shorter track records than VIG but have slightly outperformed VIG since their inceptions. The figures below assume dividends were withdrawn rather than reinvested:
Annualized total return from 10/10/13 (NOBL’s inception) to 6/30/22:
- VIG: 10.1%
- NOBL: 10.4%
Annualized total return from 1/8/14 (RDVY’s inception) to 6/30/22:
- VIG: 9.5%
- RDVY: 10.1%
However, overall performance has been a mixed bag given VIG’s smaller drawdown during the pandemic and less volatile dividend growth over the years:
Max drawdown during 2020 pandemic:
- VIG: -32% (2/14/20 – 3/23/20)
- NOBL: -35% (2/14/20 – 3/23/20)
- RDVY: -40% (2/12/20 – 3/23/20)
Trailing 12-Month Annualized Dividend Growth from January 1, 2015 to June 30, 2022:
- VIG: 7.3%
- NOBL: 11.4%
- RDVY: 6.1%
Although it is not clear whether the equal-weighted Dividend Aristocrats or Rising Dividend Achievers Index will provide superior future income and/or risk adjusted total returns than the Dividend Achievers Index, collectively, they lead us down a path toward direct indexing. Specifically, in contemplating the arbitrary and awkward structure of the four rising dividend ETF portfolios reviewed, one cannot help but wonder if it might be possible to create a more refined screening methodology to build their own diversified baskets of rising dividend stocks with superior income and risk-adjusted return characteristics. It may very well be possible to do that, and such portfolios might also play a role in retirement income planning and enhancing lifetime portfolio sustainability.
Rising dividend portfolio construction
A logical place to start is to build direct-indexing rising dividend portfolios as subsets of the Dividend Achievers Index, which, as of September 23, 2022 comprised of the 371 U.S. companies that have raised their dividends for at least 10 consecutive years.
In terms of the optimal number of companies in the final portfolio, an important element of portfolio construction is to do a better job of avoiding companies that may be forced to reduce their dividends during economic downturns than the parent index (and other indexes) has experienced. A review of the past quarter-century of down markets finds that dividend cuts sometimes occurred as part of industry-wide trends. For instance, several electric utilities and pharmaceutical companies were forced to cut or eliminate their dividends in the early 2000s. During the 2007-2009 financial crisis, many large financial institutions were affected. During COVID, however, the sector range of companies that reduced dividends was somewhat broader. Taking these experiences into account, it may be prudent to set a limit of no more than two or three companies in any single industry sector and to have exposure to at least 10-15 of the 19 total industry sectors in the Achievers Index. This implies a portfolio size of at least 20-45 companies. Weighting the positions approximately equally, at least initially, will also reduce both company- and industry-specific risk.
The goal of our search is to find stocks with greater potential to maintain their historical pace of dividend growth in all manner of economic environments. Businesses with lower payout ratios, or the percentage of annual earnings distributed as dividends, have a larger margin of safety to defend and raise their dividends if profits hit a rough patch. Similarly, companies with little debt may be less likely to freeze or cut their dividends during a downturn because deleveraging does not need to take top priority. Valuation plays an important role in the stock selection process as well. A great business with a safe dividend can still be a risky investment if purchased at a rich premium. Finding quality, growing businesses that trade near or below the broader market’s average valuation multiple provides some protection. With these objectives in mind, we filtered the universe of dividend achievers using the following criteria:
- 5-year annual dividend growth rate: 8% or higher
- Payout ratio: less than 50% (less than 70% for utilities)
- Leverage ratio (net debt / EBITDA): less than 2.0x (less than 5.0x for utilities; not applicable for most financials stocks)
- Forward P/E ratio: less than 20
- Qualified dividends only (no REITs or MLPs)
Using data as of September 23, 2022, our screen returned 102 dividend achievers, with an average dividend yield of 2.7%, an average five-year annual dividend growth rate near 13%, and an average payout ratio of 30%.
You can view the results in the spreadsheet here.
To be clear, we offer this list merely as an example of how one might go about constructing a rising dividend portfolio. We are not suggesting that it is the only or the best screening model. For instance, instead of using a particular P/E ratio as a screen, one could choose based on whether or how much a company may be trading below its five-year average P/E. One could consider trends in cash flow, earnings, and/or revenues. One could also use the same screening criteria we have used but change the screening numbers.
Readers who wish to tinker with their own filters can download a spreadsheet with data on all 371 dividend achievers here. The stocks are sorted by dividend yield to make it easier for investors to find appropriate income stocks for their life stage. That said, there are two important concepts inherent in the criteria we have chosen in our example: (1) they are designed to screen for healthy companies; and (2) dividend yield is not a screening criterion.
While we believe that the screening criteria we put forth may be useful for building a sound rising dividend portfolio, what separates direct indexing from merely stock-picking is the existence from the outset of a predetermined sell discipline. Just as there may be more than one way to screen for rising dividend stocks, there are many different sell criteria that may be imposed as well. An announced dividend cut is one obvious unambiguous example, and one that would likely be a ubiquitous sell trigger across all such direct-indexing portfolios (assuming the cut reflects a dimming outlook for a company’s business). One of the understated benefits of this criterion is that it effectively eliminates the possibility of holding a company to failure. However, this trigger alone does not prevent investors from side-stepping potential value traps.
