Mitigating the inherent risk of inflation
With the mainstream financial media focus on “new and exciting” ways for an investor to commit their hard-earned money, attention has shifted from those “boring” public companies that have a long, highly consistent history of returning their growing earnings to shareholders in the form of cash dividends. It shouldn’t.
The stocks of companies that distribute consistently growing cash dividends should not be ignored in favor of the more “exciting” strategies of our day. These stocks are a trusted and viable way to not only accumulate wealth in the long term, but also to establish a growing, tax preferred income stream when you’re ultimately living off of your accumulated assets.
The concept of dividend growth provides a natural offset to rising costs due to inflation. Here’s what many people tend to forget:
#1 What the actual objective of investing is
All investment decisions should be made with an eye towards the intended outcome given the objectives for your capital and what the risks of that investment are.
It’s important to realize what many lose sight of: the ultimate objective for any investment is current and/or future cash flow from that investment.
It doesn’t matter what the promises are. The investment must, at the end of the day, return cash flows or it hasn’t helped you.
And if inflation is the enemy of present day capital, then tax consequences of any investment is a close second. Cash flow in the form of taxable income received is subject to ordinary income tax rates in the year that cash payment is received. Realized capital gains are taxed at either the short or long-term capital gains rate, depending upon the holding period of an investment. And the “qualified dividends,” which is defined as a dividend paid by a U.S. company or a foreign company incorporated in the U.S., are taxed at the preferential long term capital gains rate (currently at a maximum rate of 23.8%). This is just general guidance; if you have specific questions please ask your CPA.
#2 Inflation is a potent enemy
The enemy of any well-conceived retirement plan is the erosion of purchasing power of future cash flows from inflationary pressures.
People tend to have the attitude that inflation comes and goes, and why worry so much about something you can’t control.
Let’s look at the historical trends here.
Setting aside the recent flare up in inflation, the very long term CPI compound growth rate since 1926 has been roughly 3% annually (CPI is the Consumer Price Index, which tracks the average change in prices for a typical basket of goods and services).
Seems harmless? It’s only 3%, right?
This can be a huge threat to your retirement.
If the expected life expectancy of an average couple retiring by age 62 today is 30+ years, a lack of inflation protection of future cash flows might spell retirement disaster. Or put another way, leaving the work force does not suddenly stop or slow down the rising cost of goods and services you’ll be consuming over a well-deserved, multidecade retirement.
Over the last 50 years (1973-2023), which include the highly inflationary decade of the 1970s and the most recent inflationary pressure post-COVID, the CPI has risen from 46 to an estimated 310. (U.S. Bureau of Labor Statistics, inflationdata.com)
That is a factor of almost 7 times!
This can be catastrophically damaging for someone who is relying upon distributions from their portfolio to fund their living expenses for the remainder of their life. If those expenses are rising this drastically. Do you really want to feel the pinch at a time in life when you aren’t working and have little, if any, recourse?
#3 Dividends have the potential to offset inflation
Here are reasons that dividend stocks may come to the rescue:
- Over the last 50 years, the cash dividend from the S&P 500 has risen from $3.61 to an estimated $70.00, or by a factor of 19 times. (need source) This means that the dividends paid by the companies in the S&P index, which is a representative sample of the 500 leading companies in the United States, have risen by 19 times versus inflation’s rise of 7 times over the same number of years
- Back in 1973, that $3.61 dividend represented a bit more than 45% of that year’s earnings; in 2023 this year’s estimated $70.00 dividend represents a payout ratio of closer to 32%. In other words, over time it is taking a smaller share of corporate earnings to fund this accelerating dividend growth
- The dividend growth rate of the S&P 500 has averaged just under 6% annually since 1950 – stock buybacks which accelerated since the 1980s have not impacted this trend
Proquility applied this historical data to create our flagship model portfolio in January 2003 called ”Value Equity,” which we believe improves on simply relying on the S&P 500 as an investment solution. In the last 20 years, this model portfolio has averaged an annual dividend growth rate of 8% while turning $1,000,000 into $6,548,244.
You can learn more about Value Equity here:
What it means for you
Stocks come with risk, typically more volatility than the steadier types of investments such as bonds. Although it may seem counter-intuitive for a retired person to hold them, we believe our retired clients need to maintain a healthy exposure to equities, and more specifically high-quality equities that pay and grow their dividends with consistency. This is, in our view, a viable way to counter the harmful effects of inflation on the portfolios of retired people.
Your asset allocation, or the mix of stocks versus bonds and other investments, is specific to you and is decided upon through a process of risk analysis and thorough understanding of your tolerance for volatility. While this newsletter has discussed many topics, none of what we have mentioned can be interpreted as advice specific to any particular individual. If you would like to discuss your portfolio, please set up a time to speak with us.
YCharts. (2023). S&P 500 Data [Chart]. Presentation S&P 500 Data.
YCharts. (2023). S&P 500 Div Growth [Chart]. Presentation S&P 500 Data.
US Bureau of Labor Statistics. Consumer Price Index. Accessed on November 19th, 2023. https://www.bls.gov/cpi/