The Case for a High and Growing Dividend Stock Strategy in Retirement Portfolios

FEATURE | The Case for a High and Growing Dividend Stock Strategy in Retirement Portfolios

By Jan Blakeley Holman, CFP®, CIMA®

he discussion about retirement Building Sustainable Retirement In 2006, Bengen published the book income within the financial advisor Income Portfolios Conserving Client Portfolios during Retire- T community covers a disparate range, In 1994, William P. Bengen, CFP®, pioneered ment as a review of his research (Bengen from simplistic comparisons of product research into sustainable retirement income 2006). The book also provides an eight-step features to academic, holistic financial portfolios and establishing appropriate process for developing a withdrawal rate and planning processes. For those advisors withdrawal rates when he published retirement income portfolio tailored to a who take a process approach to retirement “Determining Withdrawal Rates Using client’s needs. Bengen studied how various income, there is a broad body of academic Historical Data” (Bengen 1994). Using asset allocation strategies affect both the research regarding spending policies, tax historical returns data, Bengen tested withdrawal rate and sustainability of a retire- planning techniques, and evolving asset 50 different 30-year retirements that ran ment portfolio in distribution. For instance, allocation strategies. The goal of this from 1926–1955, 1927–1956, 1928–1957, he concluded that the optimal equity alloca- research is to enhance the client’s annual and so on up to 1975–2004. The analysis tion was 60 percent, with the remaining spending in retirement and the sustainabil- covered many business cycles and included 40 percent allocated to intermediate-term ity of the retirement portfolio for 30, 40, or four major bear markets. A major bear government bonds. He studied how the possibly 50 years. market was defined as one that lasted more addition of small-cap stocks to a retirement than one year and consumed 50 percent of portfolio could offer diversification benefits In our opinion, only a few of the retire- the retiree’s purchasing power after factor- and allow a retiree to increase the with- ment products now available have a place ing in effects of both the S&P 500 Index drawal rate or have greater confidence in on the market. So many are overpriced or decline and inflation. Needless to say, major the portfolio’s sustainability. too complicated, and most require loss of bear markets have a devastating effect on control over assets. We know the so-called any portfolio, but they especially impact Many academic studies have sought to retirement income product industry is those also undergoing withdrawal. determine the benefits of allocating a bracing for a wave of capital from baby portion of equity to various asset classes boomers, but we do not believe it will As a result of this research, Bengen is including small-cap, real estate investment materialize because the products cost too credited with establishing the 4-percent trusts, and international stocks. We found much and investors are loath to lose con- withdrawal rule (or “SAFEMAX,” to use limited information, however, on how a high trol of their hard-earned assets. This reluc- Bengen’s vernacular), which states that for and growing dividend total-return strategy tance will create an opportunity for a retirement portfolio with a beginning might benefit a retirement portfolio that is knowledgeable financial advisors to assist value of $1 million, a retiree can spend under the duress of withdrawal. Several aca- baby-boomer clients. During this pivotal $40,000, or 4 percent per year, and demics have studied high and growing divi- stage of life, boomers’ accounts will need increase the annual spending amount by dend strategies—most notably Jeremy Siegel to be consolidated under one advisor to an annual cost-of-living adjustment. (2005) at Wharton in his book The Future accommodate implementation and moni- Bengen concluded that at this spending for Investors—all these earlier studies pro- toring of a retirement income process. level, there was a 100-percent probability ceeded from an accumulation perspective. To participate in this opportunity, advisors that the portfolio would last at least need to know about all the tools available 30 years. Since then, Bengen has developed To advance this research, we analyzed a to structure retirement portfolios and be asset allocation models and withdrawal hypothetical retirement portfolio with committed to staying abreast of all the methods to find ways to increase the with- an allocation to high-dividend-paying academic research that is being done in drawal rate without affecting the portfolio’s stocks. We found that this focus on divi- this area. sustainability. dends had a significantly positive impact

