Author Topic: Does the stock market dropping matter, if you're making X% a year to live off?  (Read 9114 times)

ariesonthecusp

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I was thinking about this tonight, but wanted to know what you all think.

Imagine you buy $1 million in stock from various blue chip dividend aristocrat companies (eg: Coca Cola, General Mills,etc) and your average dividend return is 5% a year. You also have a emergency fund of $100,000 in cash.

So if you're making $50,000 a year from dividends, does it really matter if the price of the stocks you bought is going  up or down (even if you're down 60%) ? If you're living off of that $50k a year, it would seem irrelevant if your $1M is going up or down since you only care that you get your dividends

It seems to me, that in the scenario above, you converted your money into a income stream from companies, so the original amount of the money doesnt matter anymore since you're not living off of it. If the companies are failing, then the entire economy is probably in a depression or worst since the type of companies you get your dividends from produce essential things that almost every person needs to use or consume. The dividend aristocrats all have paid a dividend for over 25 years consecutively. Obviously the dividends arent guaranteed, but the track record of these companies is even more important.

So really, it comes down to money being a medium that allows you to transform it into dividend paying shares to generate more money.

Thoughts ?  Or am I missing something

« Last Edit: July 07, 2012, 09:42:54 PM by ariesonthecusp »

maizeman

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It depends. If you're thinking about the "Safe Withdrawal Rate" the math on how likely you are to run out of money all assumes you set your income as X% of your net worth per year the day you stop working and stays fixed (adjusted for inflation) regardless of what how your net worth in coming years. So from that perspective, no, if the stock market dives you wouldn't reduce your spending at all.

One of the really good points MMM makes is that the above is actually a very unrealistic assumption. If you were frugal enough to save up a million dollar nest egg, surely you are frugal enough that surviving on less than $50,000 a year for several years would not be a serious hardship. If nothing else, reducing your living expenses temporarily would be the the excess dividends could be reinvested in more shares of the same companies (which assuming an initial 5% dividend and a 60% drop in value would now be yielding 12.5%!) resulting in an even higher standard of living once the market recovered.

TL;DR The safe withdrawal rate assumes you won't adjust your spending even if your net worth changes. Being willing to adjusting your spending both increases your safety margin and opportunities for runaway wealth in retirement.

arebelspy

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EDIT: maizeman got his post in while I was typing.  I think he missed though that the OP is talking about an all dividend strategy, rather than a 4% SWR based on total returns.  So much of maizeman's reply is moot.  In the case of talking about a typical SWR strategy though, everything he said is correct, and I'd especially highlight the importance of being flexible with your plan/spending.

As to the OP's question, based on a divided strategy, here was my original reply:

They could cut their dividend.

As long as you take a long term view and don't sell low, the stock market dropping shouldn't affect your plans.

Early bad returns might.

As an aside, going an all dividend plan over a total return may cost you in terms of time (longer to build up, so you cant FIRE as early) and the fact that dividend stocks seem to be in a sort of mini bubble due to hype right now.  All divided plan seems nice because it's easy to understand and "sounds" nice, but mathematically it shouldn't be superior to a total returns plan, and in many instances would be inferior.
« Last Edit: July 07, 2012, 10:08:35 PM by arebelspy »
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ariesonthecusp

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ARebelSpy: You are correct, I'm not talking about  SWR at all, only a dividend strategy.

My point of saying you would put that money towards dividend aristocrats is because by definition, these companies have to be increasing dividends every year for at least 25 consecutive years to be considered dividend aristocrats. So these companies havent cut their dividend in 25 years, they've actually increased it every year and pay it even with bad returns

I'm not sure what you mean by FIRE or how it could be inferior to a total returns plan. Please explain in detail if you care to.

