Tuesday, February 12, 2013

Passive Income Goals

A common goal for investors, particularly dividend investors, is to build savings to the point where they can replace their salary income with dividend income. I have this goal as well, although I’m happy to generate this income from a combination of dividends, capital gains and interest.

A critical factor in determining whether you’ve truly reached your goal is whether your capital is still expected to grow at least as fast as inflation after you take your income each year. Some investors say they don’t care about the amount of capital they have saved as long as they hit their income targets. This is fine if the capital isn’t shrinking, but could be a disaster if the capital can’t keep pace with inflation.

An investor with the wrong focus could hit an income target quite easily – just find a few stocks with ultra-high dividend yields. I did a simple screen of Canadian stocks that showed 21 stocks with dividend yields between 10% and 20%, with an average dividend yield of 14%. So, a $500,000 portfolio invested in these stocks would earn an income of $70,000 per year. Many people would be happy to retire permanently on this income. But the important question is whether the income will stay this high. High dividends are often unsustainable. If a company consistently pays out more in dividends than it earns in business profits, eventually it will have to cut its dividend, perhaps drastically.

The iShares Dividend Aristocrats ETF (ticker: CDZ) has a dividend yield just over 3%. On a $500,000 portfolio, this is just $15,000 per year. This income level is depressingly low compared to $70,000. But what is the point of the $70,000 income if it drops drastically in future years? You’re effectively spending your capital even if you own the same number of shares from year to year. With dividend aristocrats, at least there is a reasonable hope that the income will continue and even rise over time.

In my opinion, an even better strategy than investing in dividend aristocrats is to be more broadly diversified. This drops the dividend yield to a little over 2%, but the possibility of higher capital gains makes up the difference.

Dreaming of leaving a hated job is understandable, but reaching too far for yield is dangerous. Investors are better off focusing on the profitability of the businesses they own rather than the dividend yield. This is true whether you buy individual stocks or buy funds that hold many stocks. Not all income streams are sustainable.


  1. How do you apply your comments above to a stock like EMA (Emera) for example?
    You have a strong yield and you have this steady line of growth over the long term. I feel trying to seek out a stock which is a little of both is also a valid strategy.

    1. @Paul: I don't make any attempt to seek stocks that will outperform. I've decided I can't do it, and I think extremely few investors are capable of outperforming market averages over the long run. So, to me, all stocks have roughly the same expected return, and I use diversification to minimize risk. Viewed this way, all diversified portfolios of stocks have roughly the same total return characteristics. You're just choosing the mix of capital gains and dividends. Investors who believe they can choose superior stocks take a very different approach. Sadly, far too few of them actually check whether they are really beating stock indexes.

  2. Ah yes... I forgot that you index. I guess reading your article I missed your point.

    Any Dividend investor would have a few rules in place particulary about stocks with high yields. You would not pick a stock with a "maxxed out" unsustainable yield even close to 10-20%. It's an odd example.

    You could have also picked XDV with a still safe 4.12% yield as your etf. That would net you over $20 K/year and as companies increase their dividend over time you may get a benefit from that? Add that to your CPP/OAS maybe that's enough for some people and limit dipping into their principle? If you have to, you could sell some of of those shares like you would broad market etf's if you need a little more cash.

    Sorry I normally catch on to your post's and really like them, I must be missing something here with your examples today.

    Sometimes I just think if you have $500,000 available and you simply drop it into the BMO monthly income fund and get a payout of $3500.00 a month ($42,000/yr) that would do most people just fine and it's very simple... It's been paying out that "unsustainable"? yield for about 10 years...

    1. @Paul: The BMO monthly income fund is a good example of what I mean. Looking at the last 10 years, the monthly 6 cents/unit distribution has stayed steady. However, the unit price from Jan. 2003 to Jan. 2013 has dropped from $9.2654 to $7.2029, a drop of about $2.06. In that time the distributions have been a total of $7.20. The distributions have been about 40% larger than the investment returns. And we haven't even accounted for inflation yet. So, this distribution really is unsustainable.

