The research on how best to generate retirement income has been evolving for decades.
In the 1950s and 1960s, the leading strategy was to buy bonds live off the interest. This prevailed until the high inflation of the 1970s ravaged the true value of bond interest. In the 1980s, retirees shifted to buying dividend-paying shares instead. They counted on the ability of businesses to raise prices and keep pace with inflation. In turn, the idea was this would help the income they pay to keep pace with inflation also.
Issues with focusing on income
This strategy was popular and retirees continue to use it today. But there are a few issues with it. Buying shares because the company pays a high dividend is not a good investment strategy.
If a business thinks cutting its dividend and reinvesting the money is a better plan, they can. Then, of course, there are external events that impact the payment of dividends. These remind us ‘safe’ dividend-paying firms are not safe at all. Companies paying unsustainable dividends usually cut them. Sometimes they even disappear altogether. This is what we are seeing now in the current coronavirus climate.
So why do retirees use this strategy? The most common reason is taking dividends “leaves the capital intact”. One of the best-kept secrets in finance is that this statement is 100% not true. Assets paying an income (e.g. when a stock pays a dividend) drop by the value of that dividend on the day they pay it out. People often do not realise this because the size of the individual drops is so small. You can find a good post about the disadvantages of relying on dividends here.
A better way
Those relying on dividend payments this year may need a different strategy. This is what happened in the 1990s with cutting edge retirement portfolio strategies. However, it was for a different reason.
Retirees found focusing on dividends led to large portfolio balances later on. This is money they could have spent along the way. Retirees looking to meet their spending needs should not focus on either income and capital growth. It is better to focus on total return, which incorporates both.
Although capital growth may be one of the largest drivers of total return, over time it can be the least stable. This forces the retiree to sometimes rely on the underlying invested capital as well. In the same way, unspent capital growth is a wasted spending opportunity, so is unspent capital. However, retirees should call on this prudently. This is because they will not know how long they have to rely on it.