Saturday, January 12, 2008

A Dividend Approach to Retirement

I just started reading The Ultimate Dividend Playbook: Income, Insight and Independence for Today's Investor by Josh Peters and already I can see the value of investing in dividend paying stocks for retirement. When I went looking for an income strategy a few years ago I completely ignored dividends, since I thought the yields were too low. So, I decided to use covered calls instead, which offer a much greater yield, at least initially. However, as I've discovered over time, the yield on covered calls is at the whim of Mr. Market. When stock prices decline so do the option premiums, so what may start out as a high yield position can quickly become a low yield position.

The are many possible ways in which to fund retirement withdrawals, but I'll only cover two of them in this article. One is to accumulate a large portfolio of stocks and simply withdraw a portion each year by selling some stocks to raise cash. For example, if you had accumulated $1,000,000 in stock and you withdrew $50,000/year the account would last 20 years, assuming the account value remained the same. However, Mr. Market might have other ideas. Sometimes the value of the account would be high and sometimes it would be low. If you were forced to sell positions for your annual withdrawal at the lows then you would need to sell more shares to receive the same $50,000 and the account would last less than 20 years. In other words, with this method liquidation value and timing is extremely important since you're retirement is subject to the whim of Mr. Market.

The other method is to accumulate a large number of shares of dividend paying stocks and withdraw the dividends every year. The dividend payouts would not be affected by the current market value of the stocks and is therefore not subject to the whim of Mr. Market. Regardless of the value of their stocks, most companies will continue to not only pay dividends but also increase them over time. With this method you don't need to sell stocks to generate cash, so the liquidation value doesn't matter. This is a hard concept for many to accept since they equate success with a rising account value. Instead what really matters is the annual yield and dividend growth that the portfolio can generate.

For example let's look at BBT, which I just added to my portfolio. Five years ago on 1/6/03 BBT closed at $38.25. It had a dividend rate of $1.16/share for a yield of 3.03%. The closing price as of Friday 1/11/08 was $28.16 for a $10.09 or 26% decline. The current divided rate is $1.84/share for a yield of 6.53%. Although the stock price declined over the past five years, BBT continued to pay dividends totaling $7.84/share and raised the dividend 5 times for a growth rate of over 9%/year (dividend info), which is well above the rate of inflation. Today, the dividend yield is even more attractive at 6.53%. If BBT continues to pay dividends at the current rate and continues to increase the dividend every year at 9+%, does the value of the stock really matter? What really matters is the cash flow generated by the dividends, which can be withdrawn from the account to pay for living expenses without reducing the principal and future dividend payments. This is stable, sustainable, passive income, which is what you want in retirement.

Now let's look at some numbers. If you bought $1,000,000 worth of BBT on 1/6/03 at $38.25 you'd have about 26,143 shares. The value of those shares today at $28.16 would be about $736,187, which is a $263,813 loss of value. However, you would have generated dividend income of $31,894 the first year, $35,032 the second, $38,169 the third, $41,820 the fourth, $46,012 the fifth, and $12,025 so far this year, for a total of $204,961. Did the loss of $263,813 in market value have any effect on the dividend payments or dividend growth? No, it made no difference at all.

I know someone who has a few million invested in dividend paying stocks which generates over $100,000/year in dividends, every year. This person never worries about the value of his portfolio, which goes up/down by large sums that would make most people lose sleep. But he knows he can count on the income it produces every year so he sleeps very well. This is the goal of passive income, where your money works for you instead of you working for your money.

I still plan to write covered calls, and possibly cash secured puts, to enhance the income potential of my portfolio, but I'll be focusing more on accumulating shares of undervalued dividend paying stocks, since I believe these tend to be less volatile and offer a greater opportunity for stable, sustainable, passive income and income growth. This way by the time I retire, I can just sit back and collect the income without much further effort. So, I'll be revising my trading plan based on these new objectives once I finish reading Josh's book. It's going to take some time to work out all the details, but as soon as I'm done I'll post my new trading plan here, so stay tuned.