One of the bogeymen that we have to address when structuring our financial lives is the fact that every dollar that we create for ourselves will be worth around $0.97 next year, around $0.94 the year after that, and then $0.90 or so in the third year.
If you want to separate yourself from most people out there, you need to borrow a couple chapters from Irving Fisher’s The Money Illusion, and condition yourself to think in terms of purchasing power. Most people aren’t equipped to do that. Even if you had a guarantee that the United States would experience 3% inflation over the next year, my guess is that a lot of people would think that $10,000 deposited in the bank today was less than $10,250 deposited in the bank account next January.
In terms of nominal dollars, sure. But if inflation hits 3% on average over the next twelve months, you’re not going to be able to walk out of Wal-Mart with as much stuff this time next year if your January 2015 budget is $10,250 because you’d need $10,300 in your pocket to match what you’d be able to buy with ten grand today.
Obviously, you’re a smart bunch, and you already know.
But I want to connect that fact to a strategy when you are planning to live on passive income sources rather than the dollars that come your way as the result of your own labor.
Very few, if any, strategies are indexed for you to grow richer in retirement. If you have a pension, it’s extraordinarily unlikely that it comes with raises of above 3% or so (more specifically, annual raises in excess of inflation). The Social Security system is currently designed to match you with cost-of-living-increases that roughly mirror the inflation rate, and there is certainly no inherent structure in place that gives you perpetual raises in excess of inflation. And, although the world of annuities is huge, you’re not going to find perpetual increases in excess of inflation without a surrender of your principal (if you do find one that does, let me know!).
This is why a stable of high-grade dividend stocks can completely transform the final third of your life, whether you are your town’s Astor collecting $20,000 monthly dividend checks or have an accumulated portfolio that generates about $1,000 per month in income as more of a side project. A dividend growth portfolio in retirement taps into an energy that 99.9% of the population can dream of: growing richer through retirement.
In a very good year, your portfolio could experience 9% dividend growth, or roughly triple an increase in purchasing power. In an average year, you can get a portfolio-wide dividend growth rate of 6-7%. You’re typically going to be experiencing a dividend growth rate that doubles your purchasing power. And if you make mistakes in your selection process and have to deal with a couple of dividend cuts or two, your dividend growth rate might be in that 0-3% range. It’s a great set-up: a bad year in which you make a few mistakes still puts you in the same position as the people that are exclusively relying on flat payouts (i.e. $500 every month into perpetuity) or have something that is indexed to inflation.
When you make ExxonMobil, Chevron, Johnson & Johnson, Procter & Gamble, Coca-Cola, PepsiCo, and Colgate-Palmolive big parts of your individual holdings, you are playing a different game than the rest of the world. You’re not reading articles about the 4% rule, because you’re not trying to craft a withdrawal strategy that maximizes the amount of money you can take out each year without going broke. You spent your life being a builder and saver, and you don’t have to spend the tail end of your life seeing decay and depletion.
If you have $25,000 in annual income at the start of your retirement, and you achieve 6.5% annual dividend growth over the next 20 years, you will be collecting $91,411 in income in the 20th year. Inflation means that you would need $45,500 in annual income in 2034 to have the same amount of purchasing power as 2014. During that time, your dividend portfolio would likely go from giving you half of the average American household’s annual income to giving you an annual income that puts you slightly ahead of the average American household twenty years from now, if current trends hold. And the thing is, you were getting money to spend all along the way. You were reaping the seeds you had sown, and still increasing your wealth simultaneously. That’s a hell of a one-two punch that makes this whole thing appealing.