The reality is that in retirement, you will need multiple passive income streams. Defined contribution retirement plans such as a 401(k) or IRA are only one component of a passive income stream in retirement. Moreover, following the 4% rule even with a $1 million retirement portfolio may not generate enough income. Social Security is another component but the average benefit is only $18,576. The two combined are unlikely to meet your monthly expenses. One alternative is to live off dividends using a passive income stream.
A dividend growth strategy can permit you to build wealth and generate future passive income using dividends. The question remains, though, how to live off dividends. It is often a goal by many retirees, but can it be done?
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Retirement Plans and Social Security May Not Be Enough
Many future retirees understand the concept of the 4% withdrawal rule from the so-called Trinity study. The Trinity study is named this because it was a study published by professors from Trinity College. The article “Retirement Spending: Choosing a Sustainable Withdrawal Rate” was published by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz in the February 1998 issue of the Journal of the American Association of Individual Investors.
The basic strategy is to work, save for retirement in a tax-advantaged account, and withdraw 4% per year for annual living expenses. One conclusion of the study is that a 4% withdrawal rate for stock-dominated portfolios has a very high success rate of a 30-year payout period even after accounting for inflation assuming you saved enough for retirement. The amount associated with the Trinity study is usually $1 million is saved for retirement.
What if you don’t want to draw down your principal and instead save it for your spouse, children, and future generations. The question is how to live off dividends. Is it even possible?
Social Security provides a guaranteed income stream. But many retirees do not receive the full retirement or maximum benefits. According to the Social Security Administration, the average monthly benefit is only ~$1,548 or $18,576 annually.
What Are Dividends?
Before we delve deeper into the subject, first, let’s discuss dividends. Regular dividends are cash distributions paid by companies from their earnings to their shareholders. A shareholder can receive the dividend payout provided they owned the stock before the ex-dividend date. Dividends can also be paid in stock, and special dividends are paid irregularly from excess capital.
Dividends are paid by stocks, mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and master limited partnerships (MLPs). In some cases, the dividends are paid in capital distributions, which is a return of capital. There are many reasons why dividends are essential to investors.
Lump-Sum Investment Strategy
The first strategy an investor can use to live off of dividends is a lump sum investment strategy. A retiree can invest a large amount of cash in a short time to generate a passive income stream from quality dividend stocks with a proven track record. For example, a retiree may sell a business, real estate, or other assets and use the proceeds to invest in quality dividend-paying stocks. Some workers receive buyouts for pension plans or accrued vacation benefits. Other workers receive buyouts during layoffs. Instead of parking the proceeds in a savings account he or she can buy high quality dividend stocks.
How Much Do You Need?
The size of the investment depends on the desired annual income and the calculated dividend yield. For example, if a retiree has $1 million to invest and wants $30,000 in yearly income, his or her portfolio would need to have a 3% average dividend yield. An investor is not limited to only stocks that yield 3%. Instead, the investor creates a portfolio of stocks that have a weighted average yield of 3%.
The equation that will let you determine annual income is
Using the above example:
Creating a spreadsheet to calculate annual income based on initial investment and the dividend yield is not too difficult. For example, in the table below, yearly income was determined based on a lump sum investment of $500,000 to $5,000,000 and a dividend yield from 1% to 10%.
Can You Really Live off Dividends?
The reality is that few retirees will have a large enough lump sum amount to invest in creating a high passive income stream. The median net worth is only $266,400 for those between 65 and 74 years old, according to the Federal Reserve’s Triennial Survey using 2019 dollars. The mean net worth is higher at $1,217,700 since high net worth individuals pull the average up. Assuming you sell a business or rental property for $1 million, a weighted average 4% dividend yield results in an annual income of $40,000. If your business nets you $3 million, a 4% dividend yield will result in a six-figure passive income.
A $40,000 passive income stream is a decent amount, but it may not be enough by itself to cover annual expenses for a retired couple. However, when combined with social security benefits and required minimum distributions (RMDs) from retirement plans, it can be sufficient to retire on. For instance, the average social security benefit is $1,514 monthly, which is $18,170 annually. The maximum benefit is $3,011 monthly, which is $36,132 annually. Thus, a retired couple each receiving the average social security benefit can have a total retirement income of over $75,000 annually.
Notice that we did not even include RMD from 401(k) plans or IRAs. Let’s extend this example further. We assume that you are 72 and taking the RMD from a 401(k) plan with $500,000. This amount is greater than the average, but we assume that you and your spouse were smart and started saving for retirement early. We also assume that your portfolio’s estimated rate of return is a very conservative 4%. The RMD for year 1 is $19,531, according to the AARP calculator. The dollar value of the RMD goes up from there until you reach 94.
A retired couple, each with $500,000 in their 401(k) portfolio, would receive an annual retirement income of over $100,000, including dividend income, social security benefits, and RMD from a 401(k) plan.