My point was, you can have a really good chance of having very steady and consistent income by taking the approach I mentioned. The Div. Aristocrats kept paying and increasing their dividends even during the financial crisis in 2008, the .COM bubble in 2000, etc. I'm not saying its guaranteed, but my point is, this seems like a solid plan considering their track record couple with investing a large sum with them
« Last Edit: July 07, 2012, 10:23:20 PM by ariesonthecusp »

maizeman

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Hi ariesonthecusp,

So it's evident I completely misunderstood your question, sorry about that. For my own interest though, may I ask, if you're not considering things like safe withdrawal rate at all, what _would_ be the argument for cutting spending when the price of your stocks dropped? (That's the only link I could see between the two, which is why I initially answered your post the way I did.)

fiveoh

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Yep.  This is why I'm using a dividend growth plan for investing.  You have to take into account inflation as well but a lot of those companies raise their dividend by an amount higher than inflation each year.  Go to seekingalpha and look up chuck cranevale for some good articles.  Also check out dividendmantra.com although he recently went inactive.

Another Reader

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You are talking about doing what I was taught to do by my parents.  The idea is after you accumulate assets, the maximum you may spend is the net income those assets produce.  You do not "decumulate," which is what the 4 percent SWR and virtually every financial planner assumes you will do.  In your case the accumulated assets consist of dividend paying stocks with strong track records.

The problem with relying solely on stock dividends is there are no guarantees the dividends will continue.  If a business' income declines, then the payout ratio increases.  That's sustainable for short term declines, or during relatively short windows of volatility.  Long term drops in income result in dividend cuts or elimination.  That's what happened to the large banks when the real estate market collapsed.  Some of those banks had been paying steady dividends for well over 25 years.

Diversification among business types helps protect your income, as does selling companies that reduce dividends or dramatically increase payout ratios, but in my opinion it's not enough if the rate of inflation is 12 percent, if the tax treatment of dividends changes, or if dividends go out of style.

My preference is for a mix of assets that includes real estate right now.  The net income is usually a much higher percent of value and it will also rise over time as will the underlying asset value.  The current tax treatment is very favorable.  When rates are higher, I will probably add some bonds, mostly treasuries.

The folks here that believe in the 4 percent SWR understand the FIRE number you need to achieve using that rule is lower.  They are willing to make changes, including reducing their spending significantly, when things go bad.  The reward for taking on additional risk and being flexible about spending is they retire earlier.

arebelspy

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I'm not sure what you mean by FIRE or how it could be inferior to a total returns plan. Please explain in detail if you care to.

FIRE = Financially Independent, Retired Early

Putting off your FIRE when you have enough assets because you are pursing a dividend strategy versus a total return costs you in terms of years of your life.

People like dividend strategy because it means they don't have to sell, ever, and it sounds nice.  Company pays me money, that money covers my expenses.

But if your return is higher from a total return strategy, where stocks go up, you sell some, and that pays for your expenses, then you're using dividends as peace of mind, but it does have a real cost in time.  Sure, sometimes stocks drop, and that's when you get the peace of mind benefit from the dividend, but if total return has a larger return over the long run, taking all factors into account, and you're able to "stay the course" when the market drops, then there are real advantages to not pursing a dividend strategy.  Not to mention certain tax benefits, which may or may not be realized in the future, along with the minibubble hype I mentioned earlier.  Overall, I would be fine with someone going with some dividend holdings in their assets, but to rely on that totally seems actually risky to me, despite investing in dividend aristocrats (or dogs of the dow or whatever your flavor of the day is).  And even if it is not risky, it may still be inferior due to lower returns.

Have you looked into the the average yield on a diversified dividend aristocrats portfolio is?
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ariesonthecusp

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ARebelSpy:  You make some good points.  I have already looked at the average yield for div aristocrats and with the right portfolio allocation, you could easily hit at least 4%.

I will say the original plan I outlined wouldnt preclude you from selling when your dividend portfolio was up to buy more shares. Actually, thats an even better plan. You could continually sell and rebuy whenever you were up by more than a certain percentage actually increasing the amount of dividends you'd be paid by consistently reinvesting gains back into new shares when you're in the positive. Ingenius !

