Most clients who seek estate planning advice share similar hopes for a worry free retirement. Their top three financial “wishes” include: having more than “enough” of a nest egg to manage inflation, tax efficiency and wealth preservation for a legacy or heirs. Wishing at the financial fountain and having a strategic plan that suits today’s investment environment however are two separate things.
Investors are facing a crisis of low returns due to historically low interest rates, but people have not updated their strategy to reflect this reality. Most investors believe they can still build a significant nest egg by investing 60% of their funds in an equity index and 40% in a bond index. This advice has been in every book published since the 1980’s; it is not original, and unfortunately it is no longer effective.
As low interest rates persist, people planning for retirement using yesteryear’s 60/40 passive index investing playbook will likely only achieve real returns of around 3-4% a year, not the 7% needed to accumulate a serious nest egg. Even one of the anointed godfather’s of this investment approach, Random Walk Down Wall Street author and Princeton Professor Burt Malkiel calls the 60-40 portfolio “outright dangerous” and “wrong for investing in a globalizing world”. (CNBC Nov. 2013)
As I write in my book, "Own Your Financial Freedom", planning gets tougher for investors who intend to rely on “traditional wisdom” for retirement planning. Most retirees equate retirement income with fixed income from CDs and bonds with an eye to capital preservation. Using the rule of thumb draw down of 4% per annum, if the “safest” bonds yield only 2.5% or less, simple math tells us you won’t be preserving capital but tearing a gaping hole in your nest egg unless you cut back on expenses dramatically in retirement.
Because of the unprecedented low interest rate landscape, investors need to look past investment advice based on a 1980’s world order. And while many asset classes should be considered such as productive farmland, emerging market debt and foreign real estate, not everyone can access or afford these options. Dividend growth investing however is accessible to investors along the entire wealth continuum, and should have a place in everyone’s portfolio whether you are building wealth or preserving it.
Dividend growth stocks are equity investments that pay an increasing dividend year on year. This is not about chasing the highest yield, but rather investing in companies that consistently grow their dividend payments. Smart wealth builders reinvest growing dividends. They do so through bull and bear markets to accumulate significant shareholdings without further capital commitments or tedious rebalancing that raise tax liabilities.
But the real beneficiaries are retirees. Retirees can pair these growing income streams with fixed income investment streams to bolster cash flows and stave off inflation. Take a $100,000 allocation of dividend growth stocks that yields 3% today and delivers a growing dividend at a modest increase of 10% per year for 10 years. Over ten years you will collect $52,593 in payments and that’s before even considering capital gains.
Most people don’t realize that since 1988 40% of the US stock market’s total returns are due to dividends. The best dividend growth payers are known as “Dividend Aristocrats”. These companies have increased dividends every year for 25 years or more. Mostly US companies, these include: Emerson Electric, Coca Cola, Diebold among others. For those who find investing in individual companies nerve wracking, the ETF NOBL or VIG follows this group of companies.
The real bonus with dividend growth is that as a group they consistently outperform most other US equity indices (see graph) in the long term. So you outperform and get paid in good times and bad, making this the ultimate “set it and forget it” asset class and what I consider the comfort food of the investment world. Dividend growth also helps you achieve all three “wishes” above: capital gains tax avoidance, growing cash flows to offset inflation and wealth preservation for heirs. And who doesn't love comfort food?