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For more on this topic read our article on retiring on dividends and if investors should only invest in shares during retirement.

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

So, Mark, you recently got back from France.

Mark LaMonica: Like very recently, last night.

Jayamanne: Yeah. How are you feeling?

LaMonica: Well, I haven't slept in two days. So, yeah, feeling good about things right now.

Jayamanne: So, we'll see how this goes.

LaMonica: Exactly.

Jayamanne: Maybe we should just jump into it.

LaMonica: No, we're going to be very high energy today, right?

Jayamanne: Okay, sounds good.

LaMonica: All right. Well, let's get started. So, we got a question from a listener, which we always really enjoy. And the question was about retirement, and I thought it was a really good question. So, we're going to dedicate today's episode to that question.

Jayamanne: Yeah, I feel like it's quite nice when somebody does the work for us and comes up with the topics.

LaMonica: Yeah, no, it is. This is just outsourcing topic selection. So why don't we get to the question, Shani?

Jayamanne: All right. So, the question was based on the 4% rule, which is a conventional wisdom about a safe withdrawal rate. And the question was that if the ASX dividend yield, including franking credits, is more than 4%, why wouldn't a retiree just live off dividends instead of worrying about the withdrawal rate?

LaMonica: So, I don't know if I mentioned this, Shani, but I think it's a really great question. Did I say that?

Jayamanne: I think you did.

LaMonica: Okay. Well, I actually wrote an article on this question as well. And I did ask for feedback from readers, and a lot of people emailed me and shared their stories about how they have done this. They've retired on dividends.

Jayamanne: So, it seems like the answer to the question is, yes, if people have actually done it, then it must be possible.

LaMonica: That is true. But like everything else with investing, there are some considerations and ways investors can set themselves up for success.

Jayamanne: So perhaps we can start with the basics. In theory, if an investor only lives off the income generated by a portfolio, then they'll never run out of money.

LaMonica: And that is a very good thing, because of course, not running out of money is the whole point of trying to figure out a safe withdrawal rate. Living off of dividends means relying on the income generated from the assets held in a portfolio. If those assets are never sold, there would always be a source of income. The market goes up, the market goes down, none of it matters. Only dividends count.

Jayamanne: But the challenge with retirement is amassing enough money to support your day-to-day life. So, the first thing we need to do is figure out how feasible it is to acquire enough assets to generate the income needed to pay for your expenses.

LaMonica: Well, on a global basis, this is really hard. So, the S&P 500, of course, the 500 largest stocks in the US, which makes up around 70% of the global share market, has a dividend yield of 1.51%, and that's on the 1st of September 2023. So that is, of course, significantly lower than the 4% figure that is often cited as a safe withdrawal rate. That means a retiree needs a portfolio that is 2.64 times larger to generate the same amount of money that the 4% rule would provide.

Jayamanne: And as Mark said, that is really hard. But Australia is different. ASX shares typically have a higher yield due to the local preference for dividends that comes from the tax advantages in Australia.

LaMonica: And Shani, of course, that means you get franking credits. So that's, of course, the tax advantage. So franking credits eliminates the double taxation of dividends in Australia by offering a credit for corporate taxes that are paid. So franking credits increase the post-tax income for Australian investors that hold Australian shares.

Jayamanne: As is pointed out in the question, the yields on Australian shares when franking credits are included exceed 4%. That means a retiree can support the same level of income with a smaller portfolio than using the generally accepted withdrawal rate. The ASX 200 currently has a trailing 12-month yield of 5.18%.

LaMonica: And the ATO estimates the franking credit yield on the ASX ordinaries each month. So, over the past year, the average franking rebate yield is 1.46%. Now, of course, this is a different index than the ASX 200, but it's a good approximation for franking credits.

Jayamanne: And investors are able to get around a 6.5% total yield by investing in the ASX 200. Following the 4% rule and generating the same amount of money as the dividend and franking credits from the ASX 200 would require a portfolio that is approximately 1.6 times larger.

LaMonica: And of course, in the pension phase of super, a retiree would not pay taxes on dividend income or on the withdrawal of funds from super. Franking credits would still be provided to the retiree and could be claimed even if there was no taxable income that needed to be offset. Government would pay the retiree the amount of the credit, and that is a very, very favorable tax treatment.

Jayamanne: So, at first glance, this strategy seems sound. That is why so many people wrote in talking about how they've done this, retired and lived off of dividends. At the risk of overcomplicating things, there are some considerations for investors pursuing this strategy.