This would actually be a blended version of the total return and the div strategy. I cant actually see to many downsides to this new DivAristo/TotalReturn plan
:-)

arebelspy

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I cant actually see to many downsides to this new DivAristo/TotalReturn plan

Lower total yield due to dividend hype.  Diversification. 

But if it makes you comfortable, go for it!

I don't think it's a bad plan by any means.  Much, much better than many out there.  I'll even go so far as to say it has potential to be better than what I would choose.  But it's still not a route I would personally build a whole portfolio on.
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Nords

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ARebelSpy:  You make some good points.  I have already looked at the average yield for div aristocrats and with the right portfolio allocation, you could easily hit at least 4%.
I will say the original plan I outlined wouldnt preclude you from selling when your dividend portfolio was up to buy more shares. Actually, thats an even better plan. You could continually sell and rebuy whenever you were up by more than a certain percentage actually increasing the amount of dividends you'd be paid by consistently reinvesting gains back into new shares when you're in the positive. Ingenius !
This would actually be a blended version of the total return and the div strategy. I cant actually see to many downsides to this new DivAristo/TotalReturn plan
:-)
You've pretty much described the Dividend Growth Investor's process:  http://www.dividendgrowthinvestor.com/  Keep in mind that they're extraordinarily disciplined in their criteria and they do considerable due diligence.  Having said that, they've never admitted to making a single mistake-- which keeps me skeptical about the success of the process.  Another excellent reference on the subject is Josh Peters' "Ultimate Dividend Playbook".  More disciplined analysis.

ClifP at Early-Retirement.org is a strong dividend investor (among other assets).  During the pits of the 2008 recession, "all" of the dividend cuts reduced his dividend income by about 10%.  (All of that has since recovered.)  Of course if a stock cuts its dividend then you're going to sell it and buy some other bargain, so this rebalancing technique works out quite well when the market recovers.  Clif is no dividend zealot, though-- he's also buying Las Vegas single-family homes.

Here's some obstacles to consider:
Major dividend companies stumble all the time (BofA, GE).  You never know who's going to cut their dividend, and you have to diversify considerably to avoid getting whacked by single-stock risk.  The Dividend Growth Investor limits his single-stock exposure to something like 2.5%-3%.
Major ETFs (like DVY) tend to over-concentrate in a sector like financials or utilities.  They're subject to dividend cuts, too, so the dividend income from an ETF can also drop during a nasty recession.
Even dividend ETFs can become overpriced, which makes it tough to buy a good yield when the bull market is running strong.  A 4% SWR requires a portfolio only 25x your spending while today's 2-3% dividend portfolios require 33-50x your spending. 
Large-cap dividend investing is hot.  It's become the trend of the decade.  I'm not sure that you want to jump on this bandwagon, and I'm not sure that you want to stay on it.  It's probably better to go digging for a good small-cap value stock or a REIT.  Lots of people hate those now, yet they pay dividends too.
Political risk:  dividends are about to be taxed as regular income instead of the 15% rate.  Of course that might help dampen the enthusiasm of the large-cap dividend fanboys.

No matter how logical & rigorous you are (or think you can be), what matters is how comfortable you are with your chosen asset allocation and how well you sleep at night.  If dividend investing improves your rest more than a 4% SWR approach, then that's what you should do.  You're also more likely to stick to it during the next bear market, instead of panicking and selling out and then being paralyzed about getting back in.  (In early 2009, DVY was selling at a trailing yield of 5.89% but investors were running away screaming because they were sure the forward yield was going to zero.)  I think it's a lot easier to do dividend investing with ETFs than with individual stocks, and it certainly requires less maintenance.

But you don't have to stick to just one style.  Dividend investing is only about half of our portfolio (DVY and EFV).  We also invest in small-cap value ETFs (like IJS) and in Berkshire Hathaway, which enjoys gargantuan dividend income yet pays no dividends at all.  We spend on a 4% SWR because most of our income is annuitized (military pensions).  You could replicate the stability of dividend investing by annuitizing a portion of your portfolio with a SPIA, freeing up the rest of the portfolio to invest in more volatile assets. 

