Sunday, August 10, 2008

Dividend Focused Equity Portfolio Maintains Real Purchasing Power In Retirement

(I originally posted the following article on The DIV-Net website on August 3, 2008)

The last ten years have been difficult ones for equity investors. The ten year annualized return on the S&P 500 Index as of June 30, 2008 is 2.88%. Essentially, an investor's return has consisted of the dividends received on their stocks. According to a recent report from T. Rowe Price, "since 1980 reinvested dividends accounted for more than half of the total return on the S&P 500 Index." What does all this mean for retirees? An important aspect of dividend growth investments is the ability for these types of stocks to provide a growing income stream that keeps pace with inflation. Additionally, dividend paying stocks tend to be less volatile in down markets. This can be an added benefit if one is relying on their investment portfolio for retirement income.

Recently, T. Rowe Price (TROW) and Ned Davis Research conducted a two part study. The first part compared a dividend paying stock portfolio against the S&P 500 Index. The second part of the study compared the income generated from this dividend paying portfolio compared against a government bond index. The two stock portfolio were comprised of:
...the S&P 500 and one comprising the top 50% of dividend payers in that index each year. Each January the the high yield portfolio was adjusted to include the top 50% of dividend paying companies based on the prior year.
The study parameters are as follows:
The study assumes the investor retired with $500,000 at the end of 1972, just before the 1973–1974 bear market—one of the worst bear markets ever. The investor withdrew 4.5% of assets the first year, with annual inflation adjustments of withdrawals tied to the consumer price index. Annual withdrawals grew from $22,500 the first year to $106,835 in 2007.
As the below chart details, the high yielding stock portfolio supported the inflation adjusted 4.5% initial withdraw rate and allowed the equity portfolio to grow. In the case of the S&P 500 Index portfolio, the portfolio ran out of funds in 2005.

(click on chart for larger image)

High Yield Equity Portfolio Value versus S&P 500 Index 1972-2007
In the second part of the T. Rowe Price/Ned Davis Research study, they evaluated the income generated from a bond portfolio versus the high yield stock portfolio noted above. The study value of the portfolios consisted of annual $100,000 contributions beginning at the end of 1972. Additionally, the dividend and interest payments were taken in cash versus having them reinvested. The outcome from this income study was:
In the high-inflation 1970s, as bond yields reached double digits, interest payments substantially exceeded dividend income. But as interest rates declined steadily over the 1980s and 1990s, the dividend payments surged ahead.

Over this entire 35-year period, the high-yielding equity portfolio generated more than twice as much income as the bond portfolio—about $476,000 in dividends compared with about $230,000 in interest income.

Moreover, in terms of principal value, the original $100,000 investment in the stock portfolio had grown to more than $711,000 by the end of 2007, compared with about $121,000 for the bond portfolio.
Graphically, the income flows would appear as noted in the chart below:

(click on chart for larger image)

annual income high yield equities versus government bond 1972-2007
For investors, an all equity portfolio may seem too aggressive. However, considering a combination of stocks and bonds in an investment portfolio could provide a certain comfort level while at the same time, allowing for a growing income payment stream that keeps pace with inflation.


Dividends Can Play Key Role In Retirement Income Plans (PDF)
T. Rowe Price Report
Summer 2008

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