For this reason, we suggest that other sell criteria be established as well. Examples may include the five-year dividend growth rate falling below a certain percentage, a certain number of years of declining earnings or revenues, and/or a specific payout or debt ratio cutoff. There are many other potential sell triggers. A challenge in selecting direct indexing sell criteria lies in making them clear enough to minimize subjective judgment and straightforward enough to be implementable across client portfolios.
Practical applications: Rising dividend stocks for retirement saving and spending
Based upon the discussion above, investing in shares of U.S. companies that pay rising qualified dividends is an appropriate long-term saving strategy for both tax-sheltered retirement accounts and taxable investment accounts. However, rising dividend stocks may be particularly well-suited for investors seeking to grow passive income in taxable accounts as an alternative to mutual funds and ETFs. In fact, a common lament among mutual fund investors is the unpredictable tax impact of annual short- and long-term capital gains distributions. Although this is less of a problem with ETFs, an issue with both mutual funds and ETFs is that upon retirement, the investor is often forced to realize capital gains to convert the portfolio into securities that generate income. Of course, dividends are taxable annually, but the income is more predictable from one year to the next. Qualified dividends are also taxed at a lower rate than earned income, interest income, and short-term capital gains. Further, an investor saving for a 20- to 30-year retirement objective may be able to produce a ready-made passive income upon retirement without the need to sell securities.
In terms of implementation, younger investors who start saving today for retirement in 25-30 years may wish to emphasize companies with the highest five-year average dividend growth rates with little heed given to current dividend yield. A hypothetical growth-oriented rising dividend portfolio with a 1% average dividend yield today would produce an 8% yield-to-cost in 27 years assuming an 8% average annual dividend growth rate.
At the other end of the retirement planning spectrum, investors who are approaching or entering retirement may wish to take their screened portfolios and then sort the companies according to dividend yield.
For instance, building a retirement spending portfolio today with an average dividend yield of 3-4% and a five-year average dividend growth rate of 5-7% may produce current income that is on par with treasury and CD rates replete with an inflation adjustment that can generally not be matched in the bond world. To the extent that the dividend income generated from the portfolio and other sources of income (e.g., Social Security, pension, etc.) is sufficient to meet current spending needs, the advantage of this strategy relative to traditional spending models is that, barring exogenous income shocks, such as long-term care expenses, it does not require the investor to ever sell principal shares.
Critics may counter that this model does not account for the possibility of a rash of dividend cuts during future economic downturns. As noted, we have tried to minimize that possibility in the careful selection of our screening criteria, but we acknowledge that the possibility exists. However, we also note that traditional Monte-Carlo based models, which employ annual rebalancing to maintain a constant allocation over time, necessarily expose investors to sequence risk in both stocks and bonds by requiring the investor to sell securities even if they are depressed. In our approach, dividend income may be reduced, but it does not require selling shares ever. Further, the notion that dividend income may decline during prolonged economic downturns does not invalidate the concept. In fact, most advanced dynamic-spending models include decision rules that require the consumer to reduce spending in a particularly awful investment environment to ensure sustainability. See supporting research:
Dynamic Retirement Spending Adjustments: Small-but-permanent vs. Large-but-temporary
Dynamic Spending in Retirement Monte Carlo
Stock prices, including those of rising dividend stocks, may be depressed in severe economic downturns, but the historical record (e.g., the 2007-2009 financial crisis) suggests that rising dividend companies may suffer smaller drawdowns, and that most will continue to pay and even increase their dividends through such periods.
The merit of direct indexing is a hot topic within the financial planning community. Many researchers are skeptical that picking baskets of stocks from within a larger index adds value in an efficient market and question whether it is active management in sheep’s clothing. We have made a case for the construction of rising dividend stock sub-indexes from the parent Dividend Achievers Index by applying carefully crafted screening criteria paired with strict, unambiguous sell triggers. While screening for the healthiest companies within the Dividend Achievers index may very well lead to the creation of portfolios that outperform the parent index, this strategy offers investors one major advantage over traditional index funds (including the S&P 500) or bonds. It may generate passive income that grows over time at a pace that may be much greater than the cost of living.
Our discussion has focused entirely on dividend income and its growth, and we have not discussed the potential for capital appreciation. This is deliberate because, as with the stock market in general, future returns follow a random walk. We have no way of accurately predicting total returns. However, by screening for healthy, profitable companies, it is reasonable to expect that their share prices will, over the long run, continue to rise. Even though we have ignored it in our discussion, over a long savings period or a 20- to 30-year retirement horizon, it is realistic to expect that the value of the companies’ share prices will appreciate considerably as well.
