A loyal reader, Chereen, asked me the following question via email:
“I would like to retire with a yearly income of $39,000. I wonder how much I need to put aside in order to receive this amount in dividends each year”.
A blunt answer would be the following:
“Assume a 3.5% dividend yield and divide $39,000 by 3.5%. You will get $1,114,285. This is your magic number”.
Well, technically, if you invest $1,114,285 today and build a dividend portfolio paying a 3.5% dividend yield (which is still conservative), you will receive your $39,000 annually without touching your capital.
I wish the answer was just this simple. But it’s not. The magical number of $1.1M is only good for today and if you were to invest $1.1M in today’s stock too.
The Power of Dividend Growth
The answer to this magical question is a lot more complicated than this. I actually played with my Excel spreadsheets for a good 2 hours and wasn’t able to pull out a table that would satisfy my geeky dreams: showing that a smaller portfolio could generate the same $39K in dividends. How is that possible? It’s because of the power of Dividend Growth!
Take Coca-Cola (KO) for example; it currently pays a 2.90% dividend. However, the company is very keen on increasing its dividend. Therefore, it has doubled its dividend every 6-7 years for the past 50 years. So if you bought the stock 21 years ago, your dividend on your original investment is more likely to look like 9% than 2.90%. So imagine that 21 years ago, you had $300,000 to invest. Today, this $300,000 would pay $27,000 in dividend instead of $8,700 if you were to invest it today. All right, we need to compound inflation, $300K 21 years ago is now worth $478,686. Therefore, a similar investment would pay $13,881 in today’s dollar ($478,686 * 2.90%) as compared to $27,000 if you had invested the “same amount of money” 21 years earlier.
This was the premise and the easy part of my calculation. My brain almost burst when I tried to factor an annual contribution to the chart. For example, if you are 40 and expecting to retire at 65, you will most likely save money during the 25 years. It’s easy to know how much your current portfolio at the age of 40 will pay in dividends 25 years later. However, it gets complicated if you want to know how much each contribution will generate in dividends over time. Then, I would also have to factor in a capital gain somewhere. Do you get why I stopped my calculations? I would need an engineer or an actuary to translate what’s in my brain!
An Example of Dividend Growth
While I wasn’t able to pull a crazy calculation sheet that would make the whole financial planning industry jealous, I did run some calculations to see how much your dividend stocks would be paying after several years. I started with the assumption that you make regular contributions of the same amount over X number of years. So the chart would read as follow: if you invest in a dividend stock over 35 years with a dividend growth of 3% per year, you will earn an average of 6.05% on your initial investment:
35 years: 6.05%
30 years: 5.55%
25 years: 5.10%
20 years: 4.70%
15 years: 4.34%
10 years: 4.01%
In an ideal world, you would invest all your money and wait 35 years… and make a 9.85% dividend yield! However, you surely don’t have 300K at the age of 30 to invest and wait for your retirement ;-). On the other hand, you can see with this simple chart the huge power of dividend growth if you start investing young.
Based on these assumptions, a young investor, who starts investing $5,000 per year at the age of 30, will have invested $175,000 and receive $10,587 in dividends per year. The 10k is in today’s dollars not considering inflation.
Dividend Growth Helps to Hedge Against Inflation
If you live from your dividend payouts, you will be happy to know that you are able to hedge yourself against inflation if you pick the right stocks. In fact, if your portfolio shows a dividend growth of 3% per year in a tax free account (RRSP/TFSA or 401k/IRA), you will be 100% hedged against the rate of inflation.
How You Can Calculate How Much You Need
When I started writing of this article, I wanted to share with you an excel spreadsheet telling you how you can calculate how much you need to save in order to receive $39,000 in dividends at retirement. Unfortunately, this calculation is too complicated when you factor regular contributions, investment return, dividend growth and inflation. In fact, if you want to know how much you need to save, your best solution is still to have a financial plan done by a CFP. Then, you will know how much to save and at what rate. It will all be pretty easy to manage your portfolio after that!