By Sean Sparkman
At their core, dividends are distributions of company profits paid to shareholders. These stocks can create a steady income stream, typically paid quarterly, and they can be a valuable part of retirement income.
However, retirees considering dividend stocks, need to understand that dividends are a component of your total return and not a separate “magic” income source.
In many instances, when a company pays a dividend, the stock price will adjust downward by a similar amount. In other words, dividends are not “free money.” Instead they represent a shift in how your returns are delivered. This fact doesn’t mean that dividend stocks are bad for your portfolio, though. It just means that you need to understand them thoroughly and gain insights into how they might fit into your overall retirement strategy.
What role can a dividend stock play in retirement income planning?
As part of a retirement cash-flow plan, dividend stocks function in three essential ways:
- They give you baseline income to form the foundation layer of your plan.
Dividend-paying stocks may generate a relatively predictable stream of income, especially when you focus on stocks from established, profitable companies. Your baseline income can be positioned to help you with essential costs such as utilities, groceries, insurance premiums, and other basic lifestyle expenses. Including this type of consistent income source is one way retirees can achieve greater peace of mind and bridge gaps before their Social Security or pensions start.
- A dividend stock help your income grow over time.
Many dividend-paying companies increase their payouts over time. This can be crucial during times of high inflation or when your expenses unexpectedly change after retirement. After all, many people will be retired for 20 years or more. A dividend growth element added to your portfolio can create an income stream that continues to rise instead of slowly losing purchasing power.
- Dividend-paying stocks may have a hidden benefit.
Although it might make sense and is usually a financially sound move, many older Americans struggle with the idea of selling off their investments to fund their retirements. Having dividend stocks can make the spend-down process feel less anxiety-inducing and more sustainable. Dividends give you the feeling you are living off income without having to sell off all your assets. This translates into greater peace of mind and perhaps better money decisions overall.
Why not rely ONLY on dividend stocks?
I mentioned that dividends can give you more peace of mind and reduce your anxiety when the time comes to fund your retirement. However, having a “dividend stock only” approach to paying for your retirement may not be a good idea.
In my experience, dividends alone are usually not enough to generate the income you’ll need to fund your lifestyle once you’ve retired. A solid dividend portfolio might typically yield 2-4%. This means that if you have a $1 million portfolio, your dividend stocks may generate only $20,000-$40,000 annually. For many retirees that isn’t enough, even factoring in Social Security.
Additionally, when you rely only on dividend stocks, you might find yourself overly concentrated in riskier assets in a bid to chase after higher yields. Retirement is usually the time when you want to mitigate risk, not take on more.
Relying on dividend stocks as your only source of retirement income also means that you give up a measure of flexibility. Dividends get paid on the company’s schedule and not yours. You have no control of when they are paid, how much is paid, or how the dividends are taxed. Such lack of control could become an issue, especially when doing tax planning.
Finally, if you are thinking of trying a dividend-only approach in your retirement income planning, remember that dividend-paying stocks are still stocks. These stocks carry full equity risk. Just because a company is known for paying dividends does not mean they don’t have market exposure. Dividends can and do go down. A company could even decide to cut dividends. A dividend stock is not a bond substitute.
Could a total return approach be the better way?
Modern retirement income planning has evolved to the point where retirees are no longer asking, “How do I live off only my dividends?” Instead, they want to know “How do I turn my entire portfolio into a reliable income stream that I won’t outlive?”
That’s the essence of the total return approach.
Many retirement income planners have decided that focusing only on dividends and interest may not realistically meet income needs. Many advisors are encouraging their clients to consider the entire portfolio, including capital gains and asset sales, as sources of retirement income.
A well-designed modern retirement income plan typically includes dividends to provide steady income. Interest from assets such as bonds and certificates of deposit is added into the mix for a measure of stability. Some cash is allocated to deal with short-term needs. Flexibility may be created using strategic withdrawals.
The objectives of this strategy are to allow you to take income from multiple sources, avoid selling in bad markets, and adjust your income to reflect current market conditions
How do dividends fit into the bigger picture?
When considering adding dividend-paying stocks to your retirement income plan, it’s best to think of them in the following ways.
Dividends can be a “partial paycheck.”
Having steady dividend income will reduce how much you need to withdraw from the rest of your portfolio.
Dividend stocks can shield you from volatility.
When markets are down, your dividends may continue, even if prices fall.
Dividend reinvestment can help grow your portfolio.
Dividend reinvestment (before retirement) compounds income over time.
How this works in real life.
Let’s say you need $80,000/year in retirement. You might create a balanced income system instead of having a single point of failure situation.
- $30,000 → dividends
- $15,000 → bond interest
- $35,000 → strategic withdrawals
The biggest mistake isn’t using dividends. It’s building your entire plan around them.
As I mentioned before, a solid portfolio should be designed for income, growth, and liquidity, not just for yield.
Successful retirement portfolios blend multiple assets to provide both income and long-term growth and don’t rely on a single source.
Sean’s Summary
I believe in the power of dividend-paying stocks to improve the financial outcomes of many retirees and pre-retires. When they are correctly selected and wisely allocated, these stocks can provide a steady source of reliable income. They can also grow over time and reduce withdrawal anxiety.
To create a more enjoyable and prosperous retirement, your goal shouldn’t be to just “live off dividends.” Instead, you’ll want to partner with a trusted advisor who can help you use dividend-paying stocks and other assets to build a flexible, durable cash-flow system. You should consider how your portfolio will survive inflation, market fluctuations and downturns, and longevity, among other things.
Dividends can be one tool you can use to solve these threats to you
If you’d like to see if adding dividend-paying stocks will work in your particular situation, call my office now and make an appointment for your no-cost portfolio review. Together, we’ll take a look at your plan and find ways to remove any gaps and improve its efficiency and resilience.
Sean Sparkman
Pathfinders Wealth (248) 487-9148
