by Dividend Growth Investor | August 15, 2014 10:30 am
There are millions of baby boomers in the U.S., and every day, thousands of them retire from the workforce. Most will rely on a mix of Social Security, company pensions and personal assets for income in their golden years.
However, fewer employers are offering traditional pensions these days, and the future of the Social Security system is not as sound as it once was. Depending on who you listen to, the Social Security system will either run out of money in 35 years or continue paying benefits at a deeply reduced rate. Therefore, retirement planning should start sooner rather than later.
Investors outside the baby-boomer generation may have to do more for their own retirement planning and not rely on employers or the government.
One strategy that can help retirement planning is investing in dividend stocks. Creating a portfolio full of dividend stocks allows you to receive regular income from those investments. Obviously, a stream of income through your brokerage account eases the burdens of budgeting, and living off dividends can certainly help in those retirement years.
Let’s say you invest a dollar in a dividend stock that yields 4%, whose stock price increases 6% every year, and that grows distributions by 6% every year to “keep up.” If you were to just collect the dividends, here’s how much your dollar would be generating over time:
Year 10: 07.16 cents
Year 20: 12.84 cents
Year 30: 22.96 cents
However, if you were to take those same dividends and reinvest them in the stock, here’s how much your dollar would be generating over time:
Year 10: 10.60 cents
Year 20: 28.12 cents
Year 30: 74.52 cents
If you keep adding dollars to your investment portfolio and let them compound through dividend reinvestment, you can generate enough income to retire. Investors’ portfolios should focus on dividend growth stocks, which are companies that have a history of regular dividend increases. A company that regularly increases dividends essentially provides investors with a stream of income that keeps its purchasing power over time. Compared to interest income, dividend income looks like a clear winner for preserving purchasing power from inflation.
Investors need to design diversified dividend portfolios that consist of at least 30 individual stocks. The portfolio should draw dividend stocks from as many industries as is smart. If one or more companies in a sector crumble during a recession, it could potentially destroy the whole portfolio structure. Having a diverse foundation would protect investors’ income portfolios in tumultuous market conditions that could lead to dividend cuts or eliminations.
Deciding your holding time frame is another crucial element for retirement planning through dividend stocks. Depending on the amount of capital invested initially, as well as the amount of capital added thereafter, a portfolio requires differing amounts of time to compound to generate a sustainable amount of income. The portfolio would need more time to compound investment dollars in order to reach a target monthly dividend income if the amount of capital added is lower and less time if it is higher.
For example, an investor puts $1,000 per month in dividend stocks maintaining a 4% yield. If he reinvests dividends, the portfolio will generate over $7,900 in annual dividend income in ten years. However, if our investor put away $2,000 per month in the same dividend stock, he would achieve $7,900 in annual dividend income after just six years.
Besides diversification and the power of compounding over time, another crucial factor to building a successful dividend portfolio is stock valuation. Purchasing shares when they are cheap maximizes price gains and dividend income for shareholders over time.
Typically, I look for companies that have raised dividends for over 10 years, trade at less than 20 times earnings, have a dividend payout ratio of less than 60% and yield at least 2.5%. The only difference for master limited partnerships and real estate investment trusts is how I calculate payout ratios and what minimum yield requirements I selected.
A few attractively valued companies today include:
Full Disclosure: Long ADM, AFL, CB, CVX, JNJ, MCD, MMM, WMT, XOM
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