LaMonica: So, the first consideration is that a dividend is of course not guaranteed. It is not a contractual obligation like a bond interest payment, which can only not be paid if a company or a government defaults. A dividend is a choice by the board and management of a company. They choose if a dividend is to be paid at all and what level they are paid. This choice is driven by preference, but also by the ability of the company to fund a dividend.

Jayamanne: Dividends, of course, are funded by the profits of a company. There are lots of factors that influence profits, the performance of a specific company and the overall economy all come into play.

LaMonica: And we've discussed this on many of our income-related podcasts, but the safety of a dividend is governed by the payout ratio. Payout ratio refers to the percentage of earnings that are paid out in dividends. So, a 100% payout ratio means that all earnings are paid out in dividends. A 50% ratio means that half of earnings go on to dividends.

Jayamanne: The higher the payout rate, the smaller the margin of safety for any fluctuations in earnings. At a 100% ratio, if earnings drop by 10%, the dividend will exceed earnings. In theory, a company could support this dividend by spending cash from the balance sheet or by borrowing money. In practice, a company would just likely cut the dividend.

LaMonica: And this is where we need to explore Australia a bit and not just say that Australia has higher dividends than the rest of the world. We need to understand why.

Jayamanne: And largely, this is simply because of preference. Australian companies choose to pay out a higher percentage of profits as dividends, which is reflected in the payout ratio. In Australia, the payout ratio is much higher for ASX-listed shares than other global markets. That accounts for the higher dividend yields of Australian shares compared to global shares. The current dividend payout ratio in Australia is around 62%. And this is actually quite low for Australia. In 2016, the payout ratio was over 75%. It's still much higher than many markets around the world. The S&P 500 has a dividend payout ratio of just under 24%.

LaMonica: And the choice to pay out a higher percentage of profits as dividends impacts the safety of those dividends. And dividends in Australia fluctuate constantly. And we can use BHP as an example. So, BHP is, of course, Australia's largest company, makes up over 10% of the ASX 200 index. In the calendar year of 2022, BHP paid total dividends of $4.64 a share. In the calendar year of 2023, BHP will pay out dividends of $2.61 a share.

Jayamanne: This presents a real-world impact on investors living off dividend payments. A retiree living off dividends would see a fluctuation in year-to-year income. And that can be a challenging way to live. If a whole retirement portfolio was invested in BHP, income would drop by 43% in 2023 compared to 2022.

LaMonica: And we can, of course, address this risk by diversification. We diversify to remove single security risk from our portfolio. In an income investing strategy, we are removing the risk that company-specific problems will impact a dividend and the overall income generated from a portfolio. We'll get back to diversification a bit later.

Jayamanne: Single company risk isn't the only thing that a dividend investor faces. The other issue that can arise is if something happens to the economy that impacts many companies. COVID was an outlier, but also a cautionary tale. A quarter of Australian companies cut or deferred dividends during 2020. More dividends were cut in Australia than globally, which shows the risk of a high payout rate.

LaMonica: And one way to ride out the volatility of dividends is to hold cash. When dividend income falls, the cash could be used to make up for the shortfall. If dividend income increases, a portion of the increase could be used to replenish the cash reserve.

Jayamanne: So, holding cash can smooth out changes in dividend income and provide more predictability for a retiree. This is an income investing equivalent to a bucket method of investing for income. The cash bucket is replenished if dividends increase substantially. The cash bucket is used to smooth out falls in income.

LaMonica: And hold more cash and it provides more safety if there are years of dividend cuts. And the nice thing about cash now is that you can still earn income off of it simply by holding it in a savings account or a term deposit. And this was certainly not the case during the years of low interest rates. But cash still provided safety back then.

Jayamanne: The next issue we're going to look at is the need for dividends to grow in line with inflation. One little appreciated aspect of the 4% rule is that it only governs how much money is withdrawn during the first year of retirement. After that, a retiree would increase the dollar amount of withdrawals by the rate of inflation. This guarantees a steady, real standard of living, something that has hit home recently as inflation has surged.

LaMonica: And to keep up with inflation over a multi-decade retirement requires income growth. This is another concern with Australian dividend paying shares. The average dividend growth per share in Australia has been 3.70% a year over the last 10 years. The S&P 500 has grown average dividends per share by 7.82% a year over that same time period. Australian dividend growth has outpaced the RBA target for inflation, but it has fallen short in the current inflationary environment.

