Living off dividends, cap gains and interest

[Another Reader]

I own mutual funds, including broad market funds, that include growth stocks. I just don't plan on selling those to produce income. I might sell and reallocate the capital at some point, but I'm not going to sell without putting the principal back to work somewhere else.

I operate a "business" with a decent ROIC and favorable taxation - rental properties. I have sold equities to buy real estate when it made sense to make that trade. I have sold houses when the rates of return dropped so low that it made more sense to sell the property and pay off other high rate mortgage debt. The frictional losses were made up for by the superior returns in both cases. I do not sell houses or stocks to eat or pay the bills.

I am forced to liquidate an inherited IRA. This galls me no end. Fortunately, I am able to pay more off in mortgage principal and invest more in paper assets every month than the government forces me to take out.

 

[Texas Proud]

"Investopedia defines it thus:

Original Investment
Principal is also used to refer to the original amount of investment, separate from any earnings accrued. Assume you deposit $5,000 into an interest-bearing savings account, for example. At the end of 10 years, your account balance has grown to $6,500. The $5,000 you initially deposited is your principal, while the remaining $1,500 is attributed to earnings."

And if you buy a $6,500 CD at that point, that's your new principal.

The only flaw in this is that you have the definition of "Original" investment principal...


When you have a trust, cap gains is usually allocated to a principal account... there can be a separate beneficiary for the income and for the principal... so the accounting for these items are critical...

 

[Another Reader]

OK, it's your new "original" principal for the next investment period. If you spend $500 and buy a $6,000 CD your new principal is $6,000. Any reinvestment becomes principal.

Trusts have a specific purpose and the accounting follows that.

 

[JohnT]

My view of mutual fund cap gain distributions: Since they are taxable, and I can choose where to invest (that is, I do not have to reinvest), I consider them as increase in my cash - to be allocated according to my needs. Some may be reinvested.

As for me, I am trying to increase my cash to cover 2-3 years net expenses (target is $250K). I am ER starting last year, and am closely focusing on my cash position. I see the market as frothy right now, so time to take some cream off the top. A robust cash position is critical to weather the upcoming downturn.

I agree you can think of these cap gains as part of your principal, as they decrease the NAV by the same amount - every December. But dividends also behave this way somewhat, with a usual (small) dip when a stock goes ex-dividend every quarter.

 

[HFWR]

For the purpose of this discussion, I'd define principal as the amount of assets one has/had at FIRE.

 

[pb4uski]

...If it's just a dollar amount that seems wrong too. - I've actually paid for my DS's entire college education from $3,000 of AAPL stock I bought in the 90's. BUT SINCE I HAVE MORE THAN $3,000 LEFT IN THAT ACCOUNT, "I NEVER TOUCHED THE PRINCIPAL!" Nope.

So my take is that it's a pretty plastic term that can be used to support a wide variety of behaviors. i.e. not particularly useful.

No, I think what you described is exactly right... principal is what you put in... to the extent that the value exceeds what you put in then your principal is still intact... any value over principal (original investment) is either income reinvested or unrealized appreciation.

While it is a little easier to see in a bank account or fixed income investment, the principle is the same. (pun intended)

And it become really hard to track as you trade from one stock or fund to another.

 

[robertf57]

I find this discussion a bit silly. In my mind, money is money. Entirely fungible. $5 spent from dividends buys the same cup of coffee that $5 from capital gains buys. The only real difference is what it costs you to get the $5 (how it is taxed/sales charges). If it comes from your pre-tax retirement accounts, it is ENTIRELY a distinction without a difference. If you receive a distribution of CG, interest, or Div in a post tax account, the tax obligation is already set and what is left is just money in your account. The "Benjamin'" have no idea where they came from.

The discourse in this thread, in my mind, really translates into a discussion of several variable withdrawal rules (I'll spend only dividends or dividends + 1/2 cap gains....) and a hidden asset allocation decision ( If you have chosen to target dividend paying stocks). These should be eminently evaluable in back testing models and the approach is common enough that I an certain someone has already examined it well.

 

[Ronnieboy]

What I always have trouble understanding is that people save for retirement but then fear using principal.... that is what you saved the money for... to spend it in your retirement! IMO if you can live on just income then you probably worked too long and will have wealthy heirs.

+1

This falls into the "How long will I live" category. If I knew the date of mine and DW death, I'd know exactly how much we'd need to save and not worry about over saving.


