Saturday, March 27, 2010

Dividends - A Safe Way to Retire?

A Different Way to Retire: Dividends
I recently picked up, from the library, a book called, "Stop Working: Here's How You Can," by Derek Foster.  Foster is the self-proclaimed "Canada's youngest retiree" (at age 34).  He's written a few books, but this was his first.  It was a fairly easy and interesting read.  Being relatively short, I finished it in a couple of days.  It was also interesting because it was unconventional.  I'll go through the main points of his book here.  If you're interested, grab a copy from the library or Foster's website.  I've put a link on the right.

So what is the conventional way of retiring?  For most people (myself included), it's all about accumulating a large sum of money.  By having this large sum (say $1-2 million), even if you live off the interest, the money should be able to last you well into your golden years.  Since it is not easy to accumulate such an amount of money in a short time, either one has to invest aggressively in the stock market, or one accumulates wealth over a long period of time.  Either may not be the ideal routes for everybody.  Foster presents yet a third way.

Increasing Dividends During a Bear Market
Foster's book can be summarized in one sentence: accumulate stocks/income trusts with steadily increasing yields during a bear market.  Let me illustrate with one of the examples in his book.  He looked at Royal Bank of Canada (Ticker: RY).  In 1995, the stock was at $15.56 and paid a dividend of $0.59/year.  That equates to 3.8% yield per year.  Over the next 9 years, the yield steadily increased and by 2004, it had increased to $2.02/year or 13.0% yield (relative to your initial investment).

Since the stocks that you would buy would be recession-proof stocks with a long history of increasing dividends (e.g. stocks like McDonald's, Proctor & Gamble, Johnson & Johnson), the chances of dividends being cut or the stock depreciating are low.  What you are banking on is an ever increasing yield.  You also rejoice when there's a bear market, because good companies like P&G will likely not decrease dividends even during a bear market, but like most other companies, its stock value will decrease.  When this happens, the effective yield of the stock goes up (i.e. the amount of dividends remain the same while the stock price decreases).  So, for Foster, the lower the stock price goes, the better.

An Example from 2009
If you had bought Proctor and Gamble (Ticker: PG) in March 2009, you would have been able to buy it for $47 (stock price is now around $64).  The dividend paid for 2009 is $1.72 or 3.7%.  Looking at the history of the dividend increases, the dividends double every 5 year or so.  So, in 10 years, if the dividend increases follow what has occurred in the last 30 years or so, the yield would be about 14.8%.  If you had placed $100K in P&G stock in March 2009, by 2019, you would be receiving $14,800 per year in dividends.  As time passes, this amount would continue to increase, at a much faster pace than inflation.  So, you will get wealthier and wealthier!

How Much Do You Need to Retire?
Foster shows a sample portfolio in his book, which I suspect is fairly close to what his portfolio looked like.  The "sample" portfolio cost $100K and by the time of his retirement, was worth about $330K.  The dividends from this portfolio was $18,845.  There are, however, a few caveats with this method: i) you need to have paid off your mortgage, ii) you definitely can't live like a king, iii) if the stocks you own decide to cut dividends, as unlikely as it may seem, you'd be in trouble fairly quickly.

So, Does It Work?
Foster wrote his book in 2005.  As we all know, the Great Recession hit in 2008/, was he able to continue his retirement?  In short, yes, but after some quick googling, I found that he had reportedly sold all of his equities in February of 2009 and had gone into the market of options (soon to be discussed in this blog).  It appears that he has done exactly the opposite of what he has advocated in his first book.  But in the end, he is still semi-retired (he works as an author now, promoting his books).

In my opinion, Foster's method is definitely a viable way of ensuring a steady income.  However, I would still try to accumulate a greater portfolio value before retiring to ensure there's some buffer if another recession hits.  While you may not need $1 million to retire, you may want to have $1 million so you have a safety net if something bad happens.

One last word: if you need to do some retirement planning in this conventional way, be sure to read my previous post on retirement.