Matching Retirement Income Sources to Goals & Thoughts on Dividend Investing

Income planning will make or break your retirement years. This is because your income in retirement will be what controls your lifestyle, not your net worth. When doing your pre-retirement planning, hopefully several years before your desired retirement, you'll want to match your lifestyle wants, needs, and goals with the income you are able to generate from your various financial assets. But depending on where and how you plan to generate that income from, you may run into problems along the way. Many times, we see issues arise with those who primarily focus on a dividend spending strategy from their investment portfolios to supplement their other retirement income sources. In this episode, we break down the important pillars of retirement income planning, matching your income sources to your retirement goals, and why a dividend income strategy may not be the best choice.

Welcome to the Retired-ish Podcast. I'm your host, Cameron Valadez. And in this episode, I want to discuss some of the pillars of retirement income planning and address the concept of dividend investing as a primary source of retirement income. Now, retirement income is going to be the lifeblood of your retirement. Without enough income to meet your necessary and discretionary needs, retirement can become anything but cozy, which is why it's important to understand how you will structure your exact income plan and what it may or may not be able to do for you during a potential 20 to 30-year retirement.

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I find that there are still many pre-retirees out there who plan to completely solve for their retirement lifestyle by fully relying on one primary source of income, such as a stock and bond portfolio, maybe dividends from a large stock portfolio. It could be rental real estate or even insurance products such as annuities. And there's an old saying that if the only tool you have is a hammer, then everything starts to look like a nail.

For example, if I can just have enough rental real estate or maybe dividends to get me X dollars a month at the start of retirement, I'll be set for life. Or if I can just save, say $2 million by the day I wanna retire in my 401(k) plan, I can spend X amount of dollars a month all the way through retirement without interruption. In other words, if I just have this one tool, I can solve any potential issues that may come my way. There are several issues with this relatively basic level of planning. The major issue is that this doesn't account for any unexpected large lump sum expenditures that will happen during your retirement years. And secondly, it can't account for investment mistakes or errors due to normal human investment behaviors. These large unexpected expenses, as I said, will happen throughout your retirement.

You have to plan and expect them to happen. Some will happen much more frequently than others. And when they occur, if you have to produce the cash needed for that expenditure from an asset that also provides some of your retirement income, your income from that asset will be reduced. Either directly or you will now have higher expenses, such as, let's say, getting cash out of an investment property to pay for something. And you now have a loan to pay back at an unforeseen and unexpected interest rate.

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These unexpected expenses may be for something exciting or for things that aren't so exciting. For instance, deciding to relocate next to your adult children and new grandchildren, or having to replace the roof on your home, or gift money to a child in desperate need of financial assistance.
The key is that most people don't plan for these things because no one thinks they will happen to them, especially extremely large expenses, such as long-term care needs that can go on for years and years. The second issue has to do with making good investment decisions over potentially the next 20 to 30 years, which is a long time and much harder than it sounds. Some examples of this could be the tendency to chase hot stocks or alternative and “new age” investment opportunities, only to get burned and suffer significant losses in net worth and, therefore, your income. Another might be focusing too much on your total return from your investments each and every year, rather than aiming to try and achieve just the rate of return that is needed to satisfy your income needs. I would say this one is by far the most common error that can truly derail a retirement.

These days, everything is marketed towards getting a better return. And on the face of it, it makes sense, right? Why not try and get the best returns, and while I'm at it, pay as little as possible to get those returns and take as little risk as possible to get the best returns. If I can just do that, I'll be fine. So what could go wrong, right? Everyone, of course, wants the highest returns with the least amount of risk. But to get a higher return, you have to take more risk. When you only focus on returns, it's easy to begin taking more risk than might actually be needed for your particular financial goals.

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In addition to adding possibly undue risk, focusing only on returns year in and year out causes you to take a probability-based approach to retirement. For instance, if your financial advisor were to run mathematical and historical probability-based tests on your retirement plan and available resources, often referred to as a Monte Carlo simulation, you may end up with, say, a healthy 90% success rate. However, what if you end up being part of the 10% statistic of failure? Examples of this are best explained by sequence of returns risk, which we have talked about countless times on the podcast in previous episodes. So, in case you're new to that term and want to look more into it, I will provide links to the previous episodes in today's show notes. In a nutshell, you might experience phenomenal returns leading up to your retirement and outearn everyone you know with your investment choices and your investment portfolio. But once you start to turn that portfolio into an income producing machine at the onset of retirement, or you have to liquidate a large sum to help relocate next to your children, if things start to go south with your portfolio soon after that, you could run out of income 10 or more years earlier than expected. While another retiree with the exact same starting amount of money at their retirement date, same total lifetime portfolio withdrawals, the same life expectancy, but earns below average returns, might never run out of money. It's not all about returns.