However I strongly feel that by far the most important factor is investor confidence/comfort with their chosen asset allocation.

Jamesqf

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The idea is after you accumulate assets, the maximum you may spend is the net income those assets produce.  You do not "decumulate," which is what the 4 percent SWR and virtually every financial planner assumes you will do.

The problem there, I would think, is that you have to plan your decumulation strategy without knowing the target end date.  So if for instance you RE at age 50 figuring you'll live to 85 (somewhat beyond the average life expectancy), then you live to 95, you spend those last 10 years destitute.


grantmeaname

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The whole point of the 4% SWR strategy is that it's not a meaningful amount of decumulation! Firecalc reports a 94.6% success rate on a 30-year window even without social security, the reductions predicted by Bernicke's research (showing a decrease in real spending on the order of 2% a year from late 50s to early 70s), spending less in lower-earning years, or side income (run a simulation with the default 30k/750k/30yr to see; the results link isn't working for me so I can't directly link it to you). With Bernicke's adjustment alone, that increases to a 100% success rate, even if we increase the term to an amazing 80 years (if I, the youngest forum Mustachian, were to retire in two weeks and live to 100...)! A reasonable fraction of the portfolios don't finish the 80 years with more than $750k retirement-year dollars, but none of them leave you destitute.

Here's the obligatory insightful MMM blog post.

skyrefuge

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Imagine you buy $1 million in stock from various blue chip dividend aristocrat companies (eg: Coca Cola, General Mills,etc) and your average dividend return is 5% a year.

Yes, if you can make this hypothetical assumption a reality, then your plan works.  But if you could also buy $1 million in stock from various non-dividend paying companies whose stock price appreciated 5% a year, that plan would work even better (just because you'd likely pay lower taxes on selling $50k of shares than on $50k of dividends).

So the payment of dividends really has nothing to do with it.  If a particular stock doesn't pay a dividend, just sell some shares to pay yourself a dividend; the effect is exactly the same. The trick is selecting stock in "good companies" that will provide the long-term total return (whether via dividends, growth, or a combination) that you're looking for.  That's the hard part.  I'm not sure why you'd be more likely to succeed at it by narrowing your focus to such a small segment of stocks, particularly such "obvious" stocks.

If you're looking for rational counterarguments to dividend hype (and you should be), I recommend:

http://seekingalpha.com/article/270070-understanding-compounding-berkshire-s-not-so-hidden-dividend-contrarian-secret

http://canadiancouchpotato.com/2011/01/18/debunking-dividend-myths-part-1/ (a 6 part series)

BenDarDunDat

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ARebelSpy: You are correct, I'm not talking about  SWR at all, only a dividend strategy.

My point of saying you would put that money towards dividend aristocrats is because by definition, these companies have to be increasing dividends every year for at least 25 consecutive years to be considered dividend aristocrats. So these companies havent cut their dividend in 25 years, they've actually increased it every year and pay it even with bad returns

I'm not sure what you mean by FIRE or how it could be inferior to a total returns plan. Please explain in detail if you care to.

My point was, you can have a really good chance of having very steady and consistent income by taking the approach I mentioned. The Div. Aristocrats kept paying and increasing their dividends even during the financial crisis in 2008, the .COM bubble in 2000, etc. I'm not saying its guaranteed, but my point is, this seems like a solid plan considering their track record couple with investing a large sum with them

The difficulty I could see is to worry about how mature these companies are. Companies really don't get to become dividend aristocrats unless they are already extremely mature. So you buy into these old companies while you are young, and they are paying you richly in dividends which you are taxed on. Then as you age and need to depend on these dividends, the companies have begun to decline. You could probably do better to pick growth stocks now, enjoy the tax free appreciation, and then by the time you retire, you will be holding onto mature companies that are paying appreciating dividends and eventually become dividend aristocrats when you actually need the dividend.

arebelspy

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The difficulty I could see is to worry about how mature these companies are. Companies really don't get to become dividend aristocrats unless they are already extremely mature. So you buy into these old companies while you are young, and they are paying you richly in dividends which you are taxed on. Then as you age and need to depend on these dividends, the companies have begun to decline. You could probably do better to pick growth stocks now, enjoy the tax free appreciation, and then by the time you retire, you will be holding onto mature companies that are paying appreciating dividends and eventually become dividend aristocrats when you actually need the dividend.

