Laguna Beach Bikini

A big question for retirees is how to create cash flow from your retirement nest egg. There is a debate among retirees whether it is better to collect dividends or sell shares. Financial writers sometimes characterize this dichotomy as being either an “income investor” or a “total-return investor”.

An argument for dividends is you don’t have to sell shares when the stock prices are down during a bear market, which many view as the road to ruin. Income investors sometimes say that selling shares is akin to “eating your seed corn.”

The total-return viewpoint is that money is fungible. Whether a dollar comes from dividends or capital gains it is still a dollar. Furthermore, capital gains are taxed more favorably than dividends.

Income investors counter that dividends are a reliable source of  returns while capital gains, which depend on stock prices and the whims of the market, are unreliable. Some years there are capital losses rather than capital gains.

Then total-return investors respond by saying that owning only dividend stocks is less diversified than owning a broad market index like the Total Stock Market and is therefore riskier. Dividend-only stock portfolios take on uncompensated risk. They also point out that were massive dividend cuts during the 2008-2009 financial crisis and dividend stocks lost more than the broad market, largely due to over-weighting financial stocks.

The debate goes on and on. I decided to investigate. The result may surprise you. It certainly surprised me.

The Simulation
Using Microsoft Excel, I simulated withdrawing from a portfolio. Returns each year were generated randomly from a probability distribution. The mean portfolio return was 10% and the standard deviation 10%. Inflation was 3%.

For withdrawals, I used the a 4% plus inflation withdrawal policy. This is a constant consumption withdrawal model because real spending is constant. Each run was for 100 years.

For each run I simulated cases from Zero-Dividend/All-growth to All-Dividend/Zero-Growth. I even simulated the case when the dividend yield exceeded the total return. For each case, the initial yield plus the dividend growth was 10%.

In each case (and this is key) the total return and amount withdrawn each year was identical. The share price went up or down depending on the total return and the dividend amount. New shares were sold or bought, depending on whether the withdrawal was covered by the dividend or not.

Here is the Excel spreadsheet EatSeedCorn.xls that simulates withdrawing from four different portfolios. The tabs labeled Case1 through Case 4 show the detailed annual transactions for each case. The tab labeled “chart” summarized the results. Download it now, open it in Excel and go to the “chart” tab. Press Re-Calc to run one scenario. Everytime you press Re-Calculate a new scenario is run. (I call this the Poor Man’s Monte Carlo simulator. It runs only one scenario at a time.)

The spreadsheet also allows you to change the parameters like inflation rate, withdrawal rate, mean return and standard deviation. If you have these paramaters for your favorite fund or for your entire portfolio, you can enter those parameters and observe some possible scenarios that you might expect. [The default parameters are intended to simulate the Vanguard High-Yield Corporate Bond Fund (VWEHX)]

Surprising Result
How would you guess they all made out? Which had the highest ending balance? Which generated the most income?

Well here is the answer. They were all the same! See Table 2 which summarizes the results for one example run of the simulation. The ending balance and total spending was identical for each case. Whether the return came from yield or from capital gain had no bearing on the outcome. In some cases you were selling shares in some you were buying shares. Some ended with more shares at lower prices, others had fewer shares at higher prices. But in the end it didn’t matter. The only thing that effected the outcome was the sequence of annual total returns.

If you downloaded the spreadsheet, try changing the INITAL YIELD to a some other number. (DIVIDEND GROWTH automatically adjusts to maintain a 10% total return. No matter what value you enter for yield, the outcome is the same.

Total-Return Investors Are Correct
So It appears that the “total-return investors” are correct in their assertion that total return is what matters. It makes no difference if the return comes from dividends or capital gains, just as long as sufficient returns are realized. So it looks like total-return’ers win this argument.

So Dividends Are Irrelevant?
Does this mean that dividends and income are irrelevant? Not so fast. You don’t want to jump to any conclusions.

Withdrawal success depends on the sequence of total returns, which is a function of both average annual return and volatility of return. Higher return increases the maximum withdrawal rate (MWR). But higher volatility decreases it.

For retirees, a lower average return can beat a higher average return if the volatility is reduced enough. Stated differently, the portfolio with highest total return may not have the highest maximum withdrawal rate, if the returns vary a lot from year to year.

It is conceivable that for a portfolio of dividend stocks, the annual returns may vary less than for a broad market index like the S&P 500. If that is the case, an income portfolio might be a better choice for retirees. Traditional retirement funds, like Vanguard Wellesley Income (VWINX), are designed to work this way. Sometimes old-fashioned common sense ends up being the correct way in the end. Again, it is only the sequence of total returns that matters.