Retirement Income Strategy: Dividend Stocks Explained and Pitfalls to Avoid

Troy Sharpe: You may not receive those really big checks that we have on the thumbnail for this video, but dividend investing in retirement can be a way to generate consistent, reliable income over time for you and your retirement. We see a lot of mistakes, though, with dividend investing, and also some common misunderstandings. This video, we’re going to cover the basics. We’re going to show you some examples of two different dividend strategies. We’re going to make sure you do have that deeper understanding of how to use dividend stocks as part of an overall retirement plan. At the end of this video, I’m going to show you what I believe is a powerful accumulation strategy using dividend stocks to potentially create tremendous wealth over long periods of time.

Understanding Dividends and Corporate Strategies

What exactly is a dividend, and why do corporations even pay dividends to begin with? A dividend is nothing more than a return of cash to you from the profits of that corporation’s operating business. Meaning the company does certain sales, it makes a profit margin, and it returns to you a portion of those profits for simply owning the stocks. A dividend is a cash payment.

Why do corporations pay dividends? When they make money, they have two choices. They can either take those profits and reinvest into people or other projects, expand globally, open new offices. That is typically what growth companies do. They don’t take their profits and give it back to you. They invest in new projects. Dividend-type companies, they’re more stable. They’re typically older, and there aren’t a ton of projects for them to invest in, at least relative to the amount of income that they’re making. They say, “You know what? The best use of this capital is to simply reward those people who have invested in us and return a portion of these profits to you.” Typically, dividend companies are more stable, they’re profitable, they’ve been around for a very long time, and they’re not looking to reinvest all of those profits into a ton of projects to grow exponentially.

Dividend payments are determined by a corporation’s board of directors. They have their quarterly meeting. They get together, and they decide how much dividend payment they’re going to pay out, if they’re going to increase it, if they’re going to cut it. They make the decision about dividends. They’re typically paid quarterly. Some real estate investment trusts or oil and gas limited partnerships will pay monthly dividends, and some others as well.

Companies that do have growing profits are typically more stable and more likely to continue to pay those dividends. This is an important part of the analysis. You want to make sure you know that dividends are not guaranteed. As I said, they’re determined by the board of directors. Any type of dividend strategy is not something you want to be moving in and out of. They are a long-term strategy. You want to allow the power of compound interest and compounding dividends to work for you over time.

Before I jump into some of the dividend strategies and also mistakes that people commonly make that we see, I want to make sure that this basic element of yield is understood. Yield is only important when you’re first making your investment into a dividend stock or a dividend fund. If we have $1 million and we’re about to invest and it’s paying a 3% yield, all that means is we’re going to receive $30,000 based on that initial yield. Again, it’s not guaranteed, but that’s what that means, $30,000.

This is where a lot of times people get confused. Six months later, the investment, let’s say it went down in value, now it’s worth $900,000, you’re still theoretically getting the $30,000 if the board of directors hasn’t made any changes. You’re still getting $30,000, but your yield has not changed. Your yield for new investors, so if someone was going to come along today as a new investor and take $900,000, buy that stock, receive $30,000, their yield would be 3.3%. You still invested $1 million. The fluctuation in the value typically does not affect the dividend payout at all, but it doesn’t affect your yield. Because you paid $1 million, you’re getting $30,000. The prices went down, but you’re not now earning 3.3%, you’re still earning 3% on your money.

Conversely, if the investment increases in value, now it’s up to $1.2 million, you’re still getting that $30,000. A new investor who’s coming aboard today, they’re going to invest $1.2 million, get $30,000, their yield is 2.5%. What I want you to do when we’re talking about dividend investing is think about the dollars. Forget about the percent. The only way that the percent is important in the beginning is when you’re determining how much income you’ll generate. That’s the only purpose for looking at a dividend yield. Once you’ve made your investment, the only thing that matters is the amount of dollars that you’re receiving.

Types of Dividend Stocks and Their Performance

Now I want to look at three different possible outcomes from companies that are known to be dividend stocks. First, you may just have a company that has a long history of paying stable dividends. This is what they’ve done. This is what we can continue to expect. The dividend’s fairly stable. We may get some increases there, but stale dividend.