Epilogue – The holy grail of retirement spending strategies
Throughout the 1980s and the 1990s, the standard approach to retirement spending was for financial advisors to allocate enough of a given retirement portfolio to bonds to generate the income needed to maintain the client’s standard of living in retirement. The rest of the portfolio was allocated to stocks to provide growth to keep up with inflation over time. The 100-minus-your-age was a popular guideline for determining the appropriate stock allocation at retirement at that time.
We refer to these spending strategies as declining equity glidepath portfolios. A common objective among retirees at the time was to “live off the interest and leave the rest to one’s heirs.” A big part of what made this approach seem plausible for retirees at that time was that interest rates on bonds were much higher than investors have experienced in the 21st century. Yields of 6-10% or more on investment-grade bonds made filling up the income bucket far easier than it is today. As interest rates fell and it became necessary for investors to rely more heavily on stock returns in retirement.
William Bengen’s seminal 1994 paper was among the first to raise awareness of the threat posed by sequence-of-returns risk caused by declines in the stock market early in the retirement spending years. In that piece, Bengen observed that under the worst of investment conditions, inflation-adjusted withdrawal rates much above 4% might be vulnerable to premature depletion in a normal 30-year retirement period. This figure was far lower than most practitioners at the time had perceived. Bengen used historical back-testing to generate his results and the mean interest rates on bonds over the time period he considered was far higher than today. As such, many researchers have suggested that the actual “safe” 30-year withdrawal rate today may be less than 3%.
Researchers have advanced retirement spending efficiency and portfolio sustainability beyond Bengen’s simple static, inflation-adjusted, constant-allocation distribution models largely through the application of various decision rules that guide consumers to increase or lower spending throughout retirement depending upon the return environment at any given point in time. To the extent that these strategies are implementable, they undoubtedly enhance sustainability. However, a common denominator in virtually all modern retirement spending models is that they assume consumers sells securities each year to meet their income distribution needs.
In this context, an alternative retirement spending strategy offering an income stream sufficient to meet client spending needs that grows at a rate that matches or beats inflation without ever requiring the investor to sell stocks (thus eliminated sequence risk) might be regarded as a holy grail for financial planning. To the extent that a rising dividend portfolio paired with a bond portfolio can generate enough income to meet a given client’s income needs, it may indeed be possible to create such a spending model, particularly now that interest rates on fixed income investments (e.g., Treasury securities and CDs) have risen this year to the point where interest income may once again may a meaningful contribution to portfolio returns.
This notion was explored in a 2015 article by Wall Street Journal columnist Jonathan Clements, Dividend Stocks Beat Bonds for Retirement Income. At that time, bond interest rates were far lower than they are today. Clements estimated that an initial spending portfolio of $1,000,000 with 60% allocated to rising dividend stocks with a 3% yield and a 3.5% dividend growth rate and a 40% allocation of 2% Treasury bonds and an assumed annual inflation rate of 2% per year and an initial withdrawal rate of 4% ($40,000) would take 21 years to spend down the bond portfolio while leaving the rising dividend stocks untouched to generate a growing passive income stream. Clements then postulated that not only would the equity position be sufficient to last another nine years to complete a 30-year retirement horizon, but the appreciation from the stocks would value the portfolio more than the initial investment amount.
Investment conditions are more favorable today for the construction of such portfolios and the application of our direct-indexing strategy may be more advanced than the approach applied in the Clements article. To illustrate what a “holy grail” portfolio might look like, refer to the Screened Dividend Achievers Index list comprised of companies that met our aforementioned suggested screens for payout ratio, P/E ratio, net debt to EBITDA, and five-year annual dividend growth rate. Of the 102 companies that met the screening criteria, 15 have current dividend yields of 4% or higher, 47 have yields of 3% or higher, and 72 have yields of 2% or higher. From this, we should reasonably be able to create an industry-diversified, equal-weighted rising dividend stock portfolio with an average yield of 3.5-4.0% with five-year average dividend growth rates of 8% or higher. With respect to bonds, the yield curve is essentially flat (slightly inverted) with the 10-year Treasury yielding 4% and the one-year Treasury yielding 4.16%. The inflation rate is roughly 8%. We can construct a portfolio comprised of 60-70% rising dividend stocks and 30-40% Treasury bonds that could keep pace with long-term inflation of 5-6% per year.
We assume that interest rates on Treasury bonds and CDs do not return to the recent historic lows. We also assume that our rising dividend companies continue to grow dividends annually at 8% or more, that the current historically high inflation rate will recede in a reasonable amount of time, and that no companies in our portfolios cut their dividends. Readers can judge for themselves how realistic these assumptions may be, but investing in rising dividend stocks offers a viable way to sidestep sequence risk and a reasonable alternative to models that require consumers to spending down the equity portion of the portfolio over time. We hope this article lays the foundation for further quantitative research on this novel retirement spending strategy.
Brian Bollinger, CPA is the president and founder of Simply Safe Dividends, a subscription-based company that provides online tools and research designed to help investors generate safe retirement income from dividend stocks. J.R. Robinson is the owner/founder of Financial Planning Hawaii, Fee-Only Planning Hawaii, and Paraplanning Hawaii. He is also a co-founder of fintech software maker Nest Egg Guru.
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