Is Achieving a 4% Average Dividend Yield Hard to Do?
Generating a 4% annual yield is not that hard even when the broader stock market’s valuation is elevated. For instance, many high-quality stocks have dividend yields of 4% or more with a safe dividend.
Checking a watchlist for the Dividend Kings on Stock Rover*, there are multiple stocks with dividend yields over 4%. If one reviews the Dividend Aristocrats watchlist, there are eight stocks with a 4% dividend yield or more. There are dozens of Dividend Contenders and Dividend Challengers with dividend yields of 4% or more.
The point here is that if you have a lump sum to invest, you can generate a decent passive income stream from quality dividend stocks with a 4% weighted average dividend yield. Moreover, most of these stocks are reasonably conservative investments with suitable dividend safety. Hence, a lump sum investment strategy is one method of how to live off dividends, especially when combined with social security benefits and RMD from retirement accounts.
Dividend Growth Can Get You There
The problem with the lump sum investment strategy is that many retirees don’t have a business or rental property to sell. In addition, today, fewer retirees have a defined benefit pension plan and a buyout. Next, investing $1 million or more is a lot of money to commit in a short time. However, a dividend growth strategy is a viable one for how to live off dividends and one component of a passive income stream. The main drawback is that it takes time and requires patience. However, unlike the lump sum investment strategy, it does not take as much initial capital, making it much more attractive to small retail investors.
What is Dividend Growth Investing?
Dividend growth investing is an investing style where you buy stocks that pay a growing dividend over time. Dividend yield matters, but a high dividend yield is not the focus; instead, it is dividend growth, especially during the accumulation stage. The dividends are reinvested during the early stages of investing or the accumulation stage. Most companies have a Dividend Reinvestment Plan (DRIP) that lets an investor automatically reinvest dividends.
An advantage of dividend growth investing is higher returns with lower volatility over more extended periods. In addition, dividend growth stocks tend to have good business models permitting the companies to increase revenue and earnings and thus dividends over time. Dividend growth investing also has a reasonably good ability to predict current and future income. Most companies pay consistent dividends and increase them by the same amount annually with minor deviations. Next, qualified dividends are tax-efficient. The dividend tax rates are the same as the long-term capital gains tax rate and lower than regular income tax rates.
You generally should own between 20 and 30 individual dividend stocks for diversification. You start with a handful of your best dividend growth stocks and build your portfolio from there. Since the dividends for each of your equity holdings are increased annually, the dividend increases.
By reinvesting the dividends, an investor leverages the power of compounding to increase the total investment and thus total dividends in the next year. After retirement, you can stop reinvesting the dividends and instead live off of the dividends.
How Much Do You for Dividend Growth Investing?
How much do you need for dividend growth investing if you want to live off dividends? Less than if you follow the lump-sum strategy. There are two reasons for this. First, the dividend is growing annually, and it is reinvested. Second, the stock price is appreciating on average over time. Let’s look at an example.
Example of an Individual Dividend Growth Stock
The example we are discussing is 3M Company (MMM), a well-known Dividend King with 64 years of dividend growth, according to Portfolio Insight*, and many small investors own the stock. We assume an initial investment of $10,000 in September 2011 and reinvest dividends. We use Portfolio Visualizer for our backtesting analysis. The $10,000 initial investment has turned into over $30,900. The quarterly dividend was $0.55 per share in 2011 and grew to $1.48 per share in 2021. The growth in the dividend was impressive. In 2012, 3M stock paid $289 in dividends, and in 2020 3M stock paid $891 in dividends. The question is can we live off of dividends if we have a larger portfolio?
Example of a Portfolio of Dividend Growth Stocks
An investor who only owns one dividend growth stock over a period of 10-years generated solid total returns and a growing passive income stream. What happens if we have a portfolio of 10 dividend growth stocks with dividends reinvested. We use only ten stocks here for simplicity, but we can extrapolate this example to 20 to 30 stocks for diversification. As seen in the table below, we assume an initial investment of $50,000 that is equally weighted in ten Dividend Kings. We also make another assumption that we contribute an additional $500 per month or $6,000 annually. I am long some of these stocks. This portfolio grows from $50,000 to $188,799 in 10 years. The dividend income grows from $1,793 in 2012 to $3,791 in 2020.
The total amount of capital contributed was $110,000, which is a reasonable amount and much less than the lump sum investment strategy. Although the returns are good, one cannot realistically live off of this amount of dividend income. But what happens if we add more time and start earlier?
More Realistic Example of How to Live Off Dividends
If you started investing in a dividend growth strategy 10-years before a target retirement age of 70, you started only at age 60. At this age, you need a larger initial investment, or you need to add more money monthly to your dividend growth stock portfolio.