Next, you have a company whose dividend payments may fluctuate based on the profitability of that entity. $30,000, $22,000, $28,000, $30,000 over a four-year period. Then we have what are known as dividend growth stocks. These are companies that have a long history of not just paying a dividend every single year, but also increasing the amount of dividend payment that they make. There are classifications for different types of dividend growth stocks, as we see in Example C here. Dividend Kings are companies that have paid and increased their dividend every single year for 50 years. We have Dividend Aristocrats, which are members of the S&P 500 that have paid and increased their dividend for 25 years or more. You have Dividend Achievers that are companies that have paid and increased their dividend for at least 10 years.

If you’re in retirement or approaching retirement, which one of these dividend strategies would you like to be part of your portfolio? Generally speaking, when we’re approaching retirement or in retirement, we would prefer to have a more stable dividend history and expectation, or an increasing dividend payment history. I personally prefer the increasing dividend payment history, but there are some pros and cons to all of the different strategies here, but some big mistakes that often are made, and I want to show you that right now.

Common Mistakes in Dividend Investing

Two of some of the primary strategies that we see people using dividend stocks for in retirement are either a high-income or a high-yielding dividend income strategy, or an increasing income strategy. We see people make mistakes with a high-income strategy all the time. High-income dividend stocks aren’t necessarily bad, but there are some significant risks that go along with investing in companies that pay 6%, 7%, 8%, 9%, 10%. I want to make sure you understand why those could be very dangerous for your retirement.

Here at Oak Harvest, we literally analyze thousands of held-away portfolios each year. When a prospective client reaches out to us, our analyst team, they dig into the existing portfolio to understand if there’s income being generated, what the risk is, how the investments correlate, we’re trying to understand how people are currently invested so we can determine if we can add value.

One of the investments that we see all the time is Alerian MLP, so it’s a master limited partnership. The ticker is AMLP. Very important here, I am not recommending any security that I’m going to discuss here. We’re not endorsing them, we’re not saying you should go buy them. We’re simply using them as an example for educational purposes to help you understand what some of the risks are, and also to differentiate between the types of companies that pay dividends. Just like there are multiple different cars out there, a Honda is not the same as a Lamborghini. Different types of dividend stocks. They’re not all created equally. One of the mistakes that we often see are prospective clients who are highly concentrated into very high-income portfolios. It may be 1 or 2 investments, it may be 10 or 20, maybe 50 or 60. The goal, what they’re trying to accomplish, typically, is right here, this yield. This is a 7.5% yield. What does that mean?

Go back to the beginning of the video. If we invested a million dollars, it’s going to generate $75,000, 7.5% of income. Some of you may be saying, “Hey, that’s great. I would love to get 7.5% on my principal. I could live off the interest, I wouldn’t have to worry about much.” There’s more to the story here. When we look at AMLP, over the past five years, compared to the S&P 500, it’s actually down 11.7%. Meanwhile, the overall market is up 78%. Again, some of you may be saying, “Well, Troy, that’s not a big deal because I’ve been collecting 7.5% that entire time. My principal’s down 10. Yes, I don’t really care. It should come back over time.” Maybe you should be a little concerned because when we dig a little bit deeper and we see the dividend payout history or the dividend payment history from November 14th, 2023, going back to 2019 here. 2019, it was paying $0.97 a share, $0.95, $0.97, $0.75 cents, $0.75, $0.68, $0.77, $0.86, $0.83, $0.88.

As you can see, if you remember back to our example here, different types of stocks have different payment histories. That one is required to pay out a certain percentage of its profits. When profits are up or down, that dividend payment is going to change. That’s an oil and gas midstream ETF. Essentially, it focuses on companies that are in the oil and gas industry in the midstream space.

Risk Management in Dividend Investing

What happens when oil prices drop significantly? You would expect those revenues and profits for that particular ETF, the companies that comprise it, to decrease. Therefore, the earnings decrease. Therefore, the dividend payment decreases. That’s one risk, is an uncertain payout and one that fluctuates and you can’t really rely on in retirement.

The second big risk when it comes to these type of investments is inflation. There’s also interest rate risk, but I’m going to focus on inflation because we just went through a period of inflation.

