How to generate income in retirement has evolved because the companies you invest in operate differently now. On this week’s edition of Tired & Rich, we’ll break down what you need to know to navigate these changes and set yourself up for a more secure retirement.
Somebody taught you..
Somebody taught you what you know about retirement: a colleague, your advisor, or a journalist online.
You probably have some sort of clue on:
- When to retire.
- The benefits of Roths.
- How much you need to retire.
- How much Social Security you’ll get.
- Savvy tips and tricks inside the tax code.
Inside this retirement knowledge base you possess is the importance of dividend-paying stocks.
They are almost the ultimate retirement asset: they are an inflation hedge and growth tool and pay passive income throughout the year.
Incredible, but hang on, I probably wouldn’t have a job if it was that easy.
You’ve been taught correctly, but.
One day, you log on to Schwab, Fidelity, or wherever your assets are held to check on your yearly performance, and while doing so, you go down the “can I retire” rabbit hole.
You read that the 4% rule is a decent starting point for spending, so you check how much income your $1.3m portfolio is producing. You find your number, and it’s 2.12%.
“Huh? That seems low.”
You dive deeper and investigate your stocks and find they are yielding 1.2%.
You are 7 years out from retirement, with $1.3m, and you do the math if you retire right now.
Your portfolio generates $2,297 a month in income.
“Uhhhh, that’s just a bit more than my mortgage,” you say to yourself.
A knot forms in your stomach, and you semi-freak and start googling.
“How do I generate more income in retirement?”
Google spits out a zillion articles on dividend stocks.
What’s a dividend anyway?
Let’s look at dividends from a company’s perspective.
A dividend is a payment to owners after the business has done the activities needed to fund operations, pay taxes, and grow.
Companies don’t have to pay a dividend; it’s a strategic choice they make.
Paying dividends is a way to entice shareholders seeking income to buy their stock (or hold it). Dividends could also allow the Board of Directors to fulfill its fiduciary responsibility and generate returns for shareholders.
Said returns can come from either dividends or share price growth.
“Got it, Tom, makes sense, seems like a great idea. I’m sure every great company pays great dividends.”
Well, no.
And just like in last week’s edition and in many things in personal finance, the deeper you look, the more confusing things get.
Here is a list of the five biggest companies in the S&P 500, their respective dividend yields, and their 5-year annualized performance.
| Company | Market Cap | Dividend Yield | 5 Yr Annual Return |
|---|---|---|---|
| Apple Inc | 3.745T | 0.40% | 29.89% |
| NVIDIA Corp | 3.298T | 0.03% | 92.11% |
| Microsoft Corp | 3.298T | 0.69% | 24.06% |
| Amazon.com Inc | 2.367T | 0% | 20.91% |
| Alphabet Inc | 2.284T | 0.32% | 21.39% |
| Source: YCharts 12/11/24 |
Let me translate this for you: The biggest companies of this generation hardly pay dividends to shareholders.
Buy $1,000 of Apple stock and you’ll get $4 in dividends.
Great, a cup of black coffee at Starbucks.
Yet they all have performed mind-bendingly well over the last 5 years.
But why the tiny dividend?
As I said above, executives and boards have a choice in how they generate returns for shareholders.
Executives who run these companies can do five things with the profits they generate to return money to shareholders:
- Pay Dividends
- Buy Back Stock
- Reinvest Back into the Business
- Pay Down Debt
- Buy Other Companies
And that’s about it.
And clearly, from what you can tell above, the largest, arguably best-run companies in the world pay out paltry dividends to shareholders.
But why?
Because they feel they can return more money to shareholders by not paying dividends.
Listen to any keynote address from the executive teams at these companies, and they’ll discuss how they are investing in the AI revolution rather than paying dividends to their shareholders.
So, let’s examine the top dividend-paying companies in the S&P 500 and see how they’ve fared.
| Company | Market Cap | Dividend Yield | 5 Yr Annual Return |
|---|---|---|---|
| Walgreens Boots Alliance Inc | 9.061B | 9.54% | -31.51% |
| Altria Group Inc | 94.06B | 7.14% | 2.03% |
| LyondellBasell Industries NV | 25.22B | 6.79% | -3.42% |
| Dow Inc | 29.55B | 6.63% | -4.31% |
| Pfizer Inc | 145.02B | 6.57% | -6.39% |
| Source: YCharts 12/11/24 |
These companies have great dividends, but they are either not growing or shrinking.
Take inflation into the picture, and the returns get even worse.
Ouch.
So, back to the question.
How do you pay yourself in retirement when many of the market’s best companies are not committed to paying shareholders significant dividends, and you need passive income?
The ultimate answer lies between you, the person building your financial plan and portfolio. This is the lamest but truest answer I can give you.
But here’s what I can tell you as some random guy talking to you over the internet.
Modern-day companies that millions of Americans own, like Amazon, are run differently than previous generational greats and are less committed to dividends as a way to return money to shareholders like their predecessors.
What hasn’t changed is the fact that retirees still need to live off their portfolios.
The approach that millions of retirees today take, and what you will likely take, is to adopt a total return approach to generating the returns you need for your retirement.
Your total return is the dividend and interest income combined with your appreciation of assets in your portfolio.
Using the example above, if you have a $1.3m portfolio and earned a total return of 7.12%,
- 2.12% came from passive portfolio income.
- 5% came from appreciation.
Using the basic 4% rule for spending guidelines, you’d subtract the 2.12% income and sell gains to provide for the other 1.88%.
I can feel the wrath of the financial advisors who love to dunk on me in the feedback section coming for me.
This is more nuanced when the rubber meets the road and you start putting pen to paper in a retirement plan.
How you put your portfolio together, balancing income assets and growth assets, to ultimately fund your retirement is a deeply personal financial problem best solved in the confines of a financial plan.
Total return investing is a pragmatic solution to investing in great companies (whether outright or through fund managers (index or active)) in our financial system while also realizing that producing passive income in portfolios is critical for retirement health.
Wrap Up
The world is rapidly changing, and companies you invest in are changing how they operate and produce returns for you.
Yet retirements still require income because life still costs money.
The old pundits weren’t wrong about dividend stocks, I love receiving dividends, but the market itself has changed as companies operate differently.
That means how you plan for your retirement has to change.
Total return investing is a logical, pragmatic approach to consider in light of this.
As we wrap up an incredible, yet difficult, 2024, the are opportunities everywhere for the wise and prudent investor.
Stay nimble, and keep tuning in each week.
See you around.
PS. If this hits a chord and you want to know the insides of your portfolio, what it’s yielding, and what that means for your retirement, schedule a Portfolio Review with us. It’s free, takes 20-30 minutes, and there are no strings attached. You can ask us anything, and we’ll tell you facts about your investments.
