The model portfolio which I talk about most often is an accumulation portfolio, but I also run and track a virtual dividend income portfolio as well.
Both portfolios date back to 2011 and they make exactly the same trades, at the same time, and own exactly the same companies. The only difference is size (the income portfolio is about 10 times as big) and dividend policy (withdrawal vs. reinvestment, of course).
I track both income and accumulation portfolios because I want my investment strategy to be just as suitable for dividend income as it is for accumulation; I don’t want to have to switch strategies just because I start drawing an income from my investments.
If you’re not familiar with these portfolios then have a look at the accumulation portfolio’s 2014 performance review to see how it works and the sort of companies that both portfolios use to generate dividends.
The goal of this dividend income portfolio is to generate a 4% dividend from day one, followed by inflation-beating dividend growth afterwards.
I’ll put the results chart up first and then talk about the whys and wherefores:
Targeting a 4% dividend and inflation-beating growth
Most research suggests an income drawdown rate of about 4% in order to avoid running out of funds before you die (depending on your age and asset allocation).
I think 4% is a good starting number and it should be possible, with high-quality and high-yield shares, to generate 4% from dividends alone without having to worry about selling any shares.
When I set up the dividend income portfolio it had a start date of 2011 and I guessed that an investor who was ready to live off their dividends today would want a minimum of perhaps £20k a year, assuming they had paid off their house in full and any kids had left home.
That would require a £500k lump sum (i.e. 4% of £500k is £20k) and so that was the starting value for the portfolio. Of course, your own situation will require a larger or smaller amount and will need to be adjusted upwards for inflation if your financial independence is a few years away (or more than a few).
In terms of inflation, I’d want that £20k to grow at least as fast as CPI inflation in order to retain its purchasing power. Fortunately, that’s quite an easy goal to track.
Beating the investment trust professionals
I also want to mention the investment trusts which I use as a benchmark, in addition to tracking income against a 4% inflation-linked target.
Investment trusts are a useful tool for dividend income investors in that they make the whole process easier than picking individual companies, especially if you pick trusts that pay a progressive dividend.
I want to make sure I’m doing at least as well as professionally managed funds otherwise I’m effectively paying for the privilege of picking stocks. So here’s my dividend income benchmark, made up of a handful of leading investment trusts with progressive dividends:
- Temple Bar Investment Trust
- The City of London Investment Trust
- The Merchants Trust
- Alliance Trust
- Foreign & Colonial Investment Trust
The benchmark portfolio was initially spread evenly between those trusts and, while you may prefer a different selection, I think it’s fairly representative.
Achieving that 4% dividend and inflation-beating growth
Here are the results from the chart above in a bit more detail:
- 2012 – Both the dividend income portfolio and the investment trusts managed to produce a yield of more than 4% (£20k), with incomes of £20,250 and £20,525 respectively.
- 2013 – Inflation was 2.5% so the target income to beat increased to £20,504. Both portfolios managed it, although only just, at £20,856 versus £20,575, producing income growth rates of 3% and 0.2% respectively.
- 2014 – Inflation this year was lower at 1.4%, increasing the target dividend income to £20,797. Again this was beaten by both portfolios, with income at £23,626 for my portfolio and £21,408 for the investment trusts. The effective “pay rise” over the previous year was 13.3% and 4% respectively.
Within that limited timeframe, I think my portfolio has done pretty well against both the investment trust professionals and an imaginary but highly attractive 4% inflation-linked bond. However, there are many years of testing to do in order to see if that good start is sustainable over the long term.
Don’t forget about special dividends and other windfalls
Something else that cropped up as a major issue in 2014 was special dividends and other “windfalls” such as shares in spun-off companies or the right to buy or sell shares in a rights issue (i.e. nil-paid rights).
In 2014 my income portfolio received the sum of £1,904 from nil-paid rights as part of RSA’s rights issue. That amounted to 9% of the previous year’s total income.
The payout from Vodafone was in a different league altogether. After the Verizon sale, the company paid the income portfolio £2,886 as a special dividend and £7,057 worth of Verizon shares, which I sold more or less immediately. In total that came to 47% of the previous year’s dividend, driving the total income in 2014 to £35,473.
Here’s what the chart above would have looked like if I’d included all cash income rather than just basic dividends:
I could have chosen to reinvest those windfall payments but in reality, I would probably draw them out and spend them, so that’s what I’ve chosen to do with this virtual portfolio as well.
Drawing down windfall payments reduces the capital invested of course, but with the portfolio’s current market value close to £600k I don’t see anything to worry about on that front.
Note: For the eagle-eyed who read last year’s review of this income portfolio, you may have noticed that the income amounts have changed. That’s because I’ve changed the period of measurement (calendar years instead of March to March) and I now draw out all income rather than leaving some cash in the portfolio as a buffer for bad years.