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In order to help reduce or eliminate this probability-based retirement planning, you may aim to cover your necessary retirement expenses, such as mortgages or rents, bills, food, and utility payments, with income sources that can grow with inflation and are rather stable. These might be bonds, tips, rental real estate, social security, dividends, annuities, etc. Then you might consider using the more probability and risk-oriented approach with your assets, such as stocks, real estate, etc., for other discretionary retirement spending and those unexpected expenses. Now that you have a different perspective on the various resources you might use for retirement income, I want to help you further with your retirement income planning by going over what professor at the American College for Financial Planning, Wade Phau, calls the four L's of retirement, because I think these accurately sum up what most retirees want to try and achieve. According to Wade, the four L's of retirement planning are longevity, lifestyle, legacy, and liquidity, which, put together, can help provide a way for you to better align your retirement goals with your financial resources. And the key thing I want you to understand is that you don't necessarily need to perfect each of the four L's.

The point is that each one can help you better understand how you will want to build your retirement income strategy and simply make better decisions. The first one, longevity, simply refers to the concept that you will wanna be sure that your income lasts as long as you do. Many retirees fear running out of money too quickly over death itself, which is understandable. Trying to go back to work or rely on a loved one for financial support is the last thing you wanna do in retirement, especially after becoming accustomed to your new retirement lifestyle. Accounting for longevity is critically important.

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You may knock it out of the park with your investments over time and earn better returns than let's say the overall stock market and your neighbor, but if you exhaust your resources too quickly, did you win the game? For instance, I think the best way to think of this is to ask yourself, if I can make 15% or more in a given year on my favorite investment, call it real estate, stocks, alternatives, whatever, I would never own something like bonds or maybe an annuity that limits my potential returns to anything less than 15%.

But if you make 15% and still run out of money before you pass away or live the life you plan to live, again, did you win the game? This is why you have to align your money with your exact goals. In order to make your money last, you need to build a plan that incorporates one or more income sources that are reliable and can at least cover your necessary expenses, such as housing, healthcare, and food, throughout your retirement after 20 to 30 years of inflation and taxes. As I mentioned, these might be covered by a combination of sources, such as a pension, social security, portfolio income, rental real estate, active or passive business income, or even something like an annuity.

The second L, lifestyle, refers to funding your ideal retirement lifestyle. What kind of quality of life do you desire? Your desired lifestyle will surely be unique compared to others. You may be frugal and focused on providing for other family members, such as your children, or charitably inclined, focusing on bettering our world and the organizations that you care about, while others may want to spend every last cent to enjoy retirement to the fullest. To solve for the lifestyle aspect of your retirement years, you'll likely want to create a plan that finds your ideal balance between enjoying the present and preserving some financial resources for the future.

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For instance, if you have a bucket list of things that you'd like to do and don't have much of a need to leave money to heirs or charity, your retirement income plan may allow for more spending in your early retirement years than someone else's. In cases like this, you probably shouldn't be using an income strategy, such as the 4% rule, or living off of maybe dividends only, which can have a high probability of leaving a ton of money on the table when you're gone. Relying only on rental real estate can present issues here as well, because it may not match well with your goals, whether you realize it or not.

Here's an example. You may have a $3 million rental real estate portfolio of paid-off properties that provides, say, 4% in after-tax income. That's around $120,000 a year or $10,000 a month. But if you would love to be able to spend more than that, if you could, maybe rental real estate isn't the answer. For instance, if you had little to no desire to leave money behind at your passing and you wanted to enjoy more of your money while you knew you could, you may be able to have a higher spending rate from a more liquid and diversified investment portfolio that allows you to spend dividends and principal. For example, with that same $3 million, you might construct a portfolio that can provide anywhere from 4.5% to 6% of annual income or $11,000 to $15,000 or more a month after taxes. This, of course, would depend on several factors of your plan, but it might be completely doable. The key is that you have that flexibility just based on the type of asset you're using to generate the income. And this is why aligning your investments to your goals can be so powerful.

Another related issue in this same example or scenario of wanting to maximize your own spending while you're alive, rather than endlessly just trying to pursue a massive net worth, could be that you focus so much on returns, you misalign your goals entirely.

