The 4% rule is a general rule of thumb used by financial experts to determine how much individuals should be withdrawing from their retirement account each year. This is considered a safe and sustainable rate for a retiree with a long life expectancy.
In a high interest rate environment, generating 4% of income from your retirement nest egg could be achieved. With today’s low bond, Treasury Bill, CD, and money market rates, retirees have been forced to use other alternatives. These alternatives typically require investors to reduce their retirement savings each year. Or they rely on mutual fund investments to attempt to increase their portfolio and provide income and yet, they are not aware of the fees being accrued no matter the rate of success or failure of the mutual fund. Although the 401(k) and mutual funds were created to benefit the investor, financial companies are the ones who have truly been rewarded.
In the past decade retired investors have had to weather two economic recessions, a mortgage crisis and a highly volatile stock market. Those planning for an upcoming retirement have likely heard the horror stories of retirement accounts getting wiped out during this time causing many retirees to re-enter the workforce in order to get by. This has created a great deal of timid investors wary of risking their life savings in the stock market, but still searching for a way to generate a safe and reliable income stream.
Dividend Stocks Filling the Gap
So how does one generate a safe and reliable income stream of at least 4% in an environment where 10 year T-bills are paying around 3%, investment grade bond yields are still near historical lows, and money markets and CDs are paying next to nothing? High quality dividend stocks can provide the income retirees need along with the safety and reliability they desire. Furthermore, selecting dividend paying companies who also have a history of raising their dividend payments annually will provide increases in a retiree’s income each year thus protecting themselves from the damaging affects of inflation.
Aren’t Individual Stocks Too Risky For Retirement?
Relying on stock price appreciation to fund your retirement adds risk as price movement can be affected by a number of macro and micro events. When investing in high quality dividend stocks to generate retirement income retirees don’t have to fret about day-to-day price fluctuations of their investments. By carefully selecting companies with sustainable growing dividends and long histories of dividend payments, an increase or decrease in overall price becomes much less of a concern. If a stock’s price drops 20% but its dividend remains constant, that price drop has no affect on the dividend income being produced by the stock. A stock’s dividend is much easier to predict than its price and a dividend exists independent of the market price.
For instance, investors who bought Intel Corporation (INTC) in 2004 in search of price appreciation would have a negative return today. But an investor who was in search of income from the dividend INTC was paying would be enjoying a 460% increase in dividend income since then, and would be much less concerned with the day-to-day price movements of the stock. Going forward, its much easier to analyze the safety of INTC's current dividend payment and potential for a dividend increase than it is its potential for price appreciation. Based on the graph below, one can see the steadiness of INTC's dividend (blue line) vs the volatility of its stock price (red line).
Building a 4% Portfolio
By doing a stock screen focusing on yield an investor may think its easy to build a portfolio that averages at least 4%. But one needs to look deeper in order to ensure they are investing in a company that will be able to continue to reward them with a steady and increasing dividend payment. Other than yield, a prudent dividend investor should also look at several factors to ensure they are getting a safe and reliable dividend income stock.
Dividend history – How long has the company been paying a dividend? Is the dividend part of the company’s identity?
Dividend consistency – Have annual dividend payments fluctuated over time or have they been consistent and increasing?
Dividend sustainability – Is the company earning enough to pay the dividend as well as fund future growth? Does it have the ability to weather economic downturns without risking the health of the dividend?
Growth – Is the dividend growing over time? Is revenue and earnings growth outpacing debt and outstanding share growth?
Finally, an investor should focus on building a diversified portfolio of dividend paying stocks to further decrease its overall risk. Although REITs and Utility stocks generally pay larger dividends, one should not focus just on these sectors. A diversified portfolio across multiple sectors and industries will allow an investor to survive downturns in the market or within a specific sector.
Below are five safe dividend stocks in different industries that, when invested evenly among each stock, would yield over 4%.
Intel Corporation (INTC)
Dividends Paid Since: 1992
Free Cash Flow Payout Ratio: 47%
Dividend Growth Rate 5yr Avg: 12%
Johnson & Johnson (JNJ)
Industry: Drug Manufacturer
Dividends Paid Since: 1944
Free Cash Flow Payout Ratio: 62%
Dividend Growth Rate 5yr Avg: 8%
AT&T Inc. (T)
Industry: Telecom Services
Dividends Paid Since: 1881
Free Cash Flow Payout Ratio: 51%
Dividend Growth Rate 5yr Avg: 3%
Realty Income Corp. (O)
Industry: REIT – Retail
Dividends Paid Since: 1994
Free Cash Flow Payout Ratio: 81%
Dividend Growth Rate 5yr Avg: 5%
Leggett & Platt Inc. (LEG)
Industry: Home Furnishings & Fixtures
Dividends Paid Since: 1939
Free Cash Flow Payout Ratio: 50%
Dividend Growth Rate 5yr Avg: 5%
Dividend stocks have gotten a lot of press the past few years, and for good reason. These stocks are supplying investors with the much needed income they need while other income investments continue to pay out record low rates. Even if interest rates climb I believe high quality dividend stocks should remain a large part of an investor’s retirement portfolio as they provide income growth and diversification that is necessary for a successful retirement, especially when following the 4% rule.
Disclosure: I am long INTC, O, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The 4 Percent Portfolio recommends Intel, Realty Income, AT&T, and Leggett & Platt.