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on both the portfolio’s withdrawal rate and Figure 1: Dividend Growth of S&P 500 Index its sustainability. It would be optimal to spend merely the dividend income that a retirement portfolio provides and preserve $50 50% the corpus for a legacy, but this option is $45 45% practical for only the wealthy minority. $40 40% Most retirees will need to spend dividend $35 35% cash flow and principal to sustain a retire- $30 30% ment of 30 years or more. Regardless, we $25 25% found that using a strategy focused on $20 20% Yield on Cost companies with high and growing divi- Dividends Per Share $15 15% dends alleviates the stress of regular with- $10 10% drawals and enhances the amount available $5 5% for a legacy. $0 0%

Dividend-Focused Strategy 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 Investors focus on total return when invest- Dividends Per Share Yield on Cost ing, not just capital appreciation or income. Hypothetical is for illustration purposes only. Dividends were not reinvested. You cannot invest directly in an index. Although capital appreciation may at times Past performance does not guarantee future results. provide the bulk of total returns, income has Source: Bloomberg, Standard & Poor’s, FactSet contributed its fair share as well. A broad equity index for all decades from 1871 to Table 1: S&P Top 100 Dividend Payers versus S&P 500 Index, 1968–2015 2010 had an annualized total return of Top 100 Dividend Payers S&P 500 Index 8.8 percent over the entire period; the income component was 4.7 percent (52.9 percent of Annual Return 12.53% 9.85% the total). The income component of total Standard Deviation 16.71% 16.13% return was greater than the capital apprecia- Sharpe Ratio 0.48 0.35 tion and also significantly less volatile. The Source: Standard & Poor’s, Thornburg Investment Management income component ranged from 1.9 percent to 6.4 percent, annualized over the 10-year that occurred in the broad S&P 500 Index, Bengen’s book, in which he determined periods. However, price appreciation was as with no dividend reinvestment, piqued our that applying an investment strategy with low as negative 2.8 percent and as high as interest relative to its potential impact on a the ability to consistently provide superior 14.9 percent. This wide range is unfavorable retirement portfolio in distribution. risk-adjusted returns in excess of the index for investors compared with the income had a positive effect on the maximum with- component, which can never be negative We purchased a Standard and Poor’s data- drawal rate that could be used. (Wilson and Jones 2002).1 base of monthly returns for the top 20 percent of dividend-paying companies in the Effect of Performance on Figure 1 is based on the assumption that if S&P 500 Index (hereafter, the S&P Top 100 Sustainability you bought one share of the S&P 500 Index Dividend Payers). This database begins in Before we studied the impact that a high on December 31, 1969, it would have cost 1968, is equally weighted, and provides and growing dividend strategy would have you $92.06. In each subsequent year you returns through the present. Performing an on the withdrawal rate, we wanted to chose to spend the dividends rather than initial comparison of the S&P Top 100 understand how the performance of the reinvest them. In 1970, you would have Dividend Payers to the S&P 500 Index S&P Top 100 Dividend Payers would affect received dividends totaling $3.14 for a reveals the characteristics shown in table 1. the sustainability of a retirement portfolio 3.41-percent yield on cost; by 1980, your in distribution. Bengen graciously provided annual dividend would have increased to The S&P Top 100 Dividend Payers had a information that allowed us to replicate the $6.16 for a 6.69-percent yield on cost; in compounded annual return of 12.53 per- work he had done, albeit much more sim- 1990 you would have received $12.09 for a cent, 268 basis points higher than the S&P plistically, because we were trying to solve 13.13-percent yield on cost; and in 2015 you 500 Index. This increase, together with a for only one factor to compare performance would have received $43.86 for an attractive small increase in the standard deviation, of the Top 100 Dividend Payers with per- 47.64-percent yield on cost. In fact, the results in the Sharpe ratio—which mea- formance of the entire S&P 500 Index. average annual increase of the dividends sures the ratio of reward to risk for an We constructed a model and assumed a over the entire 45-year period was 5.9 per- investment—improving by 23 percent. $1-million investment in a portfolio allo- cent. This growth in dividend cash flow Upon seeing these results, we reflected on cated to 60-percent equities and 40-percent

