Friday, August 05, 2005
Dividends matter because they are a direct contributor to the total return of a stock, and of equal importance because for many stocks, they are a predictor of the capital appreciation. Understanding the role of the dividend in the total return of a stock is helpful in building net worth, but it is critical when it comes time to live off of your assets in retirement. Let's say you are retiring and the HR department has given you the good news that your 401k plan is worth a million dollars. This good news won't last very long. In today's low interest rate environment, a million dollars won't buy much of a lifestyle. The highest yielding CDs pay only about 4%, a 10-year US Treasury bond pays about the same, and fixed rate annuities pay only about 3%. That means that the simple and safe choices available to you will only produce between $30,000 and $40,000 in income. In our experience, that level of income would be less than half of what you were earning before retirement. The need for higher "retirement income" will force you into stocks with at least some portion of your million dollars. Before we go any farther, let's get straight what this million dollars really represents. It is the capital from which you and those who depend on you must live for the rest of your lives. Stocks have produced a total return of approximately 10% over many years. Ten percent of $1 million is $100,000; now that is more like it. You can probably live on that kind of income, but if you go this route with a hundred percent of your money, we can assure you that your sunset years will feel more like "retirement roulette, " instead of retirement living. The reason is as simple as it is dangerous. An all growth stock portfolio will require that you tap your principal regularly to pay living expenses. To explain what we mean by retirement roulette, let's say we assume that growth stocks are going to make a 10% average annual return over the next 10 years. That would seem to make for pretty clear sailing for the all-stock retirement plan. The problem is the current dividend yield for the S&P 500 is about 1.5%. That means your portfolio will earn only about $15,000 per year in actual cash flow. The remaining $85,000 must come from capturing capital appreciation. I personally, believe this is possible for the coming decade, but the problem is it won't happen at precisely the rate of 8.5% per year. History shows us that the stock market is up about 7 out of every 10 years. Anyway you slice it, over the next the next 10 years, there are going to be lots of months and years when you will be taking money out of your account at the same time the market value is also falling as a result of the weak stock market. On paper this does not seem such a big deal, but history also shows that the annual gains in the stock market usually come suddenly in just a month or two, and the rest of the time it just wallows around. In actual experience, if you try to take $85,000 per year two bad things are going to happen to you. One is psychological and one is statistical. From a psychological perspective, even if the market does average 8.5% capital appreciation for the next decade, much of the time it will feel like your retirement bucket has a hole in it. Every time you get a distribution from your portfolio during times when the market is falling, you will have that gnawing feeling that you are going to run out of money. From a statistical perspective, if we experience another three-year bear market like 2000-2002, your portfolio could take such a hit that it would be permanently damaged, and with it your standard of living. Before I offer a solution to "retirement roulette," let me discomfort you even more by revealing another impediment to your retirement standard of living that you also may not have considered. I'll do that in part 2 next time.