Two retirees walk into a bar. One guy tells the bartender that he wants a portfolio of dividend-paying stocks where he can live entirely off of the income it generates. The other guy says he wants a portfolio that can provide him stable cash flow for the rest of his life. The bartender says, “what the heck is the difference?” Allow me to explain.
Why Dividends and Interest Are Attractive to People
Many people have a thing about never “invading” the principal of their nest eggs. If your portfolio consists entirely of dividend-paying stocks and bonds, it’s possible to live on the income it generates and never touch the principal balance. A client recently shared how doing just that gave his father a ton of comfort during the 2008 market correction. He wasn’t as worried about his portfolio’s (paper) losses, because those dividend checks were sufficient to meet his consumption needs. What’s interesting about this phenomenon is that, taxes aside, there’s no real difference between spending dividends versus selling a portion of your shares to produce the same amount of cash (since a stock’s price drops by the amount of the dividend paid).
Dividend Dangers
You may have heard of a little company called Apple. They paid no dividends between 1987 and 1995. Many good companies, including a large percentage of small companies (small cap) don’t pay dividends, so excluding all of them can hurt you from a diversification standpoint. And if you chase stocks paying the highest dividends, you increase the risk that the dividend will be cut off altogether – a case of fool’s gold I suppose. In short, if you focus too much on dividends, you’ll drift away from sound academic principles and risk seeing your “stable” income stream drop.
Homemade “Dividends”
A globally diversified portfolio of mutual funds that own a variety of stocks, real estate, and bonds, will allow you to receive a stable cash flow stream that’s generally higher than what you would get purely from stock dividends. Instead of focusing on the source of your income, you merely need to make sure that you’re annual spending is in a range that’s sustainable over the long run.
For a person starting to live off the nest egg in his 60s, I suggest that this spending range be between 4% and 5%. For example, if you have a $2,000,000 portfolio and expect to need between $80,000 and $100,000 per year for life, your advisor may suggest a blend of between 60% stocks and 40% bonds.
Technically, your cash flows will include dividends and interest, but this type of spending plan gives you permission to spend some of the growth and to “invade” your principal balance, without adding significant risk that you’ll outlive your money. If you require a bit more time to fully understand and trust in this kind of spending plan, talk to your advisor.
In the end, either strategy may succeed in getting you what you need to cover your expenses. But before you ask how much income your portfolio can generate, determine what your cash flow needs will be. Then, build a portfolio that will support your lifetime consumption, instead of letting your portfolio determine what you can spend. Living on dividends may feel safer and simpler, but a globally diversified portfolio and an intentional cash flow oriented spending plan will allow for more lifetime income.
Happy planning,
Barrett