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bonds, using the Barclays Intermediate Figure 2: Assumes Retirement on December 31, 1972 Government Bond Index for the bond portion. For the equity portion, we used either $40,000,000 the S&P 500 Index or the S&P Top 100 Dividend Payers. Monthly return data were $35,000,000 used and both portfolios were rebalanced at $30,000,000 the end of each year. In addition, we assumed $25,000,000 a 5-percent spending rate: $50,000 was with-

$20,000,000 drawn at the beginning of year one of the $34,282,384 retirement, then increased by a cost-of-living

Account Value $15,000,000 $7,174,430 adjustment each year thereafter. These $10,000,000 annual spending amounts were removed $5,000,000 from the investment account at the start of each year and assumed to be placed in a $0 checking account for spending purposes.

Dec-72 Dec-74 Dec-76 Dec-78 Dec-80 Dec-82 Dec-84 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Given that the Barclays Intermediate Top 100 Dividend Payers Portfolio S&P 500 Portfolio Government Bond Index began in January 1973, we decided to test three time frames. First, we assumed a retirement that began Table 2: S&P Top 100 Dividend Payers versus S&P 500 Index, 1972–2015 on December 31, 1972, and lasted for the Summary Stats Withdrawals Ending Balance entire 43 years of available data. Next, we Top 100 Dividend Payers tested a retirement that began right before $4,452,420 $34,282,384 Portfolio the 1987 bear market, assuming the retire- S&P 500 Portfolio $4,452,420 $7,174,430 ment began on August 31, 1987, and has Difference $0 $27,107,954 run for more than 28 years. Finally, we looked at the impact of the tech bubble and subsequent meltdown with a retirement Figure 3: Assumes Retirement on August 31, 1987 that began in December 1999 and has run 16 years. $4,500,000

$4,000,000 Scenario 1: December 31, 1972, to December 31, 2015 $3,500,000 Figure 2 illustrates the ending account $3,000,000 $3,557,610 value for each year, assuming the retire- $2,500,000 ment began on December 31, 1972. The $2,000,000

Account Value Top 100 Dividend Payers portfolio far $2,509,463 $1,500,000 exceeded the performance of the S&P 500

$1,000,000 portfolio. The withdrawal amounts under both scenarios are identical, but the corpus $500,000 of the dividend-focused portfolio grew $0 $27.1 million more than the S&P 500 Index portfolio. Table 2 shows the details. Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15

Top 100 Dividend Payers Portfolio S&P 500 Portfolio Scenario 2: August 31, 1987, to December 31, 2015 For the retirement that began just before Table 3: S&P Top 100 Dividend Payers versus S&P 500 Index, 1987–2015 the 1987 bear market, the dividend-focused stock portfolio again outperformed the Summary Stats Withdrawals Ending Balance S&P 500 Index portfolio (see figure 3). Top 100 Dividend Payers $2,260,943 $3,557,610 Portfolio Note that the dividend-focused strategy lagged during the technology bubble from S&P 500 Portfolio $2,260,943 $2,509,463 mid-1990 to 2001 but outperformed before Difference $0 $1,048,147 and after that period. As shown in table 3,

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the withdrawals were identical and the cor- Figure 4: Assumes Retirement on December 31, 1999 pus for the dividend-focused portfolio exceeded the S&P 500 Index portfolio by $1,048,147. $2,000,000 $1,800,000 Scenario 3: December 31, 1999, $1,600,000 to December 31, 2015 $1,400,000 $1,200,000 To illustrate a retirement that began just $ 1,565,236 before the 2000 bear market, we began on $1,000,000