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Let's say you don't ever want to have paid-for properties because you want to maximize your returns by using leverage. In other words, using the bank's money to juice your returns. Not only does this add some risk, but you will also have higher expenses due to the mortgages, and therefore less cash flow. If that cash flow isn't enough to meet your retirement spending goals, then what are we doing it for other than trying to die with more money on the table? Now, I just want to caveat that this isn't just a real estate thing by any means. This over-reliance or focus on only your returns can happen with any investment, such as a pure dividend strategy.
The real estate was just my example.

Moving on to our third L, which is legacy. And that refers to planning to provide for others after you're gone, whether that be friends and family or charitably to organizations you care deeply about. Now, legacies encompass not only money but also skills, core values, and most importantly, memories. But when it comes to the money, it's important to take the time to decide exactly what you will want to have happen with your hard-earned money, especially since we don't know just how long we'll be around. If this is neglected, an unnecessary amount of the wealth you've built could be left to the wrong people. And a significant portion could be wasted due to taxation.

There are many strategies out there to help mitigate these issues, and you'll want to be sure that these things are in place sooner than later. And as I mentioned previously, legacy planning may not be a primary focus of your retirement plan, which is okay. But regardless, something is typically better than nothing, especially for those who will never be able to spend every dime that they've saved and accumulated.

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And the last L in Wade Phau's framework is liquidity, which refers to being ready for surprises. It means having financial resources you can access when things don't go as planned. As I mentioned earlier, this can be for good reasons and bad. For example, your adult children may move out of state, and now you wanna follow them and relocate.

Or it could be unexpected medical expenses or major home repairs, or a steep market or economic downturn that interrupts your lifestyle. Without liquidity, you may find yourself in a financial bind, and your entire retirement plan can be derailed. I'll give you an example I see fairly frequently with folks who reach out to our firm. Someone works hard their entire life to accumulate a specific sum of money, let's say a million dollars, and decides that they can easily live off the income that it can provide. Then, shortly after retirement, their investments in the markets drop significantly, or they make sudden, unexpected plans to relocate, and things cost more than expected. This causes them to spend lump sums of money, which then reduces their $1 million to some lower amount that now cannot provide the monthly retirement income they were expecting originally. And now they're in panic mode.

It might even be someone who receives most of their income from rental real estate, but then things happen, and they need lump sums of money, and now they're caught selling good properties and incurring unnecessary taxation, or they have to borrow against their properties at less than ideal interest rates. The key is no matter how you invest, things will happen, and you need liquidity in addition to having a rock-solid income plan. After you've developed a good understanding of these important pillars of your retirement, you need to align them with your goals and income plan.

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Okay, now let's focus on one of the potential income sources, which is dividends. When I refer to using a dividend spending strategy or dividend portfolio, I'm referring to spending dividend income from a portfolio without touching the principal, or in other words, selling any of the investments over time. This might be through your own portfolio that you've built outside of a retirement account, or trying to live off the dividends of an inherited portfolio of stocks from a loved one. “Living off the dividends” has always been a popular form of investing, especially for retirement income.

And I think this stems mainly from the fact that Wall Street still heavily pushes dividend-focused investment products and strategies, and previous generations, such as our parents and grandparents, may have utilized a dividend strategy successfully. So we don't see any reason not to just do what they did. The difference is that we are in different times. And with that, we have a much different market at our disposal to invest in, different opportunities, more sophisticated academic research, and more history to look back on to see whether or not that's truly one of the best ways to create retirement income. Before we dive in a bit further, I just want to start out by saying that dividends are not at all a bad thing. In fact, they are extremely important to the long-term equity investor. You just have to understand how they can help and not fall for all the marketing tricks that Wall Street throws at you.

Over the last 100 years or so, dividends have made up about 37% of the S&P 500's total return. Now, this is a pretty staggering number, but keep in mind that you could not directly invest in the index over that entire time period, and that there have been years when the dividend yield of the companies in the S&P 500 and or Dow Jones were much higher than they are today.

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Today, they sit around 1.5%, give or take, although there have been stretches where the yield has been around 4%. Regardless, what this tells us is that dividends are often an important piece of your portfolio's total return, but the dividend yields themselves don't tell and explain the whole story. Here's why. When a stock pays a dividend, the value or share price of that stock gets reduced by the amount of the dividend. This is true regardless of whether or not you actually own the individual stock or own stocks that pay dividends through a mutual fund or similar investment vehicle.