      Another way to look at this is that $500,000 10 years ago would only have bought 53,964 units producing $3238/month. Ten years later, the income is still $3238/month (no inflation increase), and the original capital has shrunk to $388,700. If this keeps up, the distribution has to get cut.

  3. I agree with your points, it's exactly the reply I expectd. But lets say 2 people retired same day 10 years ago. One went the way that you have described with the BMO fund. The second person is indexing for example with a balanced etf portfolio. Both starting at $500,000.00.
    So now the second person must sell the equivelent in shares each year to match $3238.00 ($323800 from your original $500,000K) a month like the payout from BMO...

    What is left after 10 years comparatively. How close are they? Is it possible to calculate that?

    1. @Paul: The difference between how the two people would fare comes down to investment performance and costs. Let's say the investment performance is the same in both cases. The costs (MER) for the BMO income fund is 1.57% per year. On $500,000, this works out to $654/month. So, with a less expensive option such as index ETFs of stocks and bonds with MER around 0.3%, the cost would be around $125/month. So, the second person would be ahead $500 or so per month.

      However, I think the most important difference is realistic expectations. Trying to draw $3238/month from a portfolio of $500,000 is very likely to be unsustainable no matter what you try. Unfortunately for many BMO income fund holders, they don't know that their distributions are very likely to be slashed at some point. There's nothing wrong with drawing down your principal as you get very old, but people should do it with their eyes open. I fear that too many BMO income fund investors think they're just spending the "interest" and leaving their principal intact, but this isn't really true.

    2. Once again I agree with the theory behind this but not everything is always black and white. For example if someone has to pay an advisor 1-2% per year because they don't feel comfortable to invest and rebalance yearly on their own you can throw that savings right out the window. Lets face it, how many of us show interest and actually take the time to put together a methodical long term financial plan? How many get suckered by Prime America
      nuts in suits at a family party? Or fall prey to a glossy propectus with a photo of a happy healty couple on a boat?

      The monthly income route is far from the worst plan out there for many people.

      (I'm doing this as the devils advocate, not because i'm saying your wrong. I think this is a good discussion)

      To also follow up on my above comment. I picked the last 10 year timeline on purpose. If you had to sell your index ETF units of during the worst points of the crash to get your our hypothetical $42,000 out in 2008/2009 depending on your timing you could have really seriously depleated the number of shares you had. With the BMO fund you would not have sold any units and would ride back up the other side of the crash with the same number of units held increasing in value. (Granted at a slower pace then your ETF) But to the tune of $500.00 a month. That will depend on a lot of factors like what each individuals allocation was as well etc. So one has to be pretty perfect to squeeze out that optimum return.

    3. @Paul: If we assume the investor will pay the 1.57% MER in either case, then there is no difference if the investor is determined to spend the same amount in either case. However, the fact that the investor has the same number of units of the income fund after 10 years is just an illusion. The fund itself holds fewer shares per fund unit. It's like saying that that the amount of juice in my fridge has stayed constant for the last couple of days: 1 jug. The problem is that the amount of juice in the jug has been dropping; I really have less juice even though I still have 1 jug. The most important difference between the BMO income fund scenario and a scenario of other investments (with the same MER) is that many of the BMO income fund investors have no idea that they've been spending their principal and will face an income cut at some point.

  4. Good post Michael...anyone trying to live off high yield stocks is really gambling.

    I recall most of my stocks are in the 2% - 5% yielding range.

    In your example, expecting to draw a % steady yield every year is not realistic, since so many factors are at play.

    Instead, I believe a diversified stock portfolio or indexing bit in either case, spending less than the interest provides is a winning formula.

    1. @Mark: Thanks. Investor focus should be on real returns (capital gains + dividends - inflation). Focusing on just one component (like dividends) can be disastrous if another component (capital gains) is negative.