How to live off your dividend income

The goal of many, if not most, retired dividend investors is to generate enough income via dividends to cover their living expenses. And additionally to have that dividend stream increase faster than inflation. Sounds like a great goal. If you can achieve it then you can let the principal ride and compound in the market and not worry about the volatility that gyrates market prices. I heard this many a time before I retired. Before adopting this as a strategy I decided to do some research. The first question I asked myself was does the historical data say that this is possible?

Going back to the historical stock market data (I use the Shiller data set for the S&P500) I wanted to see what the dividend growth, both nominal and real, has been in the past. The data says that from 1871-2009 the nominal dividend growth rate for the S&P500 has been 3.46% and the real dividend growth rate has been 1.37%. That says that you could definitely have lived off the dividends from the S&P500 and it would also have kept up with inflation. So far so good.

Next I wanted to check what the fluctuation of the dividend stream was, i.e. its volatility. Turns out the volatility of the historical dividend growth is approximately 12%. That’s lower than the volatility of the S&P500, which is 17%, but not by much. And here is where I became concerned. This volatility means that dividend growth can be negative, especially if there a few ‘black swans’ hiding in the past. And we all know there are. That means that you face a reduction in income with negative dividend growth. Maybe with this strategy capital fluctuation doesn’t matter but dividend volatility certainly does.

How bad were these dividend reductions in the past? This is somewhat akin to looking at drawdowns for stock prices so I went back to the worst periods for stock market price declines to see what was the impact to dividends. Using inflation adjusted dividend data and starting with the most recent, the financial crisis of 2008, the S&P500 dividends were reduced by 18% from 2008 to 2009. Good thing this reduction looks to be only a one year affair, as dividends are expected to increase in 2010. The previous dividend ‘crash’ occurred in the 2000 tech bubble crash – the dividend reduction there was 11% and also was a one year event before increases resumed. Then there is the 24% reduction from 1966 to 1975 – that’s right, 9 years of dividend decreases. Then there are two whoppers from the Great Depression – two 40%+ reduction in the 1930 to 1946 time frame. Finally, prior to the depression there were 5 other 25%+ dividend reductions.

In short, history says that you can live off your dividends IF you can ride out ‘temporary’ reductions in income. I put temporary in quotes because in a few of these periods it would have taken over 10 years for your income stream to recover to its previous level, inflation adjusted. For me that was the death knell for this approach. I think most retirees would not view such an approach as a viable retirement strategy.

An additional problem with this strategy is that by living off the dividend stream you lose the power that reinvesting dividends has on compounded long term returns. Even if you do manage to live off the dividends, with their fluctuations, over time in the long run you will accumulate a lot less wealth to leave for your family, charity, whatever your wishes are nearing the end of your life.

I think there is a better way that accomplishes the same goal, living off your assets, and harnesses the power of dividends in enhancing returns, bear market protection, and long term wealth building. The basic elements of the strategy are:

1. Choosing and investing in individual high quality dividend stocks (with long dividend histories)
2. Reinvesting ALL dividends
3. Planning for potential future dividend reductions
4. Maintaining 5 yrs of living expenses in cash or other short liquid instruments.

These 4 elements work together to provide income, ride out market fluctuations, keep up with inflation, and build long term wealth.

This post is already too long so I’ll leave it there and return to the elements of this new approach in later posts. I’d love to hear your thoughts on this topic.