Therefore, if you were to receive a dividend in your account, and let's say the share price didn't move any further on that same day from normal market fluctuation, you would have the same amount of money in the account as you did before the dividend was paid. For example, if you have a stock in your account worth $100 a share, and it pays you a 2% dividend of $2, you now have a stock worth $98 a share, and you have $2 in cash in your account. If you decided to live off of dividends as one of your income sources in retirement, then that $2 would be sent out to you, and you'd have an account value of $98. If you instead chose to reinvest that dividend, you'd buy fractional shares of the stock with that $2 at a lower price. However, notice that you would still have $100 in your account in this hypothetical scenario. This is often referred to as a dividend reinvestment plan or DRIP plan. In my opinion, reinvesting dividends is one of the most powerful strategies you can implement.

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And it's simple. By reinvesting your dividends rather than spending them, or God forbid, you allow them to accumulate in cash and do nothing, you will naturally be doing what most investors should be doing, which is dollar cost averaging, especially during financial market declines. When markets go into a tailspin and everyone's in panic mode, don't forget that some of the companies you own will still be paying a dividend. This is ironic because the overall market's opinion on any given day determines the prices of the companies you own. But the dividends these same companies pay are sort of like the truth about how the company is currently holding up and its future expected earnings. Yet nobody pays attention to their dividends when markets are falling. So, if a company's stock drops 25% in value in a short period of time, yet maintains or even increases its dividend, which sometimes happens, is there really a legitimate enough reason why the company's stock price dropped 25%?
Sometimes, but usually not. This typically happens when there's some sort of economic surprise or Armageddon type of headline in the media.

Picture this: if some of the companies you own pay a dividend and or increase their dividends when the value of the company you own is down, often temporarily, by reinvesting those dividends, you're now buying shares of the great companies you own at potentially lower prices. And the lower the prices, the more intrinsically valued the companies become. Sadly, most investors see more value in buying companies that gain immense value overnight. If, instead, you were to spend the dividends and use them as part of your income strategy in this instance, your portfolio will simply drop in value by the amount of the dividend while its value is already going down.

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Reinvesting your dividends also takes some behavioral biases out of play.
Instead of accumulating dividends in cash and trying to time the market and wait for the bottom to take that cash and buy in, which you should know is a loser strategy, you will be purchasing shares regularly, regardless of the market's ups and downs. And another aspect I want to mention is that dividends are really sticky, meaning that the last thing companies and management teams want to do is cut a dividend or stop paying them entirely, which is why this is such a rare occurrence, relatively speaking. There's pretty much no worse signal about a company's operations than them cutting a dividend.

Now that we know why dividends are important, especially to a long-term equity investor, let's look at where you might get in trouble with dividends, which is when you buy into the belief that investing only or even primarily in dividend-paying companies is a superior strategy or that buying high-dividend-paying stocks can solve your retirement income problems since you'll receive more income. What you need to know is that living off of dividend income only and not touching the principal or selling shares in your accounts has its own potential issues. The first has to do with the dividend yield itself, which can act sort of as a marketing ploy or mirage, if you will. Many investors who want to live off dividends naturally tend to gravitate to companies that pay the highest dividends, many of which have been around a very long time, so investors think they can do no wrong by owning these companies.

High-dividend-paying stocks generally have lower expected total returns. Total returns refer to the stock's total return that includes its dividend and price movement or value of the share itself.

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Typically, you find these companies in the telecommunications, basic materials, industrial, and energy sectors of the markets, and many of these high-paying companies pay these high dividends for a reason and that is to attract more investors to the stock. There could be multiple reasons for that, but one might be that the price is relatively expensive, and if they are overpriced, they should have a lower expected total return in the future because even though there's a high dividend, there may not be a great amount of price appreciation ahead. In addition, if you subject your portfolio to primarily high-dividend-paying companies, you may also be increasing the risk you're taking due to having a lack of diversification. As I mentioned, many of these companies are associated with only a handful of sectors in the overall stock market. What you'll want to know is that a very small percentage of stocks over the long run make up a majority of total market returns, and therefore, you may be excluding some or all of the companies that will provide those returns.

So why take on that risk? There's also a home country bias due to tax preferences. For example, you may primarily choose dividend-paying stocks in your home country to get a more preferential tax rate on those dividends. This may mean excluding companies in other countries that can add further diversification to your portfolio. In my opinion, if you're going to buy dividend-paying stocks, don't focus on just the highest dividend-paying stocks. The dividend yield should be beside the point. You just want to own great companies. That's the bottom line. Dividends are still very important to overall returns, however. We still want them and don't want to avoid them, per se. It just should not be the primary focus, in my opinion.

