Wednesday, August 22, 2012

Building My Portfolio for Retirement, with Dividends and Bonds

In my mid to late 40’s, my focus of late has been more on planning for retirement and how I will generate a consistent monthly income to fund my retirement. I find myself in between the need to increase my portfolio through capital appreciation, but also for the need to generate monthly income in retirement. I can take early retirement nine years from now, and I fully plan on doing so! What I will need at that time is monthly income.

I’ve weighed the pros and cons. I’ve come to the conclusion that I’m better off creating a stable portfolio of monthly income, through dividend stocks and bond ETFs. I feel this is more beneficial for me, than trying to hedge my bets on where the markets might or might not be nine years from now through indexing. Right or wrong, it’s a personal decision I’ve arrived to through my own investing experience. The bottom line is I prefer to hold shares in companies directly, rather than a basket of stocks in an index. Although Index ETFs such as XIU or XIC do pay distributions, the yields at 2.5% and 2.3% respectively, is much lower than holding dividend stocks directly.
While I’m keeping my bond ETFs and bond funds, I had reached the point where it was an opportune time to sell my equity index funds at profit, and purchase dividend stocks that were fairly priced. So on Friday I sold my index equity funds, and set buy prices on dividend stocks I’ve had on my watch list over the last year or so. This is something I’ve been contemplating for several months now, and I started to pull the trigger this week in my TFSA. I had to be 100% certain it was the right decision, and I had no regrets in doing so. I’ve decided to write a couple of posts this week, on why I’m switching my index equity holdings to dividend stocks.  I reiterate this is my own personal decision, and everyone has an investing strategy that suits them – it may be 100% indexing for you. ;)

Early Retirement via My Pension Plan 

Working in healthcare full-time and part-time over the years has been generous, and I’m always thankful for that. Even when I ran a web company for several years, I still kept my hours in healthcare part-time or casual in order to keep my benefits and membership in the pension plan. I signed up for our pension plan at work when I was a casual employee starting out, because I realized the benefit in doing so. While my co-workers didn’t invest at all, or piled their savings into mutual funds on their own, I realized that my employer would match my contributions and I would have a defined pension (or cheque every month) when I retired. I realized this was worth gold!
I’m one of the fortunate ones who have a defined benefit pension plan. That means I’m guaranteed a monthly income at a fixed amount regardless of the market. I’m guaranteed that pension as long as I am alive, and as long as the plan is fiscally sound. I can retire anytime once I’m 55. Obviously I can work longer and collect more from my pension, more with each year worked, but I’ve already decided I will take whatever benefit I am entitled to at 55 and collect! :) For me it’s a lifestyle choice. That’s only nine years away, and since I’m already living a semi-retired lifestyle anyway, it’s not going to be a big leap or life style change.  In fact, I’m looking forward to it!
I’m more than thankful for that pension, but obviously it’s not going to be enough. Government benefits are also going to be a nominal addition to that amount once I’m 65. That’s where my investment portfolio comes into play, to bridge my pension and government benefits, and provide the additional income I need to live a comfortable lifestyle.  My investments are both my security cushion and an additional source of income I will require in retirement.

Drawing Down an Indexed Portfolio in Retirement

Classic retirement planning states that you can draw down 4% of your portfolio adjusted annually for inflation. This based on the work of William Bengen, assuming a 50% equity and 50% bond portfolio. If you have portfolio of index funds and index ETFs, most of your income comes from drawing down your portfolio capital. Even with a big chunk of Bond ETFs which provide monthly distributions, or holding ETFs such as XIC and XIU mentioned above, there is no way around drawing down your original capital. The idea is that while you draw down 4% of your nest-egg, you will also be accumulating at least the 4% back (or far more) in capital appreciation, dividend distributions, reinvested dividends into new fund units, and reinvested interest income of course from bonds. Rick Ferri in the U.S. has written extensively on drawing down an indexed portfolio in retirement.  The bottom line however, is with an indexed portfolio you are at some point drawing off the capital of your portfolio.

What If We Have Another Financial Crisis?

