Dividends and the 4% Rule

[Indy]

I apologize if this has been asked and answered already. I couldn't find anything but doesn't mean it wasn't already answered.

I was under the impression that dividends were considered different from what was included in a swr. Now I don't mean to try and make it overly complicated on what a swr really means so I'll illustrate what I mean.

For example if I had 500k in index funds and I withdraw 20k (4%) but I also get a 2% dividend on the remaining 480k. If I also take the 2% dividend the 480k yields what does this mean for the 4% rule?  Am I still following it or is my swr now 6%?

I'm just a tad confused on this and whether the dividend should be included in the 4% swr. And if it should be included how (is the 2% dividend now half the swr?).

I don't know if this is the rudimentary stuff I missed with the 4% rule or something but I'm unsure how dividends fit into the 4% rule.

Thanks  in advance.

[daverobev]

No, don't think of dividends as anything other than part of a stock or fund's returns. Because they aren't.

If stock X pays a dividend, when the divi is paid, all other things being equal the stock drops by the amount of dividend paid out

Eg X listed at $100; it pays out a 50c divi; in theory the stock is now worth $99.50 a share.

If you happen to have $500k and it gives 4% in divis, that IS your 4%. Generally, the higher divi a stock pays, the less it is expected to show capital growth.

If a stock gives 2% in divis, and you sell 2% of your holding each year, that is the 4% SWR. If it gives 4% divi but no growth, likewise; and no dividends but you sell 4% of your total holding, it's the same.

A dividend is just a company giving (usually) some of the profit back to you.

[MDM]

See http://en.wikipedia.org/wiki/Trinity_study and http://www.bogleheads.org/wiki/Trinity_study_update and http://wpfau.blogspot.com/2012/02/trinity-study-and-portfolio-success.html for starters.

From the wiki article (highlight added):
"...the Trinity study is an informal name used to refer to an influential 1998 paper by three professors of finance at Trinity University. ...  Its conclusions are often encapsulated in a '4% safe withdrawal rate rule-of-thumb.' ... The 4% refers to the portion of the portfolio withdrawn during the first year; it is assumed that the portion withdrawn in subsequent years will increase with the consumer price index (CPI) to keep pace with the cost of living. The withdrawals may exceed the income earned by the portfolio, and the total value of the portfolio may well shrink during periods when the stock market performs poorly. It is assumed that the portfolio needs to last thirty years. The withdrawal regime is deemed to have failed if the portfolio is exhausted in less than thirty years and to have succeeded if there are unspent assets at the end of the period."

To your questions:

For example if I had 500k in index funds and I withdraw 20k (4%) but I also get a 2% dividend on the remaining 480k. If I also take the 2% dividend the 480k yields what does this mean for the 4% rule?  Am I still following it or is my swr now 6%?

If you believe the Trinity study, your Safe Withdrawal Rate is 4%.  If you choose to make your Actual Withdrawal Rate 6% (and that is what you are doing if you withdraw $30k instead of $20k), then caveat withdrawer.

[Indy]

Fair enough. Thank you both for the explanation. I had the impression it was separate but someone told me it wasn't without an explanation so I wasn't sure why. Thanks for clearing that up. Seems a bit obvious why now. Appreciate it.

[chasesfish]

Indy - Also remember that the underlying companies tend to increase their dividend payment each year by GDP growth or a number slightly better.

Take VIG for instance, this is the Vanguard Dividend Growth Fund.  It pays around 2.2% today, which leaves you only taking 1.8% of your principal amount in your first year.

The growth in dividends is one method used to value a stock.  You can also consider PE, Free Cash Flow, ect.

Another way to look at it is if you buy a stock with a Price to Earnings of 16, your buying a stock that earns $16 for a $100 stock, which is a 6.25% return.  However, the company will usually need to retain some of the earnings to grow the business, then return some capital to the shareholders in the form of dividends and stock buybacks (which reduce the outstanding shares).

The other thing nice about dividends is they're real cash.  Lots of the companies that were manipulating their financials in the early 2000's didn't pay dividends.  Its tough for a company to lie about sending me a check.

[Thegoblinchief]

Unless you're specifically pursuing a dividend growth strategy (where dividend income is passive income to fund living expenses, much in the same way rental income does), you have to lump dividend yield into portfolio returns.