Sunday, December 4

Week 283 - Investing for Retirement Income

Situation: Investing for Capital Appreciation is mainly about reward, whereas, investing for Income is mainly about risk aversion. Upon retirement, you should try to forget about Capital Gains, i.e., selling growth stocks after a 10-yr Holding Period using a target discount rate of 9% (see Week 281). That’s what you do in your working years. In retirement, your discount rate is the average payout rate for interest and dividends from your bonds and stocks. Instead of using the S&P 400 MidCap Index as your benchmark, you’re now using the Vanguard Total Bond Market Index Fund (VBMFX), paying 2.3%/yr, and the Dow Jones Industrial Average (DIA), paying 2.5%/yr. 

However, this could create a new problem given that half your retirement savings are in bonds and half are in stocks. This implies that you will have 2.4% of your savings available to spend each year, unless you’re willing to sell some stocks or bonds. Try those sales for a few years, and see if you start having nightmares about outliving your money. 

Financial advisors (and you should have one) address that concern by recommending clients initially follow The 4% Rule for annual spending, adjusted for inflation. That rule was created decades ago by Bill Bengen, an aerospace engineer who had access to a really powerful computer that could run partial differential equations with 3 variables. People live longer now, and assets pay less. So, Bill Bengen is having second thoughts. Maybe a withdrawal rate of 3%/yr is more prudent for today’s retirees. But the message is clear. Whenever a retiree’s assets pay less than 4%/yr, she’ll have to sell stocks (to capture Capital Gains) or risk outliving her money. 

Mission: Set up a spreadsheet of A-rated Dividend Achievers that a) pay at least 2.5%/yr, and b) have a statistically lower risk of loss than the S&P 500 Index (see Column M in the Table). Eliminate companies that have long-term bonds that account for more than 1/3rd of total assets. Eliminate companies with insufficient revenue to be on the Barron’s 500 List published 4/30/16, as well as companies with insufficient Free Cash Flow to fund dividends paid in the first half of 2016. Also exclude companies if their Weighted Average Cost of Capital (WACC) exceeds their Return on Invested Capital (ROIC). 

Execution: Only 8 companies meet our requirements (see Table). 

Bottom Line: As a group, these companies pay ~3.0%/yr and have dividend growth of almost 10%/yr. Except for Wal-Mart Stores (WMT), they offer a positive NPV (see Column X in the Table) and will likely have good Capital Gains over the next 10 yrs should you have need of more income.

Risk Rating: 4 (where 1 = 10-yr US Treasury Notes, and 10 = gold bullion).

Full Disclosure: I dollar-average into JNJ, PG, and NEE, and also own shares of WMT.

NOTE: Metrics are current for the Sunday of publication. Red highlights denote underperformance vs. VBINX at Line 17 in the Table. Purple highlights denote Balance Sheet issues and shortfalls. Net Present Value (NPV) inputs are described and justified in the Appendix to Week 256. Briefly, Discount Rate = 9%, Holding Period = 10 years, Initial Cost = average stock price over the past 50 days (corrected for transaction costs of 2.5% when buying ~$5000 worth of shares). Dividend Growth Rate is the 10-Yr CAGR found at Column H. Price Growth Rate is the 16-Yr CAGR found at Column K ( Price Return (from selling all shares in the 10th year) is corrected for transaction costs of 2.5%. The Discount Rate of 9% approximates Total Returns/yr from a stock index of similar risk to owning a small number of large-cap stocks, where risk due to “selection bias” is paramount. That stock index is the S&P MidCap 400 Index at Line 23 in the Table.

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