Good reads from around the Web.

A US researcher called Wade Pfau has been wading through the weeds of retirement investing for the past several years. I’ve featured his work here many times.

An article in Financial Planning this week is perhaps the most accessible summary yet of his findings.

I’d say Wade’s biggest contribution has been to unmask the 4% withdrawal rate “rule” as an accident of history that was never meant to carry the hopes of every last wrinkly American on its shoulders.

And if the 4%-rule was adopted unthinkingly in the US, its importation into the UK was even more anomalous.

After all, the initial data that alighted on 4% as being a safe withdrawal rate was always US-derived.

Yet many UK writers and bulletin board pundits have put forward the 4% rule as if it’s a third Law of Finance.

Wade looks almost exclusively at the US market, but the article does include some international statistics – including a grim one for UK investors.

The half-as-lucky generation

All told, the article’s thrust is pretty hard reading:

New research shows that Americans retiring in 2015 need to be far more conservative in their withdrawal rates during retirement.

The historic 4% annual withdrawal rate is over two times the level that Americans can safely withdraw without expecting to outlive their assets.

The real safe withdrawal rate, accounting for fees and today’s stock and bond market levels, is under 2% per year.

Bleak!

Now, I will say I’ve long been more optimistic about future returns than today’s low rates would imply – at least when it comes to equities.

I also think the US valuation situation is more extreme than the UK one, and that UK investors will see higher returns than US investors from here.

The US stock market looks expensive to me. The UK market? Not so much.

Still, what do I know that the world’s collective investing dollars does not?

The more important takeaway is that there was never any such thing as a Safe Withdrawal Rate. It was always going to depend on starting valuations, an unknowable future, and personal circumstances.

So any such target withdrawal rate – high or low – is at best a rule of thumb.

A Southern gentleman never spends his capital

I tend to leave discussions about all this to my passive minded co-blogger, The Accumulator.

That’s not just because he finds it much more fascinating than I do – and I have a low boredom threshold.

It’s also because I am a clear oddity, whereas his path towards early retirement is a much more middle of the road affair.

True, he’s ultra-frugal. More so than me.

But I am a monomaniacal active investor who suggests other people invest passively for their own good. I don’t even really notice I’m saving 50% or more of my earnings, it’s just what I do. It just happens. It’s probably genetic, if not mildly aspergic.

In addition, I plan to someday live off investment income and never spend my capital, which in some respects makes the Safe Withdrawal Rate irrelevant for me (or at least changes the frame of the problem).

But very few people will be able to do this – at least not unless they’re born wealthy to start with. The maths and human psychology just doesn’t work for most.

If they earn enough to make saving enough to eventually live off their capital a realistic possibility, then in most cases they’ll get used to a far higher standard of living well before then than their portfolio will throw off in income alone

And if they don’t earn enough? Well, they don’t earn enough.

Sorry. Life isn’t all ha ha ha, hee hee hee.

Do it his way

In contrast, The Accumulator earns fairly well but hardly bulge bracket, lives simple but saves hard, fully intends to run down his capital, and bridles at talk of investing specifically for dividends and the like as specious active investing nonsense.

And that world view is a much more sensible one for most people, because planning to spend your capital means you’ll need much less of it in the first place.

Living off your capital implies an inefficient use of that capital, because your plan is basically to die with it still invested.

If instead you spend your capital, you can retire earlier or you can have more slap-up dinners at Nandos once you do.

Those extra chicken wings and curly fries are the pay-off in a bet that you’re making that your heart will run out before your cash does…

Get a new plan

If I were however planning to spend my capital, I’d do a few things.

Firstly, I’d almost certainly plan to at some point buy an annuity with a portion of my pot.

Creating a minimum income floor like this gives you some of the benefits of living off your capital, in exchange for effectively spending it and betting you’ll outlive your actuary’s best guess.

The inflation-linking would be expensive, but I’d do it anyway.

And yes, annuities look poor value right now. But I wouldn’t do this unless I had a fairly sizable pot to play with – that’s what I expect to have, and this is about what I’d do.

(I can’t really tell you how I’d retire early without much money, because I wouldn’t.)

Secondly, I’d investigate the various dynamic withdrawal strategies that have been put forward, including by Wade Pfau himself.

Essentially these boil down to “spend less when your investments do poorly”. Seems like common sense to me, but perhaps it is best codified.

Finally, I wouldn’t under-estimate the difficulty of actually spending your capital when you do pull the ripcord.

I know myself well enough to understand I could probably never do this (or at least not until very late in the game), which is why it isn’t in my plan.

But even pragmatic financial freedom seekers might be surprised how difficult spending money is.

Would you like to make a withdrawal?

It’s one thing to spend your money as a 65-year old who has simply flopped over the line at the end of the traditional 40-year rat race.

But if you’re someone who has saved extra-hard all your life and retired early (or even, and better, if you’ve transitioned to an opt-in-and-out lifestyle where you make money when you want to, doing what you want to), then it’s going to be tough to start splashing the cash.