A more realistic example is if you started 20 years before retirement at age 50, which is not too old to start investing. We use the same ten stocks with dividends reinvested and assume that we start with $50,000 equally weighted between the stocks. We also make another assumption that we contribute an additional $500 per month or $6,000 annually. The total capital invested is $170,000. In this case, this portfolio grows from $50,000 to $995,587 in 20 years. The dividend income grows from $1,708 in 2002 to $19,743 in 2020.
It is more realistic to live off of dividends now as a component of your total retirement income. But can we do better?
Start Even Earlier with Less Initial Capital
Suppose we start at age 40 or 30-years before retirement and with a lower dollar amount of $10,000. Most people are thinking about retiring at this point and spending time planning for it. Ten thousand dollars is an amount that most people in their 40s have in a savings account. We use the same ten stocks with dividends reinvested and again assume that we contribute an additional $500 per month or $6,000 annually. The total capital investment is now $190,000.
In this case, this portfolio grows from $10,000 to $2,347,089. Dividend income grows from $559 in 1992 to $46,807 in 2020. This example is a much more realistic scenario to live off of dividends, especially when combining the passive income stream with social security benefits and RMD for a couple in retirement. You are likely to have a six-figure retirement income. Unlike the lump sum investment strategy, you also did not need to invest $1 million or more to generate this passive income stream.
Now suppose, you increase the initial investment to $25,000. In this case, the portfolio value at age 70 raises to $2,895,225. The dividend income was $1,132 in 1992 and grew to $57,814 in 2020. Now add in the average social security benefit and RMD from $500,000 for a retired couple, and the retirement income is over $125,000.
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Risks to Living Off Dividends
The main risk to investors is that dividends can be cut or suspended. For instance, companies cut or suspended dividends in large numbers during both the sub-prime mortgage crisis and again during the COVID-19 pandemic. However, quality companies with good dividend safety, for the most part, did not. Many companies increased their dividend continuing their long-term streaks. The dividend increases occurred despite bear markets and double digits drops in stock prices.
For example, 3M’s stock price dropped from a peak of over $250 per share at the end of January 2018 to ~$118 per share at the nadir of the COVID-19 pandemic, a decline of over (-50%), as seen in the graph below. However, the dividend was still paid, and indeed it was increased each year, as seen in the chart below from Portfolio Insight*. This leads to an important point; dividends are persistent. A company is often reluctant to cut or suspend the dividend since it significantly and negatively impacts the stock price.
Diversify to Reduce Risk
The key to mitigating risk is to diversify. An investor who was concentrated in the bank and financial stocks during the sub-prime mortgage crisis was punished. Not only did stock prices drop, but dividends were slashed or stopped. Even stalwart industrial companies got into trouble. For example, General Electric (GE) was Dividend Aristocrat but cut the dividend due to problems in its large GE Capital business segment and a slowdown in its industrial businesses. Notably, GE’s dividend has not yet recovered. After the Great Recession, the company raised its dividend until 2017 but cut it twice after trouble with its Baker Hughes acquisition and total debt. As a result, it will be many years before GE’s returns to the Dividend Aristocrat list. However, the critical lesson here is not that the dividend growth strategy does not work but rather to mitigate risk and pay attention to dividend safety.
An investor concentrated in REITs, energy, travel, leisure, hospitality, restaurant, or retail stocks during the COVID-19 pandemic in 2020 was also punished. COVID-19 was the worst economic condition since the Great Depression for many of these industries, and the economy contracted at a record rate. Many of these equities have begun to reinstate dividends but have not yet reached the levels before the pandemic. Risk is the reason not to concentrate in any single sector or industry and hold basket of 20 to 30 high quality dividend growth stocks.
Risk to High Yield Stocks
The above discussion focuses on stocks yielding 4% or less. Some stocks yield more, but often a high yield signals that the dividend may be cut in the future. Investors need to worry if the calculated payout ratio is elevated and earnings do not cover the dividend payout. Similarly, if the free cash flow does not cover the dividend, this is another warning sign of a potential dividend cut. Next, if the total debt is too high, then interest payments will take priority over dividend payments. Finally, an investor needs to remember that dividend yield is inversely related to price. A dropping stock price due to company challenges will simultaneously lead to a rising dividend yield. At this point, investors need to double-check their investment thesis.
The Bottom Line
A well-constructed dividend growth stock portfolio can serve as a significant component of a retirement plan. The approach will let a retiree live off of dividends. In addition, it can generate a growing passive income stream that is a part of total retirement income, including social security benefits and RMD from tax-advantaged retirement plans. It is important to keep risk in mind and not chase high yields or be overly concentrated.
If an investor starts early enough, the passive income stream can be tens of thousands of dollars. It is important to track your dividends and stock holdings. Furthermore, the initial capital invested is relatively reasonable. Still, the total return from reinvested dividends and price appreciation over time will result in a robust portfolio that can be handed off to your spouse or future generations.
Disclosure: Long KO, IBM.
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.