Both of those ideas involve guesswork and hoping you get lucky.

I'd rather toss in my chips with the aristocrats, if it came down to that (i.e. index funds and the like weren't available), but you'd have to be really diversified.  As Nords mentioned, 2-3% of your portfolio max in any given individual company.
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Another Reader

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A question for Nords:

What does your 4 percent SWR include?  Do you capitalize the value of your pensions and then apply the 4 percent?  Or do you take 4 percent of your personal assets in addition to the pensions, figuring your pensions offer an additional level of security?  I have tried capitalizing the value of my pensions and my future Social Security using an estimated lifespan to see what percentage of my net worth these things represent, but I haven't bothered with figuring a SWR, since a large piece of my income is net real estate rents.

vwDavid

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FINALLY! a rational comparison of a dividend portfolio vs others. All other MMM topics on this question get hammered by anything but an index fund is bound to fail.

Thanks for at least allowing a rational comparison here. I appreciate it hope that it continues...

Nords

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The difficulty I could see is to worry about how mature these companies are. Companies really don't get to become dividend aristocrats unless they are already extremely mature. So you buy into these old companies while you are young, and they are paying you richly in dividends which you are taxed on. Then as you age and need to depend on these dividends, the companies have begun to decline. You could probably do better to pick growth stocks now, enjoy the tax free appreciation, and then by the time you retire, you will be holding onto mature companies that are paying appreciating dividends and eventually become dividend aristocrats when you actually need the dividend.
You seem to be implying that you're holding these stocks forever.  I wouldn't do that.

A dividend aristocrat is only a member of the club if it keeps raising dividends.  If it stops doing that then you sell it, pay your taxes, and buy a different member of the club.  If you're buying an index then they do that for you when they reconstitute the index.

It should be the same circle of life with a growth stock.  If its price grows to something near its intrinsic value then it better be giving you an incentive (like a dividend!) to hang on to it.  I'm not sure you can call it a growth stock anymore if it starts paying a dividend, but plenty of growth stocks have gone down in flames before they could have the dividend discussion. 

And finally, Berkshire Hathaway has been regarded as a great growth stock, but its returns haven't beaten its long-term average in years.  It hasn't paid a dividend since 1965.  I don't know how much longer we'll have to wait before it starts paying a dividend, but I bet it'll involve current management stepping down...

« Last Edit: July 09, 2012, 06:36:22 PM by Nords »

Nords

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This answer got pretty verbose.  Separate post.

What does your 4 percent SWR include?  Do you capitalize the value of your pensions and then apply the 4 percent?  Or do you take 4 percent of your personal assets in addition to the pensions, figuring your pensions offer an additional level of security?  I have tried capitalizing the value of my pensions and my future Social Security using an estimated lifespan to see what percentage of my net worth these things represent, but I haven't bothered with figuring a SWR, since a large piece of my income is net real estate rents.
If I was you, I'd try to keep it simple.  Add up all of your expenses (including taxes, mortgages, rental mortgages, charity donations, everything that was withdrawn from an account to pay somebody).  Subtract your pension.  Subtract your gross rental income.  The remaining expenses should be less than 4% of the value of your ER portfolio.

If you do it that way then your "ER portfolio" is probably going to be the balances in your TSP, IRA(s), 401(k)s, and taxable accounts.  It's not going to include home equity, vehicles, or personal property.  You might include the value of a HELOC secured by rental property.  If you're going to include the equity of a rental property in your ER portfolio then I would not subtract its rental income from your expenses. 

