Wednesday, June 06, 2007

The Dividend Retirement Myth

It seems to me that several people are planning retirements using at least some dividends to provide part of their income. This is a good idea, the problem becomes when you take it too far and try to pull off a Derek Foster and live off only dividends.

Let me say I do like dividends. They get great tax treatment from the government if you are lower income (see here) and if you pick good companies they will provide a nice raise and likely keep up with inflation. Yet people tend to ignore their dark side, the low yield.

You see in this over inflated market of nearly continuous record breaking highs for the TSX index the actual yield on most dividend paying stocks is very low. When most dividends are around 1 to 4% yield you end up needing a lot of cash to generate your retirement income. Let me provide an example.

Let’s say you need about $25,000/year in retirement income for a couple. If you buy all dividend paying stocks and manage to get an average yield of 2.5% you would need $1,000,000 to get your income since you are paying no tax. Yet if you use a more balance portfolio and get your income half from capital gains and half from interest income and pull off a 7% yield you need $475,950 to generate $25,000/year after taxes or $28,500 before taxes between the two of you.

So in the end you need about half the total amount of money. So remember not to get so hung up on tax advantages that you lose sight of the overall picture. The point is to retire early and to get there you need a higher yield than 1 or 2%.

5 comments:

Mr. Cheap said...

I think its good to question strategies (especially as they're picking up steam and people are wildly enthusiastic), but I'm not sure this is entirely fair. Firstly, people won't only be buying dividends in the current market, there might be a crash (here's hoping!) and yields might become more significant. People might focus on the hire current yields (trying to get closer to the 4% then 2.5%). Additionally, its not like there aren't any capital gains on dividend payers. Even if you were just averaging 2.5% dividend yield, the increasing yield, favourable tax treatment and capital gains would all combine for significantly more then 2.5% as time went on.

Middle Class Millionaire said...

CD,

I agree that you will require more money if you plan on retiring exclusively on dividends. However, personally I don’t see that as a bad thing. In my personal situation I would want that extra money to ensure that I could maintain my lifestyle after retirement. I wouldn’t be comfortable retiring early on only $475,000, as I would be worried about inflation eroding my lifestyle over the years. In your situation how would you protect your capital against inflation if interest rates were low and the markets were stagnant?

Cheers,
MCM
http://middleclassmillionaire.blogspot.com/

Canadian Capitalist said...

By making different assumptions, you can show anything to be true. But how realistic is a 7% withdrawal rate? Not much.

Future equity returns are likely to average 7-8%. Bonds are yielding less than 5%. A 50-50 portfolio will average 6.5%. So, if you withdraw 6.5%, you'll be left with the nominal value of your capital intact. In real terms, you are consuming your capital too. Don't forget that in the second year and thereafter, you should adjust your withdrawal rate upwards to keep up with inflation.

You are asking for trouble if you plan a 20+ year retirement at a 7% withdrawal rate.

Canadian Dream said...

Gents,

Thanks for all the feedback. CC hit on the head, depending on what numbers you pick you can run this game any which way. I knew that writing this post, but I wanted to see the reactions.

Overall I still like a balanced approach using all three tax classes of investments (capital gains, interest, and dividends). That way you are not betting your retirement on one portion of the tax laws, which can be changed. Do we all recall what happened to income trusts?

CD

FinancialJungle.com said...

Just want to point out that Derek Foster lives off of both dividends and income trust distributions. His portfolio yield is likely higher than 2.5%.

The income trust tax change hurts RRSP investors the most. Outside of RRSP, it shouldn't make much of a difference whether income trusts distribute interests or dividends. After corporate tax, you might receive less dividends, but you also receive dividend tax credits.