Dividend income will smooth out any market fluctuations and overcome inflation during retirement.
Highlights:
- Bonds offer consistent income but don’t increase with inflation.
- Growth stocks can offer high returns but are volatile.
- Dividends offer stable income and increase with inflation so you keep a standard of living.
- Dividends also help smooth out the ups and downs of stock returns.
How do you pay your bills during retirement?
There are several ways to finance your retirement. Some of the usual ways are collecting interest from bonds, dividends from stocks, or capital gains from selling growth stocks. Of course, you could hit the lottery or get a big inheritance from a long-lost uncle. Those last two sound pretty cool but let’s focus on the options we can control.
Interest from bonds.
You buy bonds or a bond fund. Short term prices may go up or down, but you aren’t worried about that because you can hold the bond to maturity and get your principal amount back. You focus on collecting that interest, which doesn’t change based on the price of the bond. If it pays $60 each time, it will continue paying that whether the price goes up or down. You can easily fund your retirement this way and not have to worry about the volatility of the stock market.
So why doesn’t everyone do this? It’s not all sunshine and rainbows – that $60 payment helps ease concerns when things go bad, but it also limits you. Ten years from now, it’ll still be paying $60 but you won’t be able to buy as much because inflation has been creeping up the entire time. So how do you make your payments go up with inflation? You would have to sell that bond and buy a newer bond at a higher interest rate (paying a higher coupon). The problem with this strategy is that the bond you are selling will be worth less (as interest rates rise, bond prices go down). So now you are back to worrying about your investments even though you are supposed to be in something ‘conservative’.
Capital appreciation from growth stocks
You could buy growth stocks and sell what you need out of the capital appreciation. Perfectly viable, but you take on additional risk due to owning growth stocks versus dividend-paying stocks. That’s the nature of growth stocks: their earnings aren’t consistent enough to pay dividends.
This should mean the company is plowing everything they do make back into the company so it becomes more valuable (and your stock price goes up!). As long as the markets are going up, this is perfectly fine. Selling some stock that has appreciated each year is just as good as getting money through dividends. But what happens when things are going bad? Look out below!!
Two different issues arise here for growth stocks:
- 1st: Growth stocks are going to be the first ones to go down so you don’t get much of a warning. Why? Take a look at the people needing income from their investments. Which securities are they going to sell first: the one paying a dividend that they can currently use to pay bills with or a growth stock that doesn’t pay a dividend?
- 2nd: The plan is based on selling stock that has appreciated. If the stock has gone down, you still have to sell some in order to pay your bills, but that is going to severely cut into your principal amount as you’ll have to sell more and more shares as the price goes down. That spells trouble, and way too much risk when things take a turn to the red.
Income from dividends
So now we have dividend income. You buy stocks that have stable earnings (think of the big companies whose products and services you use every day), and these companies let you share in those earnings by paying a dividend for each share you own. Any of you ever heard of the 4% withdrawal rate for retirement? Well, almost magically, there are a lot of these companies that pay a 4% dividend! Like it’s meant to be. You buy the stock and live off of the dividends it pays out. Here’s where this strategy beats bonds: that 4% dividend can increase over time, enough to keep up with or even beat inflation year after year. The dividend will buy more goods and services 10 years from now than it does right now. That allows you to keep purchasing power and the same standard of living you are used to.
How does this strategy beat the growth stock strategy?
- 1st: If you are in retirement: you aren’t worried about prices going up and down as much; it doesn’t affect the income that you actually live off of. We refer to a dividend as a percentage, but it’s actually a set dollar amount that the company pays. Investors turn it into a percentage so we can compare how much one company is paying versus another without their different stock prices coming into account. Let’s say a company with a $50 stock price declares a $2 dividend. That’s a 4% yield. What happens if the stock price drops to $40? Nothing. It will still pay the $2. That allows you to ride out any drops much easier!
- 2nd: For those in the accumulation phase: It’s a much smoother ride. Dividend stocks will drop in value after growth stocks so you’ll have more of a warning when things are going bad. (remember, growth stocks will be among the first to be sold off). So the drop will start later, and it will also be a gentler drop. If there are any skiers out there, the slope of a growth stock in a recession will look like a black diamond, while the slope of dividend payers is more like the bunny hill. Smoother, gentler, more predictable.
- 3rd: One other aspect that helps smooth out those ups and downs is how the dividend itself factors into the return. Let’s say a zero-dividend growth stock and a dividend-paying stock each go down 12%. For the growth stock, that’s the final result, but for the dividend-paying stock, you need to factor back in its dividend payment. A 4% dividend cuts that stock’s loss to only 8%. Your account balance dropped 33% less than the growth stock simply because of the dividend payment.
These advantages allow you to sleep better at night. You’ll still be getting the same income to pay your bills and not have to check stock prices every day.
What am I leaving out? Taxes? Yes, I’ll cover tax implications next.