If we were receiving that $75,000 of income and inflation averaged let’s say 5% a year over a five-year period, we discount that to the present value if we had purchased this five years ago. Assuming it had paid a stable $75,000 dividend, the purchasing power today, only five years later, is now $58,000. You’re still receiving that $78,000 payment, your principal has gone down about 11%, but the purchasing power, because of inflation, has eroded. In today’s value, today’s dollars, you can only purchase $58,000 worth of goods and services. You have inflation risk when you start to look at these high income stocks.

That first strategy is the high income, and as a general rule of thumb with high income strategies, you really shouldn’t expect the principle of those investments to grow too much over time. As we see with this one, Alerian, not only has the principle not grown, it’s actually lost a tremendous amount of value over the past 13 or 14 years.

Here on Yahoo Finance, I simply opened the chart up to max, it went up to 2011, and it shows it’s actually lost 42%, meanwhile the S&P 500 is up over 300% in that same time frame. One of the mistakes again that we often see is people piling into high income instruments because in the present, it provides a large interest yield off that portfolio, but when we create visibility into the future of what that may look like down the road and some of the risks such as inflation, we see that it may not be the best idea to pile a large percentage of your overall nest egg into high yielding investments.

Benefits of Increasing Income Strategies

The second strategy that I want to focus on here is increasing income. This is something that I’m a fan of because you have companies that have a long track record of not just paying those dividends, but also increasing them. When you’ve done something for 10 years or 15 years and you create a certain status within the dividend community, companies typically are going to do whatever they can to maintain that status. Again, not guaranteed, anything can happen, but it does create some stability around the expectation of not just a continued dividend payment, but a continued increasing dividend payment.

One company that we’re going to highlight here, again, we’re not recommending anything, but Pepsi is a really good example because when we’re building these portfolios, what we want to look for are companies that aren’t paying 6%, 7%, 8% dividends. I just went through why that may not be the wisest strategy when it comes to long-term dividend investing. We want to find companies that do pay a consistent dividend, something we can rely upon, an increasing dividend history so we can have increasing income to keep up with inflation, possibly surpass it, but also we want to see capital appreciation. We want your principal to increase in value.

When we look at Pepsi here, Pepsi has, according to Yahoo, a Dividend yield, a $5 dividend payment. Again, $5 per share, but that yield is 2.97%. If we invested a million dollars, let’s call it 3%, you’re going to get about a $30,000 dividend.

When we look at Pepsi versus the S&P 500, this is the five-year chart here. I know some of the colors may not be coming through perfectly on your screen. It’s very difficult for us to get these to accurately display because we don’t understand your resolution and your monitors, and we do get some comments about that. The S&P 500, over the past five years, is up about 78% according to Yahoo. Meanwhile, Pepsi is up about 45%.

Dividend stocks, as a general rule of thumb, won’t keep up with a rising market when things are going really, really, really well. They also shouldn’t lose as much money typically in a down market. They’re just more stable companies because they’re more mature.

We extrapolate this or we condense it to a two-year time frame, the S&P is up about 12%, Pepsi is basically flat. Again, dividends are long-term strategies. When we look at the five-year growth rate of Pepsi, so they’ve increased their dividend payment according to Google here 6.90% per year. Yes, you’re getting a more moderate dividend payment of 3%. Off a million, that’s $30,000. That $30,000, if we had invested it in Pepsi five years ago, our income would have increased an average of about 6.90% per year. That is an increasing income stream.

Additionally, we have some fairly modest capital appreciation. I think most people out there would probably like to earn 44% on an investment over a five-year period, according to the charts here, while also receiving an increasing income. Is something like Pepsi lighting the world on fire? No, it’s not going to keep up typically with the S&P 500 in a big bull market.

Incorporating Dividend Stocks into Retirement Planning

Again, we have specific purposes for the tools that we use inside a retirement plan. If you’re going to use a dividend strategy, you have to keep that in mind. You can’t be comparing, or you shouldn’t be comparing, the performance of your dividend portfolio to the performance of the overall market. It’s just not conducive to staying committed to any long-term strategy because you’re going to have a diversion of outcomes there. Pepsi could be doing tremendously well, could have a bright future, but investors are more interested in NVIDIA, and Microsoft, and Apple, and Amazon today than they are companies like Pepsi and Johnson & Johnson, et cetera.