But what if your indexed portfolio doesn’t increase when you retire? What happens if you retire at 65 and we have another 2008 and 2009 crash? Can you draw down 4% your portfolio when it has lost significant value and continues to depreciate?  I don’t know the answer to a question like that. But what I do know is I simply won’t have the time to recover from another market crash when I’m 65 or even at 55. While stock markets always bounce back, losing a third or half your portfolio value when you are relying on its capital (value) for retirement is going to be unsettling. On the other hand if you have a good allocation of bonds, then you do have some necessary income and a cushion when markets tank – unfortunately many people did not back then, and they still don’t today.
If we have another financial crisis, I would rather be holding all my equities in dividend paying stocks, and here are three reasons why. (1) Dividend stocks pay you quarterly and even monthly distributions for being a shareholder, regardless of their share price. (2) Many companies cut or suspended their dividend temporally during the crisis. However, most continued to pay dividends, and the U.S. and TSX Aristocrats even increased them in 2008 and 2009. (3) Although many investors’ endured great stress by watching their portfolio decline in value, they still collected monthly dividend income from their dividend stocks. It may not be much of a comfort, but those who were able to endure and hold on to their dividend paying stocks, made tremendous gains in the few years that have followed. In other words dividend stocks still paid you income.

Dividend Investing vs. Index Investing

That’s where dividend stocks come into play, and in my opinion can provide a benefit over index equity ETFs or index funds. Here is the key point: If you have a basket of dividend stocks for the equity component of your portfolio, then regardless of the share price of your securities (capital), you will still have the same number of shares, and the same dividends paid out (income). Actually dividend yield increases when share prices decline. So if you can hold steadfast when your dividend stocks plummet you will actually receive 
slightly more
 the same dividend income. ;)
In my opinion, this is where dividend investors have the upper hand. Regardless of their overall portfolio value (share price) their monthly income (dividends) remains constant. So while many long time dividend investors, such as Susan P. Brunner among others, have noted their portfolio value may oscillate wildly during times of market crisis, their monthly dividend income remains relatively constant.
There is a trade off of course. What you give up for the steady income is the potential for larger gains. For example, you won’t beat the market holding bellwether stocks like Johnson & Johnson (JNJ) or Procter & Gamble (PG). JNJ is a pretty stable stock, and its’ very unlikely to outperform the market in any given year. But it will give you a consistent 3.5% yield with lower volatility than the overall market. And you will likely see an increase in JNJ share price over the years. But when your equity investments decline in value they will still generate income through dividends.

I’m Keeping My Bonds, Thank You!

While I’m willing to abandon my equity index funds for dividend stocks, I’m certainly not willing to go with a 100% equity portfolio route, or hold a 100% dividend stock portfolio! Part of setting up my portfolio for retirement is to sleep well at night. I was reminded of that back in August 2011 as well as the financial crisis, how important bonds are in a portfolio to cushion the blow. But bonds did much more than just cushion the blow, they provided monthly income!


Putting it all together, this is a strategy that makes sense for me in my current situation. It may not be for everyone, but a portfolio of 50% bonds/fixed income and 50% dividend stocks suits me just fine. I’m looking forward to taking early retirement, and having a portfolio that pays me regular income. When markets oscillate wildly or decline, I know my dividend stocks and Bond ETFs will continue to pay me consistent monthly income. In my next post, I’ll cover more about creating an income focussed portfolio.
Readers what’s your take? Do you think shifting to an income portfolio (of bonds and dividend stocks) at my age is too early? Do you prefer Index Equity Funds and Index ETFs, or do you prefer dividend stocks?

This article was written by Dividend Ninja. If you enjoyed this article, please subscribe to my feed [RSS]


  1. Good article! I'm 34 and slowly building up my dividend income theory is once I can generate an average after-tax wage with from dividend income I can retire early. :)

  2. I like your equity style Dividend Ninja. Just be careful to keep the duration of your bond portfolio low. The strong possibility of rising interest rates over the next 3-7 years could really cause huge capital loses in most bond funds. Personally, I'd rather hold my "bond portion" in a mix of high yield / corporate bonds and cash. I'd be quite nervous holding 10+ year US Treasuries going forward, which is what seems to make up a majority of longer term bond funds' portfolios.


  3. Agree with the rising interest rate equals lower bond price scenario, which might be an ugly shock to bondholders, unless of course you intend to keep to maturity. I suppose that you could build a bond ladder of sorts. I am old enough to remember 18 per cent interest rates which didn't last forever either. You can bet those bonds were called pretty quick after interest rates dropped. My point is that one must understand the mechanics of a particular sort of investment. We live in a wonderful age where knowledge is free and abundant and costs only your time and effort.


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