Note that I'm including your rental property expenses in your overall expenses.  If you're planning to spend $50K on a major renovation, or if you suspect that it won't rent 12 months per year, then you might want to reduce your estimate of gross rental income.  But this is a "simple" example. 

In our case-- through many small, innocuous decisions made one at a time-- spouse and I have greatly complicated our accounting.  I'm waiting out the next 10 years, when I expect it to get a lot simpler.

For example, we have a portfolio set aside for ER and a separate one set aside for college savings.  (We started doing this when our daughter was born.)  We pay all the college expenses out of the college savings.  NROTC pays tuition & fees.  College savings pays room, board, excess textbooks, cell phone, printer bills, and an occasional laptop repair.  I think our daughter successfully haggled to have it pay for an iPhone upgrade, too, but that means the college fund has less in it for profit sharing after graduation.  I don't think she'll try that again.

In any case, I don't have to make the budget jump through hoops when we visit our daughter (or when she visits us).  We pay for all of that out of our entertainment & vacation budget.

We log all our expenses in Quicken.  At the end of the year let's say that we spend $100K.  (We have a home mortgage, a rental mortgage, and other rental property expenses.  We fly back & forth to the Mainland a lot.  Our Mustaches are very scraggly.)  That includes all taxes, mortgage payments, other rental expenses, charitable donations, everything that was withdrawn from an account to pay somebody else.

My pension is $40K.  Our gross rental income is $34K.  $26K has to come out of our portfolio, and as long as the portfolio is more than $650K (= $26K/0.04) then we'll probably be OK.  This math got pretty exciting in March of 2009. 

We can get away with this accounting because of several safety factors.  First, we can greatly reduce spending if necessary.  Second, our math does not count Social Security (although I'm confident it'll be there for us).  I'm pretty sure the federal government is going to pay my pension and my COLA.  (If they don't, SWR will be the least of my problems.)  My spouse will start drawing her Reserve pension in another decade.  Our travel expenses will go down as our ages go up.  Hypothetically SS & spouse's pension will cover most of our expenses and greatly ease the SWR demands on our portfolio.

But when we started saving in the 1980s, I couldn't count on pension income and I had no freakin' clue how to estimate Social Security.  We didn't have a photovoltaic array or solar water heating to defray an average electric bill of $175/month.  When I retired, I couldn't even count on rental income because my parents-in-law were living in our rental home.  We had a mortgage and we didn't want to pay it off right then.  We had to save pretty aggressively to get the ER portfolio big enough to cover projected expenses, and in retrospect we overshot the mark. 

That's the beauty of the 4% SWR-- it practically guarantees that you're going to overshoot the mark.  And because of the way I'm doing the accounting, if our ER portfolio goes to zero then we are not penniless.  We'll still have my pension (and spouse's), we'll still be able to reduce our spending, and we'll still have Social Security.  The key to this (as Wade Pfau and Moshe Milevsky write) is to annuitize some of your ER income for longevity insurance and to guard against a SWR failure.  For most people it's Social Security.  For us it includes our military pensions, too.

An additional factor in my retirement has been interest rates.  When we retired in 2000 we were paying 8% (eight!) on our home mortgage.  Today we're paying 3.625%.  My military pension COLA has risen roughly 25% over the last decade, but our mortgage expenses have dropped by over 40%.  In actual dollars, the refinancing has been worth more than the COLA.

Some would claim that we won the retirement lottery after I retired.  Our earned income plummeted, and so did our taxes.  Our mortgage expenses imploded.  We had more time to DIY so we cut a lot of service expenses.  We had the time to review all our spending and cut some of it, too (like insurance).  My parents-in-law moved out of our rental property and we started getting rental income again.  My spouse qualified for a Reserve retirement.  We installed a PV array and a solar water heater.  Berkshire Hathaway stock did great things for the college fund.  Our daughter decided to commit to NROTC and did even greater things for the college fund.  I accounted for some of this in our ER planning, but there were far more pleasant surprises than unpleasant ones... despite two recessions in that decade.