If you don’t believe me, ask a real early retiree like Jim at SexHealthDeathMoney.

Jim warns that:

The pain of cashing in investments just to live from month to month is almost physical.

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Good reads from around the Web.

There are many reasons to be a passive investor, but guaranteed returns is not one of them.

Is passive investing most people’s best chance of capturing the expected returns?

Definitely.

But you can’t bank on expected returns.

This was illustrated nicely by Motley Fool columnist Morgan Housel in an article this week on how long it takes to prove yourself as an active investor.

Morgan was discussing how some lauded active investors might just have been born at the start of a good run for their asset class – and wondering how long you’d have to invest for in order to know your returns weren’t simply down to luck.

But the graph that illustrates his piece might interest passive investors, too.

It shows how US stocks did over various 20-year periods, which Morgan suggests would reflect the key years in an investor’s life (35-55, he says):

Source: Motley Fool

From eyeballing the graph we can see that, for instance, the 20 years following 1910 were an awful lot easier to find gains in than the 20 years from 1930.

Lies and statistics

Now before anyone in any particular camp starts having a go in the comments, this is just one way of looking at a particular slice of data and it’s designed to make a particular point.

So yes, plenty of caveats.

For a start we nearly all invest regularly over many years, not just in a one-off lump sum.

Also, sensible passive portfolios are diversified – rather than just being all-in US stocks or any other asset class.

Indeed, rather than being pessimistic or misleading, Housel’s graph of US stock market returns reminds us why geographical diversification is important.

The evidence is that a wide variety of very simple well-diversified and rebalanced passive portfolios will deliver solid positive returns over the long-term (though nothing is ever certain!)

Finally, active investing is always a zero sum game. So to extend on Morgan’s comments, this means that an active investor in a good market may find it easier to put up impressive sounding numbers, but on average they will still lag tracker funds that follow the same benchmark.

Careful what lessons you learn

I suspect we will all take what we want to find from such graphs.

Passive investing skeptics will ignore my points about geographic diversification and regularly investing over a lifetime – and Morgan’s point about lucky fund managers – and say this is why you can’t rely on trackers for your returns.

And before I scoff at them too loudly, I must admit I did think to myself that this data shouldn’t really scare me, because as an active investor – for my sins – I flit about territories and individual stocks like a butterfly on a buddleia bush.

But it would be wrong (and ironic) to take away the message that passive investing is a flawed strategy from an article that is trying to show how the perception of an active manager’s success could just be down to when their parents happened to get jiggy with it.

(Again, read my zero sum game article if you don’t understand why.)

The active fund industry will always use the fact that shares go up and down and markets sometimes disappoint to play on people’s feeling that passive investing feels wrong.

But those feelings are not a good guide to the reality.

Certainly we need to be alert to the potential pitfalls, such as not being diversified or falling prey to sequence of returns risk.

And I do still hear too many new-ish passive investors saying things like “I can expect to get 5% from shares over the next few years”.

No you can’t, not over five-years.

You can hope to – but remember that average returns are not normal.

You know what you’ve got to do

I know these warnings and caveats are all a bit relentless, particularly if you’re new to investing.

I’m tempted to write that investing is like an onion, and that every time you peel away a layer you find a new layer and another complication.

But really it’s more like a childhood cut that turns into a scab.

You know what is happening and what you need to do – which is leave it alone – but you can’t resist picking and poking at it.

And if you do it may just start to bleed again!

The principles of investing – regular savings, compound interest, diversification, rebalancing, time horizons – were all worked out long ago.

Investors will experience very different markets depending on when they were born, but the principles don’t change.

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Whilst high-yield shares have been receiving most of the attention in this low interest rate environment, dividend growth shares should also be considered for any income-based portfolio designed to stand the test of time.

Investors wanting to maximise current income may feel content with a portfolio built solely with high-yield shares. But because today’s higher-yielding shares are also likely to be in the slower growth stage of their life-cycles, it’s important to also consider which shares might provide inflation-beating dividend growth in future years.

And that’s where dividend growth shares can play an important role.

That said, dividends that might be paid to us five-to-ten years from now are much less assured than the dividends we’re going to receive next year, so knowing how to make conservative growth forecasts is critical to dividend growth success.

As with high yield share research, healthy balance sheets and free cash flow cover remain important, so as you research dividend growth shares, keep those important factors in mind.

Today though we’ll focus on measuring dividend growth potential. Once we’ve estimated a company’s sustainable growth rate, we can better gauge the opportunities we’re presented and weigh them against alternative investment choices.

History may rhyme, but it doesn’t repeat

The first place many investors look when determining dividend growth rate potential is the dividend track record. But whilst momentum may play a role in future dividend growth – few companies growing their payouts at 15% per annum suddenly flatline the next year – it’s dangerous to presume that past is prologue.