Sent from my iPad using Early Retirement Forum

 

[Montecfo]

I find this discussion a bit silly. In my mind, money is money. Entirely fungible. $5 spent from dividends buys the same cup of coffee that $5 from capital gains buys. The only real difference is what it costs you to get the $5 (how it is taxed/sales charges). If it comes from your pre-tax retirement accounts, it is ENTIRELY a distinction without a difference. If you receive a distribution of CG, interest, or Div in a post tax account, the tax obligation is already set and what is left is just money in your account. The "Benjamin'" have no idea where they came from.

The discourse in this thread, in my mind, really translates into a discussion of several variable withdrawal rules (I'll spend only dividends or dividends + 1/2 cap gains....) and a hidden asset allocation decision ( If you have chosen to target dividend paying stocks). These should be eminently evaluable in back testing models and the approach is common enough that I an certain someone has already examined it well.

I tend to agree with you. You or I could be "living off the dividends" while capital value has declined below the original investment, reducing principal. What is important, I think is that you have a withdrawal rate and that rate is "safe" in the context of history and your plans.

What is also meaningful is the amount if cushion you have between your SWR and what you are actually drawing.

That's not to say that you or I might not receive psychological benefits from "living off the dividends".

Good Investing!

 

[eta2020]

I tend to agree with you. You or I could be "living off the dividends" while capital value has declined below the original investment, reducing principal. What is important, I think is that you have a withdrawal rate and that rate is "safe" in the context of history and your plans.

What is also meaningful is the amount if cushion you have between your SWR and what you are actually drawing.

That's not to say that you or I might not receive psychological benefits from "living off the dividends".

Good Investing!

Yea but living of the dividends only means safest SWR that there is.

Spending Capital gains means spending principal that generates dividends. It is fine to spend principal but certainly not as safe as living of off dividends only.

 

[mpeirce]

No, I think what you described is exactly right... principal is what you put in... to the extent that the value exceeds what you put in then your principal is still intact... any value over principal (original investment) is either income reinvested or unrealized appreciation.

Or is this simply the basis (as in capital gains tax basis)? Regardless, to my thinking its pretty irrelevant. We've invested and accumulated assets over our lifetimes. And though it forms the foundation of our wealth, it's totally unimportant for figuring our current spending plans.

Which, I suppose, is why I'm a total return investor. I look at the sum total of our assets and our future behavior is based on that.

 

[Danmar]

I can't stop myself from looking at total return and percentage payout from earnings once in a while, but that does not generate immediate action, just things to watch for an adjustment to mix.

Yes, I do this regularly. Also unlikely to cause action as my imbedded cap gains are very high. Quite expensive to re balance names although, I have done so occasionally.

 

[Danmar]

Canada is in the same low interest "punish the savers" environment as the US, it would be somewhat surprising if Canadian investors weren't also seeking higher dividend stocks--and maybe bidding them up considerably.

Yes, agree. CDN Bank stocks are the cornerstone of my portfolio. They have very conservative pay out ratios (generally 40-50%) but still yield over 4% in most cases. P/e's in the 10-11X range so doesn't look like they are bid up at this stage.

I think the key is to look at their underlying businesses. As long as these are strong and growing, divs are safe and should also grow. The risk is that many investors fixate on divs without understanding the underlying business. Managements can sometime ps take advantage of this and artificially boost divs.

 

[Danmar]

Since we are discussing the "never touch the principal" concept, could someone please define what constitutes "the principal"? I've never been clear on this. At what point in time is "the principal" defined?

omni

Save
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I take a classic conservative view on this. Ie selling any shares is "touching the principal" for me. Spending divs is not. There are lots of ways to define this but I think mine is the simplest and most conservative. My fear( probably not rational) is that I start selling shares, divs would thus decline, and I have to sell more shares to maintain my lifestyle-creating a downward spiral of continually increasing capital encroachment.

Also agree with the sentiment that spending divs is really just one variable withdrawal method. Divs are not guaranteed and a retiree has to be prepared to cut back if his divs are cut.

However, by focusing on div growers (as long as earnings also grow) you tend to pick low volatility, high quality companies. I have only had one immaterial div cut in 10 years of retirement (insurance co). My divs have grown by about 80% in 10 years. Portfolio would be up by about 65% in comparable terms.