Account Value $ 318,065 December 31, 1999. Figure 4 illustrates that $800,000 over a short 16-year time frame, the Top $600,000 100 Dividend Payers portfolio has been far $400,000 superior to the S&P 500 Index portfolio. $200,000 Given the drop in value of technology and $0 growth stocks during this time frame, the outperformance of the dividend-focused Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 approach was no real surprise, but the Top 100 Dividend Payers Portfolio S&P 500 Portfolio magnitude was a surprise. A retiree who began taking withdrawals from the dividend- focused portfolio at the start of the 2000 Table 4: S&P Top 100 Dividend Payers versus S&P 500 Index, 1999–2015 bear market was able to spend an equiva- Summary Stats Withdrawals Ending Balance lent amount and have a corpus more than Top 100 Portfolio $1,088,079 $1,565,236 three times as large versus the S&P 500 Index portfolio (see table 4). Just think how S&P 500 Portfolio $1,088,079 $318,065 fortunate this retiree was coming into the Difference $0 $1,247,171 market tumult we have seen since 2008. the 1956–1967 periods, who had ment. Therefore, the high and growing div- Impact on SAFEMAX “hybrid” equity allocations of first idend strategy dramatically improved the Having seen that the dividend-focused 100 percent S&P 500 Index stocks, then quality of the client’s retirement years. strategy improves the sustainability of a Top 100 dividend-paying stocks begin- retirement portfolio in distribution, we ning in 1968, also saw very substantial Key to Successful Implementation wanted to determine how much the with- increases in their portfolio longevity.2 Finding companies that have both the drawal rate could be increased without willingness and ability to increase divi- negatively affecting the portfolio’s sustain- Bengen’s conclusion focuses on the impact dends over time is the key to successful ability. Given the multiple variables, we that a dividend-paying strategy had on implementation of this retirement income decided it best to pose this question to retirees who began retirement between strategy. If you limit your universe solely Bengen. He agreed to study the impact of 1956 and 1967. This time frame is of partic- to U.S. stocks, you will be focusing pri- the dividend strategy on his SAFEMAX, ular interest given the devastating effects marily on financial and utility companies or maximum sustainable withdrawal rate. that the bear market of 1973–1974 and a for their higher dividend yields but may We provided Bengen with the S&P Top 100 concurrent period of high inflation had on not end up with the desired growing divi- Dividend Payers database of monthly retirement portfolios. To paraphrase, the dend income stream. Looking outside the returns, which he processed through 25-percent increase in the annual with- United States, you will find higher dividend- his model. drawal rate allowed the spending amount paying companies across almost all sectors to be raised from $40,000 to $50,000 per as well as a greater inclination by com- Bengen concluded the following: year plus an annual cost-of-living adjust- pany management to grow this dividend.

Substituting Top 100 dividend paying stocks for S&P 500 Index stocks had very A retiree who began taking withdrawals from beneficial effects on the “SAFEMAX” for retirees during the 1968–1975 periods. the“ dividend-focused portfolio at the start of the 2000 The “SAFEMAX” was increased by about bear market was able to spend an equivalent amount 25 percent during this period, which and have a corpus more than three times as large versus translates into a significant improvement of lifestyle for those retirees. Investors in the S&P 500 Index portfolio. ” MAY / JUNE 2016 27

