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How to plan for retirement/FIRE using dividend income?

23 Jun 2021 - Contact Sayan Sircar
6 mins read

How to get inflation-indexed income in retirement using dividends.

Using dividends as retirement income

Stock dividends can be used to get regular income during retirement. For retirement, dividends are essential in two ways. First, there is limited income potential from bonds without taking credit risk due to falling bond yields. Additionally, rising inflation makes income from bonds not sustainable for getting inflation-indexed returns. Dividend payouts have the potential to address these problems.

Table of Contents

Dividend-paying stocks in the retirement portfolio

Growth of dividends over time

Stock dividends (the above figure is for TCS) are generally stable due to the value and quality factors inherent in a high dividend yield stock portfolio. The NSE published the Nifty Dividend Opportunities 50 index to identify high-dividend yield stocks. This index has shown a 2.8% dividend yield since inception. The dividends of the underlying stocks have grown at a rate higher than inflation in this period. However, the dividend yield of a stock portfolio is typically lower than the safe withdrawal rate (SWR) used by retirees.

While dividends can be cut in case the company faces financial trouble, they are not as fluctuating as stock prices in times of high volatility. This is important in this case. Due to sequence of return risk, there is a loss to the equity portfolio at the beginning of the retirement period.

Due to this reason, dividends cannot be the only source of income during retirement. Instead, they must be supplemented via other sources of income (rent and interest payments) and growth stocks to offer income and growth, respectively.

Effect of taxation on dividends

Currently, dividends in India are taxable at slab rates. This means that as per the RRTTLLU suitability framework, dividend-paying stocks are unsuitable for the accumulation stage, i.e. pre-retirement portfolio. In post-retirement, there is a possibility of taxes being lower, making dividends more tax-friendly. Even at the highest slab rates, the chance of stable income from dividends must be balanced against the lower taxation from stock and mutual fund capital gains.

How to choose dividend-paying stocks

High dividend-paying stocks are

  • stable companies with growing profitability
  • low or falling debt to equity ratio
  • large cash balances
  • high dividend payout ratio (dividends paid out as a proportion of earnings)
  • ability to maintain and grow dividend payout

Sources of finding high dividend yield stocks using index constituents:

  • MSCI India High Dividend Yield Index
  • NIFTY Dividend Opportunities 50 Index

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What not to do while building a dividend yield portfolio

These are common pitfalls that should be avoided.

Investing in “dividend yield” mutual funds

  • the dividends declared by the stocks become part of the cash balance of the fund, and the FM can do as they please: either declare a dividend or purchase more stocks
  • mutual funds do not guarantee any dividend payouts, even in the IDCW plans
  • these funds have incredibly high expense ratios, thereby lowering overall returns

Investing in highest-yield stocks

Evaluating all of the selection factors together is essential to find suitable stocks for inclusion in the portfolio. For example, sometimes companies can temporarily have high dividend yields but may have systematic issues that make maintaining the dividend difficult.

Investing in dividend-yielding stocks at a high tax bracket

A portfolio of dividend-paying stocks will have a higher total return if held in mutual fund form than held in the hand of an individual investor. This is because a mutual fund does not pay taxes on selling the stocks from their portfolio or when a stock declares dividends. However, an individual investor will pay capital gains and income taxes respectively in the same two cases.

Suppose your retirement (or early retirement) is still some time away. In that case, you will be losing much of the returns due to taxation today. Once retired, you can consider rebalancing from equity mutual funds to dividend-paying stocks.

How much corpus do you need

An investors’ typical question is, “how much should I invest to get ₹1 lakh/month from dividends”.

Corpus size

Since this income is post-tax, we assume a 15% marginal tax rate to calculate. Yearly desired income, pre-tax is ₹ 1 * 12/(1-15%) = ₹ 14.18 lakhs. If the dividend yield is 2% when purchasing the stocks, the corpus needed is ₹ 14.18 / 2% = ₹ 706 lakhs or ₹ 7 crores. Please note that just investing ₹ 7 crores does not guarantee the desired ₹ 1 lakh/month (it will fluctuate based on company performance). There is also no surety that this income will beat inflation. It is recommended that investors build a diversified portfolio of stocks and bonds (via mutual funds) and other assets to build their retirement corpus. The following links will be helpful:

A question that came from a Twitter user on this topic is this:

If I have 7 crores, then why will I invest in stock to get 14lakh dividends yearly? That too post-retirement.FD will give 26 lakh safe and secure post-tax.

While this is correct, the major problem with this FD-only portfolio is that it does not beat inflation. Assuming 7% inflation, the rule of 72 shows that purchasing power of 26 lakhs will be 13 lakhs in 10 years and 6.5 lakhs in 20 years, drastically cutting down the quality of life of the investor. This, of course, assumes that the interest rates remain high enough to get the same level of income throughout retirement. Thus, at the end of retirement, the balance in the FD account will be close to zero since there will be withdrawals from the principal to maintain the quality of life of ₹ 12 lakhs adjusted by inflation.

The dividend portfolio is

  • expected to provide income growing at inflation, maintaining the purchasing power during retirement
  • capital gains of the stocks will likely increase the value of the original corpus leaving a substantial inheritance for the heirs. A modest 3% growth for 30 years on the stock portfolio, for example, leads to ₹ 7 crores becoming 7 * (1.03)^30 = ₹17 crores which will be valuable for the heirs

There are two assumptions regarding inflation and capital growth in the points above, and if both premises are valid, this is one portfolio that

  • lasts indefinitely throughout retirement as long as the dividends keep growing
  • leaves a substantial inheritance

We show some sensitivities of retiring without any equity exposure in the retirement portfolio in this post.

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