I don't call that "luck".  I call that being ready to exploit opportunities.  Note that spouse and I could have gone back to work any time-- blogging income, book income, public speaking, defense consulting, surfing instructor, even door-to-door handyman services.  I could even go teach nuclear power classes for Pearl Harbor Shipyard, although I'm gettin' to be a bit of a dinosaur for that group.  However I'm beginning to believe that none of our income-producing ideas will be necessary.

A classmate of mine has done quite well for himself after the military, and his bridge career gives him a very healthy six-figure salary.  He donates over $100K/year to a Vietnamese orphanage for reasons that must be very important to him-- because he's willing to work for it.  But he also enjoys his work.  Personally, I haven't found that sort of avocation yet.  I tell our daughter that I hope she finds her own avocation, but in the meantime she should be pushing for financial independence.

BTW I don't count book royalties as retirement income, but I have to report them as taxable income.  Then I donate the royalty amount to charity and take a tax deduction, so it's close enough for my comfort.  $1136.15 (so far) doesn't move the needle much against a $40K/year pension.

You mentioned capitalizing the value of a pension.  Doing that calculation for a military pension with a COLA took me three weeks and several blog posts!
http://the-military-guide.com/2011/03/17/present-value-estimate-of-a-military-pension/
http://the-military-guide.com/2011/03/21/asset-allocation-considerations-for-a-military-pension/
http://the-military-guide.com/2011/03/23/asset-allocation-considerations-for-a-military-pension-part-2/
http://the-military-guide.com/2011/03/24/asset-allocation-considerations-for-a-military-pension-part-3-of-3/

tooqk4u22

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SWR rate should include all investments not just stocks.  MMM includes his rental property, which is yielding way more than 4% (probably 10%) and in reality makes up a significant portion of his passive income. In my area you can't get these kind of returns on rentals.

Jamesqf

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And finally, Berkshire Hathaway has been regarded as a great growth stock, but its returns haven't beaten its long-term average in years.  It hasn't paid a dividend since 1965.

I think that's inherent in its nature, though.  BH doesn't actually produce products, it invests in other companies that do.  If it pays dividends, it has less money to invest, so the only reason for paying out dividends is lack of good investment opportunities.  It's basically the same as you holding a mutual fund: do you collect the ongoing dividends & capital gains from the fund's trading, or do you reinvest them?

At the other extreme, take something like your local electric utility company.  It has a good income stream from selling electricity, but only limited options on how it can spend money "growing the business", so it makes sense to pay out the rest of the profit as dividends. 

BenDarDunDat

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The difficulty I could see is to worry about how mature these companies are. Companies really don't get to become dividend aristocrats unless they are already extremely mature. So you buy into these old companies while you are young, and they are paying you richly in dividends which you are taxed on. Then as you age and need to depend on these dividends, the companies have begun to decline. You could probably do better to pick growth stocks now, enjoy the tax free appreciation, and then by the time you retire, you will be holding onto mature companies that are paying appreciating dividends and eventually become dividend aristocrats when you actually need the dividend.
You seem to be implying that you're holding these stocks forever.  I wouldn't do that.

A dividend aristocrat is only a member of the club if it keeps raising dividends.  If it stops doing that then you sell it, pay your taxes, and buy a different member of the club.  If you're buying an index then they do that for you when they reconstitute the index.

It should be the same circle of life with a growth stock.  If its price grows to something near its intrinsic value then it better be giving you an incentive (like a dividend!) to hang on to it.  I'm not sure you can call it a growth stock anymore if it starts paying a dividend, but plenty of growth stocks have gone down in flames before they could have the dividend discussion. 

And finally, Berkshire Hathaway has been regarded as a great growth stock, but its returns haven't beaten its long-term average in years.  It hasn't paid a dividend since 1965.  I don't know how much longer we'll have to wait before it starts paying a dividend, but I bet it'll involve current management stepping down...