 

[timemoveson]

I tend to agree with you. You or I could be "living off the dividends" while capital value has declined below the original investment, reducing principal. What is important, I think is that you have a withdrawal rate and that rate is "safe" in the context of history and your plans.

What is also meaningful is the amount if cushion you have between your SWR and what you are actually drawing.

That's not to say that you or I might not receive psychological benefits from "living off the dividends".

Good Investing!

Agree completely with this, spendable money is just that, no matter the source. We just happen to have enough to gear our machine to produce enough spendable money through dividends (and some fixed incomes), not through capital appreciation. There is massive psychic benefit to this. We will also take capital appreciation when it makes sense to re-balance the portfolio to harvest big winners that no longer yield at market levels, stocks that are no longer on strategy for some reason, or write off losses that do not appear recoverable. Tax considerations will play into this heavily.

The issue with a large portfolio is our long term objectives. Ours are to pay to support the rest of our lives in retirement at a selected standard of living level, but also sustain the portfolio across generations. It's a great problem to have but it required thought and a plan. After having created this situation from scratch in one generation, there is no chance we are going to let it be spent (unless that is exactly what we choose to do). We will certainly do everything we can to ensure it is not lost and in fact that it is much larger 10-20 years from now than it is today. We have too much respect for the work required to get here to allow this to just happen randomly.

 

[Montecfo]

Yea but living of the dividends only means safest SWR that there is.

Spending Capital gains means spending principal that generates dividends. It is fine to spend principal but certainly not as safe as living of off dividends only.

Actually, it depends on your total return.

And stocks which do not pay dividends I guess are ok to sell (following your logic)?

I can see that if you think of yourself as living off dividends you would not want to sell any stock. I just find that different than the concept of SWR's but also very consistent with leaving a boatload of money to heirs, which, as someone else pointed out, means you may have worked longer than you had to.

OTOH if you have a portfolio which generates a 5% total return on average, you can pull 3% from that pretty much forever, without regard to whether your divided yield is 2% or 4%. Doesn't matter.

Is this a matter of not "trusting" the SWR? I get that also. That is part of the psychological benefit I mentioned.

Good Investing!

 

[samclem]

I think the key is to look at their underlying businesses. As long as these are strong and growing, divs are safe and should also grow.

Agree with all of that, but I'd also want to avoid concentrations in particular industries/sectors. IIRC, banks/financials had good earnings in 2006, and a lot of dividend/value investors had heavy tilts in that direction. This turned out to be a problem when the bottom fell out in 2008 and these got hit particularly hard.

Investors who pick stocks to generate high/growing dividends are, often, effectively making sector "bets" (I suppose there can be arguments about whether it is a "bet" if the investor never intends to sell). But I think many are comforted by the "I'm not selling any shares" mantra and may lose sight of the fact that they aren't, in fact, behaving in a manner that best preserves/grows the value of their holdings--in the long or the short term.

 

[Danmar]

The issue with a large portfolio is our long term objectives. Ours are to pay to support the rest of our lives in retirement at a selected standard of living level, but also sustain the portfolio across generations. It's a great problem to have but it required thought and a plan. After having created this situation from scratch in one generation, there is no chance we are going to let it be spent (unless that is exactly what we choose to do). We will certainly do everything we can to ensure it is not lost and in fact that it is much larger 10-20 years from now than it is today. We have too much respect for the work required to get here to allow this to just happen randomly.

Well said. Exactly my view. Besides, spending it down even close to zero, requires knowing things that are unknowable ( life span and future health for 2 people). My current plan has a significant legacy for my daughter.

 

[Danmar]

Agree with all of that, but I'd also want to avoid concentrations in particular industries/sectors. IIRC, banks/financials had good earnings in 2006, and a lot of dividend/value investors had heavy tilts in that direction. This turned out to be a problem when the bottom fell out in 2008 and these got hit particularly hard.

Investors who pick stocks to generate high/growing dividends are, often, effectively making sector "bets" (I suppose there can be arguments about whether it is a "bet" if the investor never intends to sell). But I think many are comforted by the "I'm not selling any shares" mantra and may lose sight of the fact that they aren't, in fact, behaving in a manner that best preserves/grows the value of their holdings--in the long or the short term.

Can't argue with this. I have "made bets" all along. Most have and continue to work out. Agree, div investors tend to sacrifice some diversification especially in Canada.