I want to show you what that means in terms of real dollars now. If we had a $30,000 dividend from Pepsi over a five-year period, they increased that payment 6.9% per year, today, you would be receiving $41,880 of income. That’s interest off your principal. Instead of having a dividend that maybe fluctuates in value or is stagnant, this is one of the reasons why I’m a big fan of increasing income stocks for retirement portfolios for a portion of it. We’re going to get into how we use them for planning in this next section. Increasing income is a good way to help combat inflation while also investing in companies that we expect to have capital appreciation. If you’re wondering, Pepsi is one of those rare dividend kings, a stock that has increased its dividend payment for more than 50 years. I just looked it up and it’s 52 consecutive years. Again, we’re not recommending Pepsi, but it’s a really good example of a company that has increased its dividend payment over long periods of time.

Using dividend stocks as part of your retirement, it incorporates two components of the retirement success plan, step one and step two. Step one is the allocation. Step two is income planning. The allocation, what we’re trying to do is to identify the proper mix of financial tools across various accounts to generate income over various time frames within a risk tolerance that you’re comfortable with, something that you can stay committed to. We’re really trying to identify balance. One of the easiest ways to think about it is a recipe. You want to have some sweets and some heat and some acid. You want to have enough salt. You want to have all these different ingredients. The flavor, so it’s balanced out.

Same thing in retirement. Anyone can put together a whole bunch of retirement tools or financial tools, but how’s the balance? Is that dish going to be tasty or too much salt, not enough acid, whatever it might be? Step one, the allocation, is all about you. It’s customizing it around who you are, what your needs are, time frames, et cetera.

Just a quick example here, something very, very fundamental and basic. When we’re looking at dividend stocks, we want to balance it, of course, across the risk and time frames. Something like this, when we want to live off the interest of our principal, we’re looking at Social Security. Then we’re looking at how much income can be generated off the dividend portfolio. Also, how much can we expect that income to reasonably increase over time? If we have $1 million and someone has a retirement spending goal of $65,000, well, we know if Social Security is providing 50, if we’re getting 3% from this dividend portfolio, we can place $500,000 there. Now we’re living off the interest. This portfolio over here, maybe we can be a bit more aggressive with it because Social Security is an increasing income. This is an increasing dividend strategy. We can expect those over time, reasonably expect them to increase annually, the payments we receive. Hopefully we don’t have to touch this portfolio for a very long time. Maybe we can be 75-25 growth stocks over here. Maybe it’s 60-40. Maybe it’s 25-75. Maybe it’s 100% stocks, depending on your willingness to stay committed to the strategy and withstand volatility in the markets. All that can be customized.

Long-Term Accumulation Strategies with Dividend Reinvestment

Just at a very, very high level, I wanted to talk about what you should be thinking about when allocating your money across dividend stocks. Maybe you put all of the million dollars into dividend stocks because that’s going to give you more income than you actually need, and you feel comfortable with that. Of course, the third step is tax planning, which I’m not going to get into in this video, but I do have a lot of videos here on YouTube where I talk about dividend taxation. I just want to, at a high level, talk about this balance.

One question that you may have is, should I use IRAs, or should I use my Roth IRA, or should I use non-qualifieds or non-retirement accounts? Too deep for this video, but that is part of the overall allocation. That incorporates more of step three, the tax planning, because dividends inside your retirement account, if you make withdrawals, you’re going to pay income taxes. Whereas if you keep them in your non-IRA accounts, you typically are going to pay the preferential dividend tax rate, which is the same as long-term capital gains, 15%. It could be 18.8%, it could be 20%, it could be 23.8%, depending on your income level, but most people are going to pay 15%.

For a dividend to be considered qualified, one important concept here. You have a 121-day window from what’s known as the ex-dividend date. The ex-dividend date is the date that you must own the stock in order to receive the dividend. 60 days prior, 60 days after, you have to own that stock. You have to hold it in your portfolio for a 61-day period out of that 121-day window, 60 prior, 60 post from the ex-dividend date. If you meet that qualification, you then pay the preferential tax on dividend stocks. I said I wasn’t going to get into it, but that is something I think that’s important. If you own stocks for a long time, held in America, American corporations, you’re not buying and selling, most of your stocks eventually will become qualified dividends, and you’ll pay 15% long-term cap gains if your income is below certain high levels, certain thresholds, they’re pretty high, but I encourage you to check those out.

