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Dividend Stocks vs. a Safe Distribution Rate

One of the most interesting investing questions is "How much can you safely withdraw each year from your retirement portfolio?" In 1995, Peter Lynch wrote that a 7% annual withdrawal rate would be prudent for an all-stock portfolio. He later retracted his analysis when financial columnist Scott Burns proved that a 7% withdrawal rate could put you back into the work force just to make ends meet.

There is not a lot of research in this area since most people spend their time contemplating capital accumulation, not spending it. However, there are a few studies on "safe" withdrawal rates. Let's look at a few of them and consider what could be a better alternative...

The Bengen Study

In February 1997, the Wall Street Journal columnist Jonathan Clements reported on a study by San Diego based financial planner William Bengen. Bengen looked at year-by-year returns since 1925 for a 50/50 stock/bond portfolio. He assumed half the portfolio was in the S&P 500 and half in intermediate term government bonds. Using a 30 year holding period, he calculated that a 4.1% withdrawal rate would allow you to survive the worst market declines.

The Harvard Study

In 1973, Harvard University did a study to determine how much they could safely withdraw from their endowment fund without eroding the principal. Assuming a portfolio of 50% stocks and 50% bonds and cash, Harvard's analysts calculated they could withdraw 4% the first year and then adjust the subsequent year's withdrawals for inflation. For example, if there was 10% inflation, the second year's withdrawal would be 4.4% of the initial (i.e., first year) asset value.

The Trinity Study

Dallas Morning News columnist Scott Burns has written extensively on a "safe" withdrawal study by three Trinity University researchers. The Trinity Study measures the "success rate" of various portfolios from 1926 to 1995. The "success rate" is the percent of time a retiree could sustain a given withdrawal rate without depleting his retirement assets. The optimal asset mix is 75% stock/25% long term corporate bonds. For a 30 year payout period and a 4% withdrawal rate, this mix had a 98% success rate. At a 3% withdrawal rate, the 75/25 mix had a 100% success rate. Interpolating these results would give you a "safe" withdrawal rate of slightly less than 4%, virtually identical to the Harvard study.

So it seems that 4% is the number that all these studies are pointing to based on on historical data. But is it a safe number if you retire today? More recently Burns wrote:
The established safe-withdrawal-rate rules of thumb are based on long periods of time in which yields were higher than they are today and stock valuations were lower. A growing school of thought believes future withdrawal rates should be reduced to reflect expected lower future returns. This would knock another 1.5 to 2 percentage points off the safe withdrawal rate.
You must also consider is that these studies are based on investment returns before expenses. If you're paying an investment advisor an annual fee of 2% of assets and he has you invested in no-load mutual funds with a 0.5% expense ratio, your annual expenses are 2.5%. Your "safe" withdrawal rate is is now 2.5% lower than what you previously thought.

Dividend Growth Stocks: A Better Way

When I retire, I want a high degree of assurance that I won't run out of money and have to start a second career or develop a taste for cheap dog food. I plan on achieving my goal of an ever growing income with a diversified portfolio of high-quality dividend stocks. Why would I settle for trying to live on as little as 1.5% to 4% of my portfolio, when I can build a portfolio of dividend paying stocks that will provide for my needs without depleting the principle. Here are several stocks that I plan to rely on for decades to come:

3M Co. (MMM) | Dividend Growth: 11.2%| Yield: 2.7%
3M Co. provides enhanced product functionality in electronics, health care, industrial, consumer, office, telecommunications, safety & security and other markets via coatings, sealants, adhesives and other chemical additives. The company has paid a cash dividend to shareholders every year since 1916 and has increased its dividend payments for 60 consecutive years.

Johnson & Johnson (JNJ) | Dividend Growth: 6.1%| Yield: 2.8%
Johnson & Johnson is a leader in the pharmaceutical, medical device and consumer products industries. The company has paid a cash dividend to shareholders every year since 1944 and has increased its dividend payments for 56 consecutive years.

Genuine Parts Co. (GPC) | Dividend Growth: 4.6%| Yield: 3.3%
Genuine Parts Co. is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products. The company has paid a cash dividend to shareholders every year since 1948 and has increased its dividend payments for 62 consecutive years.

PepsiCo, Inc. (PEP) | Dividend Growth: 7.9%| Yield: 3.3%
PepsiCo, Inc. is a major international producer of branded beverage and snack food products. The company has paid a cash dividend to shareholders every year since 1952 and has increased its dividend payments for 46 consecutive years.

The Coca-Cola Company (KO) | Dividend Growth: 8.2%| Yield: 3.4%
The Coca-Cola Company is the world's largest soft drink company, and also has a sizable fruit juice business. The company has paid a cash dividend to shareholders every year since 1893 and has increased its dividend payments for 56 consecutive years.

Not all of these stocks are a buy today, but they are ones you will eventually want to add to your dividend portfolio. Retirement planning doesn't have to be difficult. A financially successful retirement requires planning, discipline and execution. The sooner you start, the easier it is. Don't risk running out of money before you run out of life.

Full Disclosure: Long MMM, GPC, PEP, JNJ, KO in my Dividend Growth Stocks Portfolio. See a list of all my Dividend Growth Portfolio holdings here.

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