Jayamanne: And the lower growth can be at least partially attributed to the higher payout ratio in Australia. Higher payout ratios mean that companies have less wiggle room to grow dividends without earnings growth. It also means that there is less money left over for a company to invest in earnings growth, which is a long-term driver of dividend growth.

LaMonica: But of course, the news is not all bad. Official inflation represents the increase in prices for a basket of goods that's supposed to represent what an average person in Australia consumes. That does not necessarily correspond with the spending of each individual. For example, in 2022, the portion of the CPI basket that is allocated to housing costs increased by 9%.

Jayamanne: Unsurprisingly, housing costs make up a big part of the CPI basket at close to 25%. If a retiree has a fully paid off house, this would not be a consideration. That is why an examination of personal inflation rates is worthwhile to understand future spending needs.

LaMonica: And once again, we can try to address this through the types of portfolios we build. We can design a portfolio that is diversified between companies that pay high dividends now and have high payout ratios and companies that may have lower dividends but better prospects for earnings growth and future dividend growth.

Jayamanne: This may include an allocation to global dividend payers, despite the lack of franking credits. Balancing dividend growth and high current yields creates a more balanced income portfolio. This of course makes it harder to hit the income number needed to support day-to-day life, since many of these shares with high growth potential have lower current dividends. Or they may exist overseas where there is no benefit from franking credits.

LaMonica: And simply put, it means you need more money to retire initially, but it puts you in a better position for a multi-decade retirement.

Jayamanne: The last issue we're going to look at with the Australian market is a lack of diversity, and we've discussed this many times on investing compass.

LaMonica: As we mentioned early, diversification is a strategy to limit single security risk. In the context of an income portfolio, this would lower the risk from dividend cuts from a single company. Purchasing each of the big four banks would lower the single security risk of an issue related to only one of the banks.

Jayamanne: But this is only one aspect of diversification. Each of the big four banks has a similar business model. Non-company specific factors are likely to impact all of the banks, and the ASX 200 is very concentrated.

LaMonica: So, as we said earlier, the ASX 200 currently has a market capitalization weighted dividend yield of around 5.18%. And market cap of course refers to the size of the company as measured by the total shares outstanding multiplied by the share price. So, it's really just the value of a company.

Jayamanne: And market capitalization is the weighting that is used in many indexes, including the ASX 200. Big companies make up more of the index. This can lead to concentration in specific companies and sectors.

LaMonica: And the dividend yield is a backward-looking metric. It is based on dividends that have been paid over the past 12 months. For current shareholders, the dividends that are paid in the future is what matters and of course may vary.

Jayamanne: We looked at the yields that is attributed to each sector, a grouping of similar companies. We looked at how much of the overall dividend yield of the ASX 200 that is attributed to each sector and the percentage of the total ASX 200 yield that has come from that sector.

LaMonica: Unsurprisingly for an investor that buys the index just under 34% of the total dividend yield of the ASX comes from the basic material sector and that's basically just miners.

Jayamanne: And just over 30% comes from financial services with another 11% coming from energy. So that is around 75% of the ASX 200's income coming from three sectors.

LaMonica: So, in other words, you better hope that miners, banks and energy companies do well. And there's a lot of single security risk baked in as well. Ten companies in the index pay out 60% of the overall ASX 200 income. BHP just by itself pays out around 17% of the total index income. Another 8% comes from CBA.

Jayamanne: In summary, this is a strategy that can work, but we suggest that investors do a couple of things to increase the likelihood of a good result over a multi-decade retirement.

LaMonica: The first is to hold cash that can smooth out year-to-year fluctuations in dividend income and act as a safety net for investors.

Jayamanne: The second is diversify. Diversify the single securities and sectors that provide your income. But also diversify by country and between shares that are more likely to grow their income versus those with high current dividends. This may mean that you need a larger portfolio to support retirement, but it builds in more safety.

LaMonica: If you're an ETF investor, you can do this by considering an equal weighted index for the ASX where the current yield may be lower, but there is more diversity away from those giants of the ASX like BHP and CBA. Means looking at global indexes, which may mean buying dividend indexes in global markets, where the yield is a little higher than the overall indexes, but where you can still get exposure to sectors that are not heavily represented in Australia.

So, there we go, Shani. You can retire on dividends. And what do you think on a scale of 1 to 10, Shani, our energy level on that podcast?

Jayamanne: I thought it was pretty good.

LaMonica: I thought it was pretty good too. So anyway, thank you guys very much for listening. Really appreciate it. And we, of course, would love any questions you want to send through to my email address, which is in the show notes.


(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)