The charm of receiving continuous payments without being forced to dispose of properties is appealing, yet can one live on dividends alone? And what amount of funds is necessary in order to live comfortably in retirement on passive earnings?
The allure of dividend investing
Dividend stocks have been reliable performers for years. Ned Davis Research pointed out in a report that between 1972 and 2012, dividend stocks returned about 8.8% per year, while non-dividend stocks returned just 1.6%. The tremendous difference is evidence of the potency of dividends in driving investment performance.
Behaviorally, dividend living allows retirees to preserve the principal investment intact. Simply Safe Dividends states that “living off the dividends it pays each month can help investors ignore the noise of fluctuating stock prices and leaves principal intact.” It gives one a sense of fiscal security, especially during volatile market conditions.
Determining the required portfolio size
The size of the capital needed to live on dividends depends on a number of factors including yearly income requirement and the average dividend yield on the portfolio. For instance, if the yearly income requirement is $50,000 and the investor buys stocks with an average dividend yield of 3%, the size of the portfolio needs to be approximately $1.67 million. This is calculated using the following formula:
Required portfolio= Desired annual income / Dividend yield
With numbers:
Required portfolio= $50,000 / 0.03 = $1,666,667
The math confirms Forbes’ comment that you would require an extremely big portfolio to live on dividends only. As the magazine states, “As the numbers show, you’ll need a large portfolio to cover your retirement living expenses entirely with dividends.”
Real life example: Living on dividends in retirement
An example of a dividend living scenario from everyday life is provided by a retired investor who wrote about his experience on a discussion board of a Reddit forum. The investor explained making over $160,000 in dividend income every year on a portfolio return of about 4.5%. He mentioned that he was “quite comfortably” getting by on this income, supplemented by social security payments. In order to be capable of doing that, his investment portfolio needs to be valued at some $3.56 million as below:
Portfolio value= $160,000 / 0.045 = $3,555,556
As can be seen in the above example, through regular saving and intelligent investment, one can build a portfolio that is capable of producing a significant amount of passive income. The investor also emphasized reinvesting a part of the dividends to build growth, by stating, “We have an ever-increasing income stream and a portfolio that still grows because of appreciation and we reinvest about 10% of our dividends.”
Designing a dividend portfolio
Judgment would be required in the selection of stocks in designing a dividend-paying portfolio. The above investor’s first-listed holdings provide us with some possible choices:
- Pembina Pipeline Corporation (PBA): Canadian company that has storage and transit facilities, which pays a dividend of approximately 4.9%.
- Realty Income Corporation (O): Known for payments made monthly, this real estate investment trust (REIT) has paid more for 30 consecutive years.
- Johnson & Johnson (JNJ): A pharmaceutical giant with a history of dividend growth consistency.
- Iron Mountain Incorporated (IRM): A storage REIT for data, providing physical storage space that yields returns of approximately 2.42% in the form of dividends.
- W. P. Carey Inc. (WPC): A net lease REIT with more than 1,200 managed properties worldwide.
These companies have a past record of rewarding value to their shareholders in the form of dividends. Of course, caution needs to be exercised and proper diversification carried out to eliminate risks associated with a particular stock.
Considerations and risks
How pleasant it is to live on dividends, but there are certain considerations to be kept in mind:
- Market volatility: Dividends are not assured and are vulnerable to economic downturn. Dividends can be reduced or suspended when things are not good.
- Inflation: Inflation can diminish purchasing power in the long run. An investor has to invest in companies that have a good history of increasing dividends to compensate for inflationary pressure.
- Tax implications: Dividend income may be taxable, and that impacts net income. A person should keep in mind the tax implications of dividends to make appropriate planning.
- Diversification: Dependence on a single industry or some specific individual stocks may enhance risk. Diversification in the portfolio can minimize potential loss.
Alternative strategies
For those without access to the vast capital necessary to live on dividends alone, other methods can be utilized:
- Income diversification of streams: Diversifying income streams with dividends through the addition of pensions, social security, or moonlighting can decrease dependency on investment income.
- Total return strategy: Rather than depending solely on dividends, investors may follow a total return strategy in which they fund expenses using both the income and capital appreciation.
- Higher-yielding investments: Investments like Real Estate Investment Trusts (REITs), Master Limited Partnerships (MLPs), or preferred stocks may yield more. Each of them carries its own risk and tax incidence, though.