That seems like a better idea then.  The larger Berkshire Hathaway grows, the more it will resemble the S&P. However, it's still kicking the S&P's ass. Until the performance gap closes, there will be no mass movement of stockholders demanding a dividend.

I remember reading somewhere that 40% of market returns have been from dividends, so I can support getting your fair share of them.

tooqk4u22

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In a vacuum and ignoring taxes there should be no difference in returns between dividend and non dividend stocks - if a company has a $30 share price pays a $1 dividend you still have the $30 share and now the $1 in your pocket to invest/spend, if it retains the $1 then you should have a $31 share price. 

That said we don't live in a vacuum.  The most meaningful issue that arises not paying a dividend and retaining the income for company is when companies deploy that capital into new investments - R&D is one thing but when they buy companies the ROI is often times very poor in the end.  Any time a company takes an impairment on goodwill it means that it isn't working as desired as (1) it means the company that was purchased isn't worth what it was and (2) the future prosects of synergies/growth have diminished.

Dividends help with this as it gives you a chance to make investment decisions.

grantmeaname

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The seekingalpha link posted above states that if the company trades at a multiple of its book value, then it's reducing its value by that multiple of a dollar for each dollar it pays out in dividends.

Let's say P&G has $68B in equity, and a market cap of $169B, so it's trading at a multiple of ~2.5. If it were to pay out $10B in dividends, it would have $58B in equity, but wouldn't it have reduced its market cap by $25B to $144B to maintain the 2.5x ratio of book value to market cap? Is that right, am I misunderstanding the author, or is the author incorrect?

tooqk4u22

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My opinion is that the writer is incorrect.  The difference between Market Value and Book Value doesn't always mean much most of the time.  Cash flows are generated from a company's assets but those assets can't be adjusted upward if they become more valuable (there are some exceptions such as securities and such).  Additionally, depreciation and amortization cause assets to decline in book value bbut that doesn't mean they are not valuable.  A perfect example of both of these at the same time is real estate  - it depreciates over a certain timeframe down to zero even though at that time there is clearly some residual value greater than zero. Although generally there are capital improvemetns along the way that add back to book value.  Patents/Trademarks are also similar examples of declining book value with potentially increasing market value. 

Another way to look at is if I have $100 of assets that got a 10% return initially ($10) and fast forward 5 years - lets say my BV is still $100 because I have only invested/retained enough to offset D&A but now I get $20 because my widget is in far more demand and I had excess production capacity.  Assuming no changes in various investment factors (P/Es, discount rates, interest rates, etc.) surely my MV would well exceed my $100 BV. 

BV matters more on companies with tangible assets and in those cases can be a proxy for liquidation value but even then it may not.  Think about all the mortgage securities that were worthless but it took time for the companies to writedown the paper on the BV but the MV tanked ahead of the actual writedowns.

skyrefuge

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The seekingalpha link posted above states that if the company trades at a multiple of its book value, then it's reducing its value by that multiple of a dollar for each dollar it pays out in dividends.

Do you have a specific quote you're referring to?  What I see him saying is that paying out a dividend reduces the market value by the dividend amount, not by a multiple. 

In the case of P&G, the exchange would reduce the share price (and thus, market cap) by the dividend-per-share amount at market open on the ex-dividend date.  So a $10B dividend payout would result in a $10B market cap reduction (absent all other trading activity), not a $25B reduction.

I don't fully understand what the seekalpha author was getting at there in terms of book-vs.-market making dividends even less-preferred over other options, but he already convinced me through enough other lines of reasoning to not prefer dividends, so I kinda stopped caring about additional reasons.  :-)

grantmeaname

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Yeah, I see what I was confused over. Here's the relevant quote, which upon a third reading doesn't say quite what I thought it did.
Quote
3.It is actually worse, since dividends are paid in cash and therefore directly reduce book value;
4.while a sale of shares is at market, often a multiple of book.

If a stock is selling at, say, twice book, why should one accept a dollar when one could sell the same amount of book for twice the amount?