Once You’re In Retirement
Thinking about this side is “fun” in that the outcomes may be broader than you first imagine. Let’s continue with the example of holding a collection of dividend paying securities.
If your annual expenses (or annual supplemental expenses) are say $25,000 and you have a portfolio generating $25,000 per year you’re in pretty good shape.
I’ll show you why this is the case…
When you hold a collection of dividend growth companies, you’d anticipate the yearly income to grow through the years. Your expenses may grow as well, but likely not at the same rate as the overall dividend income.
During the last decade Kimberly Clark Corp (NYSE:KMB) grew its payout by 7% per year, McDonald’s Corporation (NYSE:MCD) by 18%, PepsiCo, Inc. (NYSE:PEP) by 11%, Johnson & Johnson by 9%, Colgate-Palmolive Company (NYSE:CL) by 10% and the list goes on and go.
Granted this doesn’t mean that future payouts will grow as robustly, but it follows that profitable companies that have a history of paying out a portion of their earnings tend to get more profitable and pay out more dividends over time.
In keeping with above example, if your expenses grew by 2% and your income grew by 6% each year, this would mean that suddenly you’d go from “breaking even” in terms of income less expenses to having a $1,000 surplus in the second year.
In the third year the surplus would increase to over $2,000 and then over $3,000 and so on. After 10 years of this, your portfolio could be generating $14,000 more per year than you’re spending.
This has a variety of important ramifications. While it’s likely that your dividend income could grow faster than you expenses, it’s also possible that you could see lower dividend payouts from time to time as well. There are two basic ways to combat this: thinking about diversification and starting with or creating a buffer.
With regard to diversification we’ve all heard the phrase “don’t put all of your eggs in one basket.” The same basic notion applies here. No matter how great of a company you think The Coca-Cola Co (NYSE:KO) happens to be, or how spectacular Emerson Electric’s (EMR) dividend history has been, an adverse event is always possible.
If BP plc (ADR) (NYSE:BP) or Wells Fargo & Co (NYSE:WFC) made up 20% of your income a few years ago, your passive income would have taken an extraordinary hit. If these securities only make up 3% of your income, there’s still a hit but it’s much less pronounced.
The second thing to think about is creating a buffer. This can be done in one of two basic ways. You could start out with an “extra” cash allocation. So instead of relying solely on $25,000 worth of annual income you could also have a couple years’ worth of expenses in a liquid account as well. This tactic takes a bit longer to build up, but it certainly could provide a sense of security should something not go as planned.
Another way to approach it is through time. In keeping with the example, if in the second year you receive $1,000 more in dividend income than you need you can take a few approaches: spend the extra funds, keep them aside or reinvest. The second two actions act as buffers. Just like you created a gap between earning and spending during your working years, you could think about creating a gap between passive income and expenses during retirement.
The interesting part about all of this is that once you get to your desired income level it becomes more and more difficult to not get richer through time.
Let’s think about why this happens.
When Coca-Cola pays a dividend it’s doing so out of its profits. So the company sells its beverage concentrate, pays all of the expenses related to making that product, all the salaries, marketing, building utilities, all of it. After Coca-Cola does all of that, there’s still money left over.
About half of this goes to the shareholder in the form of a cash dividend. The other half is used to buy out partners (share repurchases) and redeploy into the business to grow even more. So even with half of the profits being paid out, the other half is still working for you productively in the company. In turn The Coca-Cola Co (NYSE:KO) tends to get more profitable over the years and investors are willing to pay more for the shares.
So if you simply collect the dividend payment, it becomes more and more likely that your dividend and share price will be higher through time as well. In order for the value of your holdings to stay the same or decrease you would need to start selling some shares.
Coca-Cola was in the portfolios of 51 investors tracked by Insider Monkey on December 31, with them owning over $20.28 billion worth of the company’s shares. While the number of shareholders dipped from 54 on September 30, the value of their collective holdings rose from $19.33 billion. Warren Buffett, a long-term Coca-Cola shareholder, held 400 million shares worth $17.18 billion at the end of 2015.