In other words, don’t use the past five-year growth rate as your five-year forecast.

Instead, use dividend history to understand what has been driving the growth rate. Was it due to an expanding payout ratio, for instance, or was it completely due to earnings growth?

A firm that’s been driving dividend growth by paying out a greater percentage of its earnings will not likely be able to repeat that performance. You should adjust your forecast accordingly.

Focusing on the fundamentals

Rather than look just at dividend history to determine future growth potential, we can use the financial statements to calculate a sustainable growth rate (SGR) – that is, the maximum growth rate the company can sustain without increasing its financial leverage:

SGR = (1 – payout ratio) x return on equity

Where:

Payout ratio = dividends per share/earnings per share
Return on equity (ROE) = net income / shareholder equity

To illustrate, let’s assume a share is paying out £1 in dividends for every £3 in earnings (a payout ratio of 33%) and has a return on equity of 15%.

SGR = (1 – 33%) x 15%

SGR = 10%

This SGR calculation assumes that the company takes the £2 in earnings that it isn’t paying out in dividends and reinvests in the business at a 15% return. Assuming the company’s payout ratio and ROE doesn’t change much in the next five years, then, it’s reasonable to assume that the company’s five-year dividend growth rate should approximate 10%.

To see how the SGR can change based on ROE and payout ratio, you might consider the following table:

ROE	Payout Ratio	SGR	£1 of earnings in 5 years
15%	100%	0.0%	£1.00
15%	75%	3.8%	£1.20
15%	50%	7.5%	£1.44
15%	25%	11.3%	£1.70
15%	0%	15%	£2.01

Note: SGR is rounded to one decimal place

Ah, but if it were only so simple!

Payout ratios and ROEs can change year-to-year, especially with cyclical companies. It’s extremely risky, for instance, to use the most recent payout and ROE figures for a commodity company in a peak year. You’ll come out with a very low payout ratio and a very high ROE, and thus an unrealistic SGR.

A workaround to this is to use a normalised payout ratio and ROE assumption by taking the averages over the most recent business cycle of 5-to-7 years. Even if you normalise the figures, however, the SGR results may still not make practical sense.

For example, let’s assume a large-cap company with an ROE near 30%. We’ll also assume £1 dividends per share and £2 earnings per share for dividend cover of two times (a 50% payout ratio). The share is also trading with a 3% yield and carries a £33 per share price.

If we used those figures to determine SGR, we would get:

SGR = (1 – 50%) x 30%

SGR = 15%

A 3% yield plus potential for 15% annualised dividend growth is a very attractive proposition, but it’s probably too good to be true. Large-cap shares with this type of dividend growth potential simply don’t escape the notice of institutional investors.

Buybacks and dividend growth

Large companies generally are not able to reinvest the majority of their earnings back into the business to earn 30%-plus returns. As the company gets bigger, the absolute amount of high-return opportunities doesn’t usually keep pace.

This is why more mature companies usually engage in dividend and buyback programmes and engage in more acquisition activity – they need something to do with their excess cash.

To illustrate, let’s assume the company can reinvest 20% of its earnings (£0.40 per share) at the 30% return on equity. This implies a more earthly 6% sustainable growth rate in earnings and leaves £1.60 per share remaining for dividends and buybacks.

In a perfect world, this company might pay out all £1.60 per share in dividends, resulting in a 4.8% dividend yield. In today’s markets, however, buybacks are frequently employed alongside dividends, so we’ll assume the company is using the remaining £0.60 per share (£2 EPS – £0.40 reinvested – £1.00 dividends) for buybacks.

Knowing that the company is trading for about £33 per share, we can see that £0.60 per share going to buybacks should eliminate approximately 1.8% of shares outstanding (£0.60/£33). We can then add this 1.8% to the 6% adjusted SGR result and estimate that earnings can grow at 7.8% and provide underlying support to dividend growth.

This isn’t to say that the buybacks will necessarily enhance shareholder value in any way – only that they can support dividend growth by reducing the number of shares the company needs to pay dividends to in a given period.

Don’t be afraid to forecast

As you can likely surmise by this point, forecasting dividend growth is not an exact science. If it were, we active stock pickers could all set up complex equations to automate our investment decisions and build our dividend portfolios, and turn our attention elsewhere.

Some market watchers may therefore see forecasting as a futile task, but when you purchase any share you are nevertheless making an implicit assumption about future growth – that is, the growth that’s currently assumed in the share price. I’d much rather explicitly state my underlying assumptions and hold myself accountable than make like an ostrich.

Forecasting growth is a probabilistic task. Your original assumptions may be a good baseline, but also consider alternative scenarios and see how they might affect your interest in the share.

Finally, you can be more confident with your forecasts, all else being equal, the stronger the firm’s competitive advantages. In contrast if the company is engaged in selling commodity products and has no clear advantage over competitors, it’s important to consider a wider range of possible outcomes and demand a larger margin of safety before purchasing the share.

Read all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.