One last thing here before I get into the bonus, what I consider to be a very powerful accumulation strategy using dividend stocks. You just see how this can be tailored. Maybe it’s $700,000 here, $300,000 here. This is just using two financial tools, growth stocks and dividend stocks. Maybe we incorporate other tools from what we call the core four, or other investment tools that are out there. When we do talk about the allocation, we talk about income planning, we talk about tax planning, this is what we’re doing. We’re trying to create this balance across the amount of money you have in IRAs, non-qualified accounts, the financial tools that we can use, your willingness to take risk and stay committed to a plan in down markets, what we call your portfolio’s capacity for risk. It’s ability to generate income relative to the overall balance. If you have very high income needs, and let’s say 5%, and you need to pull that out every single year, you have a lower capacity for risk because you could fall victim to what’s known as sequence of returns risk. Just want to point out that this is what we mean when we talk about the retirement success plan and really balancing out the allocation, the income plan, and also the tax strategy.

As I said before, dividend investing is a long-term strategy, primarily used to generate income for you to use in retirement. One thing that we can do with dividends, though, if we don’t need the income, is reinvest those dividends, buy more shares, which then increases the total amount of shares that we have, increases the dividend payment, theoretically.

Here I have an example. If we own 10,000 shares, it’s priced at $100 per share, that value is $1 million. Simply multiply the 100 times 10,000, we get $1 million. This is all hypothetical, but I want to convey this concept because over time, if committed to and done right, is a very, very powerful accumulation strategy, which then, once you get to retirement, you simply turn the spigot on and no longer reinvest those shares. Now you start taking the income. What’s cool about this that I like so much, dividend stocks are generally less volatile than the overall market. They are typically paid from more stable companies. If the price of the stock goes down while you’re reinvesting your dividends, the strategy actually works better. If the stock stays the same price, the strategy works well also. Even if it goes up, it still works well. The more capital appreciation you have in the price per share, the less powerful the strategy becomes. You’ll see what I mean in a minute. It’s a way to mitigate market volatility, extended down periods in the market, and not only mitigate that impact, but actually use it to your advantage. Again, you have to stay committed to the strategy, and you have to have a long period of time to be investing and to employ this.

Conclusion and Final Thoughts on Dividend Investing

We’re looking at the number of shares, price per share, to get a value. Remember I told you don’t look at percentages. Let’s look at the dollars. This is why. $3 per share. If we have 10,000 shares, we do that math, 3 times 10,000 is $30,000. Let’s say that company has a 5% historical dividend growth rate, or we expect the dividend to increase 5% per year. We take that $30,000. We reinvest at $100 per share. The price of stock does not change. We now have 10,300 shares. $1.03 million. The values went up $30,000 because all we did was we took that $30,000 of dividends and reinvested it, bought more shares. The price per share did not change. The increase in value comes from owning more shares.

Remember, it grew 5% in this example. Our dividend is not $3 per share. It’s now $3.15 per share. We have 300 more shares. Not only do we have more shares, we have a higher dividend. Now our income payment is $32,445. Board of Directors gets together in this hypothetical example, increases the dividend another 5%. Now we have 10,624 shares because we took last year’s income. We reinvested it. The price didn’t change. Now our total value is $1.062 million. Dividend increased because the Board of Directors got together. Now it’s paying $3.31 per share, which equates to $35,165 of income.

Board of Directors increases the dividend payment one more time. Extrapolate this down over several years. The name of this game is to accumulate more shares. If the stock price goes down, well, the dividends that we’re taking, we’re able to reinvest, and because prices are depressed in this example, you’re able to buy more shares. More shares equals more dividends.

Just extrapolating down here to show you the power of this over time, let’s say we grow to 15,000 shares. The price still hasn’t changed. Let’s say it’s 10, 15 years later. Now the value is $1.5 million. You started with a million, the price of the stock never changed, but now the value’s at $1.5 million simply from reinvesting.

Dividend, grown to, let’s just say this is an example, I’m just writing it down for illustrative purposes. $5 per share at 15,000 shares, now our income is at $75,000. Reinvesting dividends cannot only increase the value of your investment over time because you’re accumulating more shares, you also can position yourself to have a very strong level of income whenever you do retire, don’t need to reinvest anymore, and you want to start to turn that income on. That’s just a simple click of the button changing from reinvesting dividends to receiving dividends.


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