 

[eta2020]

However, by focusing on div growers (as long as earnings also grow) you tend to pick low volatility, high quality companies. I have only had one immaterial div cut in 10 years of retirement (insurance co). My divs have grown by about 80% in 10 years. Portfolio would be up by about 65% in comparable terms.

You got it!

Examples are 2 ETFs: SCHD and VIG. VIG had no dividend drop during 2008-2009 crisis.

There is no sector bet in VIG and SCHD. It is more high quality dividend and earnings grower bet.

 

[kcowan]

I think when people try to "live on the dividends" there is a tendency to want to overreach for yield. That has been fine these last few years, but you are putting yourself in a risky position if rates ever start to rise again.

Yes I think that is where "moderation in all things" comes into play. Getting a 3-5% dividend is a reasonable goal. Then analyze the history of increases and the percentage payout of profits, along with profit history. This does limit the potential picks. And if that is not enough, then your SWR will dictate how much capital is needed, as you have pointed out.

Of course it may lead to spending down the principle during down years. That is the basic idea behind FIRECalc. That is where "living off the dividends" falls down. If dividend yield has grown from when you established your portfolio, total spending has to still reflect your SWR to remain sound. Otherwise you might spend the buffer that you need for the down years. IOW reinvest some of those dividends in the good years (like this one).

 

[GTFan]

What I always have trouble understanding is that people save for retirement but then fear using principal.... that is what you saved the money for... to spend it in your retirement! IMO if you can live on just income then you probably worked too long and will have wealthy heirs.

Yep, that's my problem with an income approach. You're sacrificing time for perceived safety, and there's risk with any approach so I'm really not sure what it buys you here other than a perception that you don't have to worry about principal. It usually means you will have to wait longer to retire vs. total return.

 

[fritz]

Agree completely with this, spendable money is just that, no matter the source. We just happen to have enough to gear our machine to produce enough spendable money through dividends (and some fixed incomes), not through capital appreciation. There is massive psychic benefit to this. We will also take capital appreciation when it makes sense to re-balance the portfolio to harvest big winners that no longer yield at market levels, stocks that are no longer on strategy for some reason, or write off losses that do not appear recoverable. Tax considerations will play into this heavily.

The issue with a large portfolio is our long term objectives. Ours are to pay to support the rest of our lives in retirement at a selected standard of living level, but also sustain the portfolio across generations. It's a great problem to have but it required thought and a plan. After having created this situation from scratch in one generation, there is no chance we are going to let it be spent (unless that is exactly what we choose to do). We will certainly do everything we can to ensure it is not lost and in fact that it is much larger 10-20 years from now than it is today. We have too much respect for the work required to get here to allow this to just happen randomly.

Well said. Exactly my view. Besides, spending it down even close to zero, requires knowing things that are unknowable ( life span and future health for 2 people). My current plan has a significant legacy for my daughter.

+1 Comes down to the size of your stash (size matters), and whether or not you have someone you'd like to leave it to. Retirement approach is as individual as one's fingerprints.

We've been very fortunate in life to have put away a sizeable retirement stash (unfortunately no pensions and don't care for annuities). We live very well off Social Security, and taxable account dividends (occasionally pulling long term capital gains to replenish cash). Will draw off IRAs for Roth conversions in a couple of years (ACA issues), and at 70.5 when RMDs have to be taken.

We retired early at 58/57 (seven years now). We still have a LBYMs lifestyle, but it's above the norm. We have friends who've also retired early and plan to spend their retirement investments down, as they have no children to leave it to (charity and a few nieces and nephews will get the remaining balance). Our plan is to live well, and leave a nice inheritance to our daughters who have learned the value of money and how to manage it properly from us. Our grandkids will benefit from our daughters' value/understanding of how to manage money.

 

[socca]

Robert Carlson describes the notion of living off dividends in retirement as antiquated in his excellent recent book The New Rules of Retirement. Perhaps those of us who can do this (or think/hope that we can) are among the fortunate considering the current economic climate.

 

[explanade]

I'm coming up on the end of my second year in ER.

I've been drawing down my cash account but thinking of stopping DRIP on some of the accounts. The AA hasn't changed a lot because the market has been down before the recent upswing. Most of my assets are in post-tax accounts.

I've increased my spending in ER but it's been less than 2% of assets -- well a few months back, when the market was down, it was just a bit over 2%.

But yeah, I heard the utilities sector has a high P/E because of people chasing dividend yields and there are no prospects for earnings expansion so the market is bound to correct.