Living on Dividends in Retirement: How It Works and What Can Go Wrong

There are two ways to turn a portfolio into retirement income. The first is total return: own a diversified mix, sell a slice each year, and live on the proceeds. The second is income: own investments that pay cash, and live on the cash. Most of the financial industry is built around the first. We build retirement plans around the second, and this article explains why, and what the trade-offs are.

What a dividend is

A dividend is a share of a company's profit paid in cash to shareholders, usually every three months. Companies announce the amount in advance. Some companies have raised their dividend every year for decades; others pay nothing. A portfolio of dividend-paying companies produces a stream of cash deposits that does not require anyone to decide what to sell.

Why some retirees prefer it

The practical reason is sequence risk. Under the total-return approach, a market decline early in retirement forces you to sell more shares at lower prices to raise the same income, and those shares are gone when prices recover. Under the income approach, the dividend is paid whether the share price is up or down that quarter, so a decline does not by itself force a sale. Companies can and do cut dividends, especially in deep recessions, so the income is not immune to a downturn. But historically dividend payments have been far less volatile than share prices.

The emotional reason is simpler. Many retirees find it easier to spend income arriving in the account than to sell principal they spent decades building.

Rising income

Companies that raise their dividends each year give the retiree something a fixed pension or a bond ladder does not: income that grows. Over a 25-year retirement, inflation roughly halves the purchasing power of a fixed payment. A portfolio of companies that raise dividends is designed to counter that, though no company is obligated to keep raising its dividend and some will not.

What can go wrong

Dividend cuts. A company in trouble cuts its dividend, and the share price usually falls at the same time. Diversifying across many companies and industries limits the damage from any one cut but does not eliminate it.

Concentration. Chasing the highest yields leads to a portfolio heavy in a few sectors, often ones with the most fragile dividends. A sensible dividend portfolio accepts a lower starting yield from stronger companies.

Falling account value. Income investing does not protect the value of the account. In a bear market the account balance falls like any other stock portfolio. The point is that you are not forced to sell at the bottom, not that the bottom does not happen.

Taxes. In a taxable account, dividends are taxed in the year received, whether you spend them or not. Qualified dividends get the lower long-term capital gains rate, but the placement of dividend-paying stocks across taxable, IRA, and Roth accounts matters, and it is part of the plan.

Where it fits in a full plan

For most of our clients, dividend income covers the core of their spending alongside Social Security and any pension. Clients who want a portion of their income contractually guaranteed add a fixed index annuity for that portion. Growth investments are layered on after the income is in place. The estate plan is set up last, so beneficiaries and account titles match the plan.

Dividends are not guaranteed and may be reduced or eliminated at any time. This article is for general education only and is not investment, tax, or legal advice. Investment advisory services are offered through Foundations Investment Advisors, LLC, an SEC-registered investment adviser. Investments involve risk, including possible loss of principal.