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It's also important to understand that dividends can provide for a lumpy cash flow. Dividends paid by companies change over time. Sometimes they're increased, and sometimes companies cut them temporarily and can cut them permanently as well. These lumpy cash flows can obviously cause potential issues if you're using that income for necessary ongoing expenses. Another issue with living off of dividends only is what happens when you have to sell some of your shares because of an unexpected expense, like we talked about earlier. Or what happens when you get comfortable holding a stock because of its dividend, even if, over the long run, the value of the stock deteriorates due to poor performance? Then what might you do? These two things introduce behavioral issues that will cause you to have to make complicated decisions when problems arise, and an irrational decision may blow up your entire income plan. Okay, so what about the taxes? Even if you don't spend the dividends and you reinvest them, you need a plan to pay the taxes if they're held in a non-retirement account.

In order to do this, you will either have to have a plan to make what we call estimated payments or increase your tax withholding from other sources. If not, you may owe underpayment penalties, which eat into your dividend income and after-tax returns. And lastly, you might believe that your plan is limited to the dividends you receive, which, as we mentioned earlier, could be a huge mistake. You may be able to spend more given the amount of your portfolio and goals, if handled a little bit differently. Ultimately, you don't want to let a company's dividends dictate your financial plan and spending level. And this brings me to a potential alternative to just focusing on spending the dividends alone, and that is total return investing.

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Total return investing focuses on generating income from a portfolio, not just from dividends, but also principal by gradually selling shares, potentially incurring capital gains, to help supplement your income.

That being said, total return investing will still produce dividends. In addition, investors should view money equally regardless of the source. But oftentimes, dividend investors don't treat selling shares, incurring capital gains, and receiving dividends the same. Those who find both of these concepts the same are total return investors. Dividends are not free money. As I mentioned, they reduce the price of the shares. If you spend dividends and don't reinvest them, your portfolio will be lower, the same as if you spend capital gains.

Total return investing strategies are often done most efficiently with passive investing using passive investment instruments that focus on the broader stock markets. This can provide more simplicity to your plan, as well as better diversification and other ancillary benefits. So this might be through vehicles such as index funds or maybe exchange-traded funds, or ETFs. Total returns through passive index investing are kind of hard to understand since it's not all cash flow. It's very different than relying on only dividends or rents from rental real estate, for example. But having a really good, rock-solid retirement income plan can help you better visualize how this concept works, which can be sustainably spent over a potential 20 to 30-year retirement and what investments are sold and when. In short, a dividend strategy alone can be variable.

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With a total return strategy, you can dictate spending and also allow for consistent increases for things like inflation. Another pro of total return strategies has to do with taxes. With total return investing, you have more control over when you pay taxes because you can choose what to buy and sell and when you want to recognize income, since some of your shares may have gains and others may have losses.

In summary, a retirement income plan that's dynamic and helps you accurately align your income sources with your spending goals might help you feel more comfortable spending more early on while you're alive and potentially provide more enjoyment in your early retirement years. And while dividends are truly a powerful source of investment return, don't let them dictate your retirement lifestyle.

That does it for today's show. If you find the topics discussed today actionable and insightful, do yourself a favor and subscribe to or follow the show on your podcast app. That way, you get alerts each time we drop a new episode. Also, be sure to check out our free Retired-ish video newsletter to get more useful information on retirement planning, investments, and taxes once a month straight to your inbox. The newsletter will often dive deeper into some of the topics discussed on the show, as well as useful guides and charts available for download. As always, you can find links to the resources we have provided in the episode description right there on your podcast app, or you can head over to retiredishpodcast.com/70. Thanks again for tuning in and following along. See you next time on Retired-ish.

Disclosure [00:33:58]
Cameron Valadez is a registered representative with, and securities and advisory services are offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.

The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual.

To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.

All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk, including loss of principal. No strategy assures success or protects against loss.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Bonds are subject to availability, change in price, call features, and credit risk.

Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company. Fixed and

Variable annuities are suitable for long-term investing, such as retirement investing. Gains from tax-deferred investments are taxable as ordinary income upon withdrawal. Guarantees are based on the claims-paying ability of the issuing company. Withdrawals made prior to age 59 ½ are subject to a 10% IRS penalty tax, and surrender charges may apply. Variable annuities are subject to market risk and may lose value.