This difference in dividend policy between References Aristocrats Index and the S&P Global Arnott, Robert D., and Clifford S. Asness. 2003. Surprise! domestic and foreign companies is cultural. Higher Dividends = Higher Earnings Growth. Financial Dividend Opportunities Index during the In the United States, the primary measure Analysts Journal 59, no. 1 (January/February): 70–78. 2000–2015 period shows that both had Bengen, William P. 1994. Determining Withdrawal Rates of financial health is earnings, and chief Using Historical Data. Journal of Financial Planning positive returns and positive Sharpe ratios executive officers are more inclined to rein- (October): 14–24. (see table A1). ———. 2006. Conserving Client Portfolios during vest the company’s capital on the next best Retirement. Denver: FPA Press. idea in hope of attaining earnings growth. Siegel, Jeremy. 2005. The Future for Investors: Why the The Dividend Aristocrats Index had an Tried and the True Triumph Over the Bold and the Companies outside the United States often New. New York: Crown Business. income return that was 135 basis points are judged on their ability to pay a high and Wilson, Jack W., and Charles P. Jones. 2002. An Analysis better than the S&P 500 Index. It also had of the S&P 500 Index and Cowles’s Extensions: Price growing dividend, which is seen as a sign of Indexes and Stock Returns, 1870–1999. Journal of 4.57 percent of additional price return over financial health. In fact, looking at the mar- Business 75, no. 3 (July): 505–533. the S&P 500 Index (6.85 percent versus ket composites, estimated dividend yields 2.28 percent). The Global Dividend Disclaimer: The views expressed are subject to change. averaged 2.1 percent in the United States, Opportunities Index income return out- 38 percent in Europe, and 4.7 percent in the Appendix: Opportunities of a paced both the S&P 500 and the Dividend Pacific (excluding Japan). Although interna- Global Dividend Strategy Aristocrats Index (by 454 and 319 basis tional investing comes with special risks, Perspectives on dividends vary among points, respectively) and its total return using a carefully selected portfolio of cultures. Among many U.S.-domiciled of 6.58 percent outpaced the S&P 500 high-quality, global companies that pay a companies, where executive compensation by 2.31 percent and lagged the total return high and growing dividend can greatly ben- is tied to growing the share price, dividends of the Dividend Aristocrats Index by efit a retirement portfolio in distribution. are a sign of limited reinvestment opportu- 3.61 percent. nities. Arnott and Asness (2003) showed, Conclusion however, that companies with high divi- S&P Dividend Aristocrats Index Financial advisors who view the retirement dend payout ratios tend to subsequently This is an equal-weighted index of large income challenge as a process rather than a have higher earnings growth than compa- blue-chip companies from the S&P 500 product will be successful gathering assets nies with lower payout ratios, and that the Index that have consistently increased divi- and consolidating accounts from our baby- higher earnings growth may be due to bet- dends annually for the past 25 years. The boomer brethren as we all move into retire- ter allocation of capital. This view of divi- index is diversified by sector, reconstituted ment. This article shows that an allocation dend payout is more prevalent outside the each December, and currently includes of a retirement portfolio’s equity to a high United States, where payment of high and 50 companies. and growing dividend strategy can increase growing dividends is viewed as a sign of sustainability and improve retirement life- financial strength. S&P Global Dividend style via higher withdrawal rates. Opportunities Index A global dividend income strategy also This is a yield-weighted index of 100 Jan Blakeley Holman, CFP®, CIMA®, is provides an opportunity to improve a port- exchange-listed common stocks and director of advisor education at Thornburg folio’s diversification by country and sector. American Depositary Receipts from Investment Management. She earned a BA in This is because U.S. dividends typically around the world that offer high dividend political science from the University of Denver. have been more available via the financial yield opportunities. The index is designed Contact her at [email protected]. and utility sectors, but attractive dividends to provide diversification by country and are available in many different sectors of industry and is rebalanced twice a year. Endnotes the international market. 1. Data after 1990 is from Bloomberg, Confluence, and FactSet. Calculated by Thornburg Investment Management. Comparing the nominal performance 2. William P. Bengen, 2008, personal communication. of the S&P 500 to the S&P Dividend

Table A1: Performance Analysis (2000–2015 Annualized) Standard Price Return Income Return Total Return Deviation Sharpe Ratio S&P 500 Index 2.28% 1.99% 4.27% 15.13% 0.08 Dividend Aristocrats Index 6.85% 3.34% 10.19% 13.63% 0.53 Global Dividend Opportunities Index 0.05% 6.53% 6.58% 19.15% 0.19 Past performance does not guarantee future results. Sources: Standard & Poor’s and calculated by Thornburg Investment Management

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