I received a question from a reader asking about a mainstay of retirement planning - the 4% rule. I will paraphrase, but the premise of the question was if the ASX dividend yield including franking credits is ~6% why would a retiree worry about withdrawal rates. Wouldn’t it be better to just live off the dividends of a share portfolio. The reader suggested that the 4% was a classic case of the financial services industry overcomplicating a topic.

This question had it all. I am a fan of income investing. I write and talk a good deal about the amount a retiree can safely take out of a portfolio. I also fervently believe that anyone can be a successful investor. The investment industry is guilty of overcomplicating investing which makes it appear inaccessible for the average investor.

The short answer to the question is that it is a feasible approach. The long answer involves some caveats and guidance for investors who want to pursue this strategy.

Starting with the basics

In theory if an investor only lives off the income generated by a portfolio they would never run out of money. And not running out of money is the whole point of trying to figure out a safe withdrawal rate. Living off of dividends means relying on the income generated from the assets held in a portfolio. If those assets are never sold there would always be a source of income. The market goes up and the market goes down. None of it matters. Only dividends count.

The challenge of living off of income is amassing enough assets to support a retiree’s day to day life. On a global basis this is hard. The S&P 500 which makes up around 70% of the global share market has a dividend yield of 1.51% as of the first of September 2023. That is significantly lower than the 4% figure that is often cited as a safe withdrawal rate. That means a retiree needs a portfolio that is 2.64 times larger to generate the same amount of money that the 4% rule would provide.

Australia is different. ASX shares typically have a higher yield due to the local preference for dividends that come from the tax advantages in Australia. Franking credits eliminate the double taxation of dividends in Australia by offering a credit for corporate taxes. Franking credits increase the post-tax income for Australian investors holding Australian shares.

As the reader points out the yield on Australian shares when franking credits are included exceed 4%. That means a retiree can support the same level of income with a smaller portfolio than using the generally accepted withdrawal rate. The ASX 200 currently has a trailing 12-month yield of 5.18%. The ATO estimates the franking credit yield on the ASX All Ordinaries each month. Over the past year the average franking rebate yield is 1.46%. That is a different index from the ASX 200 but a good approximation for franking credits.

Investor are able to get around a 6.64% total yield by investing in the ASX 200. Following the 4% rule and generating the same amount of money as the dividend and franking credits from the ASX 200 would require a portfolio that is approximately 1.6 times larger.

In the pension phase of superannuation a retiree would not pay taxes on dividend income or on a withdrawal of funds from super. Franking credits would still be provided to the retiree and could be claimed even if there was no taxable income that needed to be offset. The government would pay the retiree the amount of credit. This is very favourable tax treatment.

At first glance this strategy seems sound. At the risk of overcomplicating things there are some considerations for investors pursuing this strategy.

A dividend is not guaranteed

A dividend is not a contractional obligation. It is a choice by the board and management of a company to pay dividends and what level they are paid. This choice is driven by preference but also by the ability of the company to fund a dividend.

Dividends are funded by the profits of a company. There are lots of factors that influence profits. The performance of a specific company and the overall economy all come into play. The safety of a dividend is governed by the payout ratio. The payout ratio refers to the percentage of earnings that are paid out in dividends. A 100% payout ratio means all earnings are paid out in dividends. A 50% ratio means that half of earnings go to dividends.

The higher the payout rate the smaller the margin of safety for any fluctuations in earnings. At a 100% ratio if earnings drop by 10% the dividend will exceed earnings. In theory a company could support this dividend by spending cash from the balance sheet or by borrowing money. In practice a company would likely cut the dividend.

Due to the preference for dividends in Australia the payout ratio is much higher for ASX listed shares than other global markets. That accounts for the higher dividend yield of Australian shares compared to global shares. The current dividend payout ratio in Australia is around 62%. This is actually quite low for Australia. In 2016 the payout ratio was over 75%. It is still much higher than many markets around the world. The S&P 500 has a dividend payout ratio of just under 24%.

The high dividend payout ratio in Australia impacts the safety of dividends. And dividends in Australia fluctuate constantly. We can use BHP (ASX: BHP) as an example. BHP is Australia’s largest company and makes up over 10% of the ASX 200 index. In the calendar year of 2022 BHP paid total dividends of $4.64 a share. In the calendar year of 2023 BHP will pay out dividends of $2.61 a share.

The problem this presents for a retiree living off of dividends is that year to year income would fluctuate. And that can be a challenging way to live. If a whole retirement portfolio was invested in BHP income would drop by 43% in 2023 compared to 2022.

The way to address this risk is by diversification. We diversify to remove single security risk from our portfolio. In an income investing strategy we are removing the risk that company specific problems impact a dividend and the overall income generated from a portfolio. We will get back to diversification a bit later.

The other issue that can arise is if something happens to the economy that impacts many companies. COVID was an outlier but also a cautionary tale. A quarter of Australian companies cut or deferred dividends during 2020. More dividends were cut in Australia than globally which shows the risk of a high payout rate.

