There are two big themes in this month’s issue: retirement and dividend income. The fact that many retirees like dividend income to fund their portfolio withdrawals is not lost on me. Nonetheless, neither theme should be viewed as applying solely to those who are in or are approaching retirement.

The process for achieving a financially successful retirement begins early in one’s career and continues throughout one’s working years. It’s not just about saving, either. The types of accounts you use—meaning Roth versus traditional IRAs and 401(k) accounts—as well as how you allocate will impact the decisions you have to make when it comes time to wind down your career.

Consider allocation. How a portfolio should evolve from one’s 20s through their retirement date and then afterward is an ongoing source of debate. Opinions on how much a retiree should hold in equities range from most of the portfolio to almost zero.

Why so much disagreement? It is due to longstanding different views on risk.

At one end of the spectrum are those who believe retirees should not put any dollars needed to cover living expenses at risk in the stock market. This view stems from the inability to recover from a severe and prolonged bear market. Advocates for this retirement allocation approach believe investors should immunize those dollars by purchasing enough in annuities to account for any living expenses in excess of what Social Security and pension benefits are expected to cover.

At the other end of the spectrum are those who believe investors should focus on maximizing long-term wealth creation. AAII founder James Cloonan was in this camp. He suggested setting aside up to four years of living expenses in safe assets and allocating the remainder fully to equities.

In between is a wide range of allocation strategies, which evolve in different ways throughout an investor’s life-span. I compare the main schools of thought regarding retirement savings allocations in my article. (My very short guidance is that the optimal allocation is one you can stick with no matter what the market is doing.)

The debate isn’t limited to allocations. There are also differing opinions about withdrawal strategies. One longstanding strategy is the 4% rule. Created by former financial planner William Bengen, it calls for taking out 4% of your portfolio’s value at retirement and adjusting that initial withdrawal amount for inflation each year. All future withdrawals are based on how much wealth you’ve accumulated when you first started taking withdrawals. As Chris Pedersen points out, there is nothing that makes this starting balance magical. It is simply a benchmark that has historically worked well.

In his article, Pedersen suggests that a diversified portfolio of large-cap stocks, small-cap value stocks and intermediate-term bonds combined with an annual withdrawal rate of 5% of the portfolio’s balance is a good alternative. In his backtesting, these portfolios had less variability and never ran out of money.

Withdrawals are taxable when taken from tax-deferred retirement accounts like a traditional IRA. They have the potential to lead to a large proportion of Social Security benefits being taxed, larger Medicare premiums or a household being bumped into a higher tax bracket. In a follow-up to their September 2023 article, “The Importance of Considering Marginal Taxes When Taking Withdrawals,” William Reichenstein and William Meyer provide a case study on how to avoid these in their article.

As far as dividends go, Brian Haughey explains how to value a stock using the dividend discount model (DDM). This model calculates an intrinsic value for a stock based on the sum of its future cash flows. The difficulty with this model—and other models that consider future cash flows—is identifying the correct discount rate and growth rate. Small changes in assumptions can lead to big valuation differences. Haughey gives guidelines for using the dividend discount model in his article.

Some dividend seekers hold business development companies (BDCs) in their portfolios. BDCs resemble private equity firms but are structured as closed-end funds. They tend to trade with comparatively high yields because they distribute 90% of all investment income and net realized capital gains. In response to member requests for information about BDCs, I asked John Deysher to write an update to his June 2007 article “Investing in BDCs: Private Equity for Public Shareholders.” 

Wishing you prosperity, good health and a happy Thanksgiving,