In a world with 10-year Treasurys yielding below 1%, stock dividend yields around 2% and the Fed mulling an extension of its dividend caps even as the ECB considers lifting its own ban, where will investors get income?[i] This is a question we see a lot, with several pundits suggesting the so-called 4% Rule—which holds that diversified stock portfolios can support withdrawals of 4% of the starting value annually, adjusted for inflation, without depleting the assets—is obsolete. In our view, this question stems from a common misperception: that income and cash flow are equivalent. We don’t think they are, and once you lift that veil, the future of retirement withdrawals should look a lot brighter to you regardless of where interest rates and dividends go from here.
Portfolio cash flow, simply, is money withdrawn (usually) regularly to fund living expenses. It is easy to think of it as income since, for many retired people, it replaces income earned from their job. But in the investing world, “income” refers specifically to investment income—interest and dividends from bonds, stocks, CDs, etcetera, etcetera and so forth. Using these payments to fund living expenses is fine, but in our view, it introduces unnecessary limitations. If you live off of only interest and dividends, you could end up over-concentrated in sectors like Utilities and Financials and with an asset allocation that doesn’t quite match your time horizon and long-term goals. Beyond that, you are at the mercy of corporate boards who determine dividend payouts and the central banks that both regulate banks’ payouts and, lately, hoover up government bonds, reducing long-term interest rates. Call us crazy, but we don’t think it is wholly beneficial for people to let their day-to-day funding needs be vulnerable to such human (and occasionally misguided) decision making outside of their control.
Thankfully, there is another way to generate cash flow: sell stocks and distribute the proceeds. This is a tactic we call generating homegrown dividends. In our experience, some people have a mental block against this because they view their stocks as the investment principal that kicks off income, and touching your principal seems to violate Compound Interest 101. But that principal doesn’t just kick off (today’s meager) dividends. It also rises (and occasionally falls, temporarily) with the market. Homegrown dividends basically harvest that price return as cash flow.
When you use homegrown dividends, your primary concern shifts from interest and dividends to total return—interest and dividends plus price appreciation. That, in turn, expands your universe of potential investments to the many companies that don’t pay dividends, choosing instead to invest in growth-oriented endeavors or return cash to shareholders by repurchasing stock. This isn’t a securities recommendation, but for one high-profile and extreme example, Amazon has never paid a dividend and is one of the highest-returning stocks in recent years. Of course, not every company that doesn’t pay a dividend has Amazon-like returns, but limiting your investment universe to dividend payers has juuuuuust a bit of a blind spot, to say the least.
Total return is also what makes rumors of the 4% Rule’s demise greatly exaggerated. When you manage for total return and have cash flows, you are basically seeking enough growth to at least partly offset your withdrawals in the long run so that your portfolio doesn’t expire before you do. We have always considered the 4% Rule more of a useful guide and illustration than a hard and fast rule, as the right level of withdrawals for any investor will depend on their unique circumstances. Asset allocation (the mix of stocks and bonds) is a critical factor, too, as reducing a portfolio’s expected short-term volatility can be key for people with relatively higher cash flow needs. But this also reduces long-term returns. Everything is a tradeoff. But that tradeoff is the same today as it always has been. Those saying otherwise lean largely on P/E ratios and other valuations to argue weak long-term returns are in store for stocks—an error we have seen again and again.
Homegrown dividends have other benefits. Portfolio maintenance is one: You can accomplish two things at once if you take your dividends from a sector weight or individual company you need to pare back for risk management. Additionally, if you are taking your withdrawals from a taxable account rather than a qualified retirement account (e.g., 401(k) or traditional IRA), homegrown dividends could easily be more tax efficient since capital gains have a lower tax rate than interest and dividends.
Note, we aren’t anti-dividends or interest. Both are great. But we counsel against limiting yourself by building a portfolio around them. Instead, think of them as one piece of your cash flow strategy and let total return be your primary consideration.
[i] Source: FactSet, as of 10/7/2020. Statement based on US 10-year Treasury yields and S&P 500 dividend yields on 10/6/2020.
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