Want to boost your income from a portfolio? Consider these strategies.
The stock market yields 1.9%, which means that a $1 million pot delivers an annual payout of only $19,000. It’s hard to live on that. Let’s look at four ways to get more.
I’m going to call these yield-extracting techniques Greedy Algorithm, Lazy Boy, Buyback Bonus and Growth Capture. Each has plusses and minuses. I like the last one.
This strategy has you buying whatever stocks have the fattest dividends. You’re likely to wind up with a bunch of oil companies, utilities and banks. Examples: petroleum vendors Statoil and Total, phone companies Verizon and Vodafone, financiers Commonwealth Bank of Australia and HSBC.
If you can stand low-growth outfits like those, it’s not too hard to get better than double the market’s yield. Here’s my shopping list:
Do understand, though, that you take risks when you reach for yield. Total might slash that tempting dividend, Target could be run out of business by Amazon, the cell carriers could get into a price war. Limit your risk by owning a large collection of these stocks.
What if you bought the whole lot? Could you safely spend the resulting 4.4% yield? Maybe.
You can hope that dividend growth from the good companies makes up for both inflation and the inevitable disappointments from the bad companies. But that’s only a hope. You really can’t count on keeping up with the cost of living when you live on shaky dividends.
Instead of constructing your own portfolio, get a mutual fund or exchange-traded fund to do the work. Advantages: Simplicity and diversification. One trade delivers the goods, and you’ll be less concentrated in fossil fuels and utilities.
There are two drawbacks. One is that the yield is going to be more modest, a bit shy of 3%. The other is that the fund is going to hit you up for an annual management fee–$700 a year per $1 million invested if you pay attention to expense ratios, and easily ten times that if you don’t.
My recommendations among low-cost ETFs: Schwab U.S. Dividend Equity (SCHD, 0.07% in annual expenses) and Vanguard High Dividend Yield (VYM, 0.08%). Top holdings include Exxon Mobil, Microsoft and Pfizer. Payouts from these blue chips are pretty safe. They have a high probability of keeping up with inflation.
In short, Lazy Boy is more conservative than Greedy Algorithm. You don’t live as well (at least in the early years), but you can sleep better.
Dividends aren’t the only way for corporations to disburse cash. They can also buy in shares. They are doing this on a large scale, and bulls make much of the resulting “buyback yield.”
Example: A company with a $100 share price has $5 a share of loose cash after spending whatever it needs to in order to keep the business going. It pays a $2 dividend and then buys in 3% of its shares. You could make a case for selling 3% of your holding, living on the sales proceeds along with the quarterly dividends. In a Wall Street Journal article (subscription required), financial planner Allan Roth makes the case for drawing down 5% annually from a stock portfolio.
The bulls take courage from Standard & Poor’s statistician Howard Silverblatt. In this report he displays a total “yield” (dividends and buybacks combined) on the S&P 500 that has been consistently above 5% in recent years.
But I see hazards. Some of the buying in merely offsets the dilution from employee stock options, and thus is not a disbursement of free cash flow. Some is financed by debt, also bad for an investor aiming to get a sustainable yield.
The full picture of how much free cash corporate America generates for investors is, in fact, quite complicated. It would have to take into account not only the options and the debt but also the cash disbursed in mergers (as when Berkshire Hathaway buys a railroad) and the cash going the other way in share offerings (as when Facebook goes public).
So how much can investors safely spend? I don’t think you can discern a correct number from the S&P stats, but I am quite sure that it’s well short of 5%.
This strategy is the safest of the four. It has you selling off a few shares every year to finance your lifestyle, like the buyback fans of the previous section–but not nearly as many shares.
Start with the observation that corporate America, by reinvesting a significant chunk of its earnings, makes a collection of stocks into a growth portfolio. Over the past century, earnings on the S&P 500 have better than tripled in real terms. Our objective is to capture this growth, turning it into immediate consumption. Then the earning power of your portfolio would merely go sideways. But you could live better.
Could you perhaps use corporate earnings, not dividends, as a guide to your spendable income? Alas, the stock market is not prosperous enough for that behavior. To keep earnings per share up with inflation, corporations have to reinvest at least some of their earnings. They do this by buying existing businesses for cash (as Berkshire Hathaway does), investing in new activities (like Alphabet) or buying in shares (like AutoZone).
To find out how much reinvestment is needed to maintain EPS at a constant real level, I looked at the last century of S&P 500 earnings. It turns out that you can safely spend a bit more than three-fourths of corporate earnings on high living. You have to leave the rest behind as your seed corn.
If you own individual stocks, you’d play Growth Capture by setting your own personal dividend policy for each. With a nonpayer like Berkshire or AutoZone, you’d sell some shares every year as a do-it-yourself dividend. If you own Verizon or Total, which are a little too generous, you’d reinvest some of the dividend payouts in more shares in order to limit your spending to three-fourths of earnings.
The strategy is easier to follow in an index fund. Each share of the Vanguard S&P 500 exchange-traded fund (VOO, recently trading at $227) is now generating $5.75 a year of spendable corporate earnings. That’s $1.30 more than the expected dividend. If you are sitting on $1 million of this fund you could draw out $25,300 a year, $19,600 from dividends and the other $5,700 by selling shares.
For these calculations I’m using a ten-year trailing average of inflation-adjusted earnings, much as Robert Shiller does in his well-known price/earnings ratio. As earnings on the S&P index climb over time your spendable income per VOO share would climb, but your share count would go down. That would leave you treading water. There would be some fluctuation in your income, as corporate profits rise and fall, but over a long period you’d maintain your purchasing power.
That’s the theory. Now here’s the reality: Growth Capture only delivers a safe yield today of a bit more than 2.5%. This will be disappointing to someone who dreams of buyback yields or chases after high-paying utilities. But it’s the inevitable result of a very exuberant stock market.
Given where earnings are, the S&P 500 ought to be trading at maybe 1,600, not 2,500. If the index fell to 1,600, the safe draw from a stock portfolio would rise to almost 4%. But then you’re probably not hankering for a 900-point correction.
Perhaps you need to spend more than 2.5% a year of your equity assets, and perhaps you can afford to. If you’re already retired, your money has to last a few decades, not a century. So live a little. But do understand that you’d be eating into capital.
Originally published at Forbes