One way to ride out the volatility of dividends is to hold cash. When dividend income falls the cash could be used to make up for the shortfall. If dividend income increases a portion of the increase could be used to replenish the cash reserve. Holding cash can smooth out changes in dividend income and provide more predictability for a retiree. This is an income investing equivalent to the bucket method of asset allocation which we discuss in this episode of our podcast Investing Compass.

Dividend growth needs to keep up with inflation

One little appreciated aspect of the 4% rule is that it only governs how much money is withdrawn during the first year of retirement. After that a retiree would increase the dollar amount of withdrawals by the rate of inflation. This guarantees a steady real standard of living. Something that has hit home recently as inflation has surged.

To keep up with inflation over a multi-decade retirement requires income growth. This is another concern with Australian dividend paying shares. The average dividend growth per share in Australia has been 3.70% a year over the last 10 years. The S&P 500 has grown average dividends per share by 7.82% a year over the same period. The growth in Australian dividend growth has outpaced the RBA target for inflation but has fallen short in the current inflationary environment.

The lower growth can be at least partially attributed to the high payout ratio in Australia. Higher payout ratios mean that companies have less wiggle room to grow dividends without earnings growth. It also means that there is less money left over for a company to invest in earnings growth which is the long-term driver of dividend growth.

The news is not all bad. Official inflation represents the increase in prices for a basket of goods that is supposed to represent what an average person in Australia consumes. That does not necessarily correspond with the spending of each individual. For example, in 2022 the portion of the CPI basket that is allocated to housing costs increased by 9%.

Unsurprisingly, housing costs make up a big part of the CPI basket at close to 25%. If a retiree has a fully paid off house this would not be a consideration. This is why an examination of personal inflation rates is worthwhile to understand future spending needs.

There are ways to mitigate the slow growth in dividends by designing a portfolio that is diversified between companies that pay high dividends and have high payout ratios and companies that may have lower dividends but better prospects for earnings growth and future dividend growth.

This may include an allocation to global dividend payers despite the lack of franking credits. Balancing dividend growth and high current yields creates a more balanced income portfolio. I cited dividend growth as a driver of my recent decision to purchase CSL (ASX: CSL). The yield is low but historic dividend growth has been high.

The lack of diversity in the Australian market

Earlier in this article I discussed diversification as a strategy to limit single security risk. In the context of an income portfolio this would lower the risk from dividend cuts from a single company. Purchasing each of the big four banks would lower the single security risk of an issue related to only one of the banks.

This is only one aspect of diversification. Each of the big four banks has a similar business model. Non-company specific factors are likely to impact all of the banks. And the ASX 200 is very concentrated.

The ASX 200 currently has a market capitalisation weighted dividend yield of 5.18%. Market capitalisation refers to the size of the company as measured by the total shares outstanding multiplied by the share price. It is the value of a company. Market capitalisation is the weighting that is used in many indexes including the ASX 200. Big companies make up more of the index. This can lead to concentration in specific companies and sectors.

The dividend yield is a backward-looking metric. It is based on dividends that have been paid over the past 12 months. For current shareholders the dividends that are paid in the future may vary. I have looked at the yield that is attributed to each sector – a grouping of similar companies. The following chart shows how much of the overall dividend yield is attributed to each sector and the percentage of the total ASX 200 yield that has come from that sector. 

Dividends by sector

The previous chart shows that just over 65% of total ASX 200 dividends come from two sectors: Basic Materials and Financial Services. This is very concentrated. A poor environment for banks and / or low resource prices make it likely that ASX 200 dividends would fall. Potentially substantially.

There is also concentration in the largest companies of the index. BHP makes up over 10% of the index and accounts for just over 17% of the total ASX 200 dividends. The big four banks make up just under 24% of total dividends. That is a lot of concentration in five companies.

Relying solely on dividends from the ASX requires confidence that two sectors and five companies within that sector do well. This is another reason why diversifying into global equities could be a prudent approach to lower the risk of volatility in income. This would increase exposure to different sectors and companies. It would also likely require more money to generate the same level of yield as the ASX. And currency risk would come into play.

Another option for investors is to diversify away the concentration risk inherent in the ASX 200. This can be done by building a portfolio of individual shares with different weightings from the index or using an equal weighted index which is tracked by the VanEck Australian Equal Weight ETF (ASX: MVW). My colleague Shani has explored this specific ETF.

Is income investing right for you?

Investing is about trade-offs between risk and reward. As investors we deem some risk as acceptable and gladly take it on to achieve our desired outcomes. Some risks we try to mitigate. An income investing strategy is no different. Take a holistic look at your financial position to see if living off dividends makes sense. It may remove the risk from fluctuations in asset prices. But it introduces new risks to a portfolio.

I would love to hear from readers who have taken an income investing approach and the pros and cons of your strategy. Email me at [email protected]

For more on income investing please see the approach I take and how to use ETFs to generate income.