Dividends vs. The 4% Rule

Have you ever wondered how a dividend income strategy would stack up against the conventional 4% retirement rule?

Let’s run a simple test to find out.

Before we get started, if you’re not familiar with the 4% rule here’s a quick explanation.

The rule was coined by Bill Bengen, a financial advisor, sometime in the 1990’s. Bill wanted to find a safe withdrawal rate for retirees allocated to a 60/40 (Stock/Bond) portfolio to ensure they didn’t run out of money in retirement. He ran his test for the 50 year period between 1926 and 1976, capturing the great depression and the market downturns of the 1970’s. What Bill found was that by using the 4% rule a retiree would not exhaust their portfolio in a period shorter than 33 years.

More conventional adaptation of the rule states that when you start your retirement you withdraw 4% of your portfolio per year, adjusting annually for inflation. Some financial advisors even suggest using a 5% starting withdrawal rate that will give you more cash and still preserve your capital for a long period of time.

While dividends can certainly produce a portion of the inflation adjusted 4% withdrawal each year, what if they made up the bulk or all of it?

I decided to run my own test, similar to Bill, testing a 60/40 (stock/bond) portfolio, a 100% stock portfolio and a dividend focused portfolio to see which one would hold up best under the 4% rule.

The 60/40 portfolio is made up of 60% VOO and 40% BND (Vanguard ETFs).

The 100% stock portfolio is made up entirely of VOO.

And the dividend focused portfolio is made up entirely of SCHD.

I ran the test for the period January 2013 through June 2024, roughly 11.5 years. Mind you these were rather good years for the stock market.

The 60/40 Portfolio

I allocated $1 million dollars to this portfolio on January 1, 2013, split $400k to BND and $600k to VOO. No annual rebalancing was performed, however, if shares needed to be sold to fund the withdrawals, shares of the overweight position were liquidated.

Using the 4% rule, we would withdraw $40,000 per year adjusted for inflation which I set at 2% per year. The withdrawals were taken quarterly, starting with $10,000 in March of 2013.

At the onset, the dividend and interest income from this portfolio covered 47.37% of the quarterly withdrawal rate. The withdrawal coverage improved to about 75% by 2024.

The withdrawals totaled $511,616.10.

Dividends and interest covered $317,805.14 of this amount.

The remaining $193,810.96 came directly from liquidating shares each quarter, entirely from VOO that always exceeded its 60% allocation.

Interestingly enough by June of 2024 the allocation split between VOO and BND was 82.66% vs. 17.34%. Aside from the interest contribution to fund withdrawals the bond portion of this portfolio was irrelevant other than mitigating risk during down market periods.

Despite having to liquidate 918.25 shares of VOO (roughly 17% of original position) to meet the inflation adjusted 4% withdrawal rate, the ending market value of this portfolio would be $2,709,672.21.

The 100% Stock Portfolio

Since BND was a drag on the 60/40 portfolio I think it will be interesting to see how a 100% stock portfolio would hold up. While this portfolio delivered a superior return the 60/40 portfolio provided a superior risk-adjusted return.

I ran the same test for the 100% VOO allocated portfolio.

At the onset, the dividend income from this portfolio covered 60.38% of the quarterly withdrawal rate. The withdrawal coverage improved to about 125% by 2024.

The withdrawals totaled $511,616.10.

Dividends and interest covered $465,513.25 of this amount.

The remaining $46,102.85 came directly from liquidating shares of VOO.

Despite having to liquidate 231.41 shares of VOO (roughly 2.6% of original position) to meet the inflation adjusted 4% withdrawal rate, the ending market value of this portfolio would be $4,372,401.33.

It’s worthy to note that towards the end of the test period dividends more than covered the withdrawals and the difference was reinvested into more shares of VOO. The 231.41 shares liquidated is the net figure of all shares sold and purchased.

Dividend Focused Portfolio

Finally let’s see how the dividend focused portfolio fully allocated to SCHD weathered this test.

At the onset, the dividend income from this portfolio covered 95.54% of the quarterly withdrawal rate. The withdrawal coverage improved to about 379% by 2024. It’s worthy to note that starting with the second withdrawal in June of 2013, the dividend income fully covered the withdrawal amount and this pattern remained intact for the remainder of the test.

The withdrawals totaled $511,616.10.

Dividends and interest covered $511,170.27 of this amount.

The remaining $445.83 came directly from liquidating shares of SCHD.

In total 9,728.93 new shares of SCHD were purchased during this test window. And the final market value of this portfolio was $4,402,224.43, just slightly higher than the market value of the VOO test.

By 2024 this portfolio was generating roughly 3 to 4 times the necessary dividend income per quarter to satisfy the inflation adjusted withdrawal amounts.

Interpreting The Results

All 3 tested portfolios easily thrived with the 4% rule during the past 11.5 years. We can however derive some insights from the final outcomes. While the 60/40 portfolio was the staple recommendation for a retirement portfolio, mainly due to its favorable risk-adjusted return, it will lag portfolios with higher stock allocations during bull markets. The 100% stock portfolio performed admirably in the test although we did have to liquidate some shares to fully fund the quarterly withdrawals. Had there been a more sour period or market crash during the past 11.5 years the final outcome may not have been so nice. The SCHD portfolio offered us a completely different alternative to the 4% rule. The dividend income almost fully covered the quarterly withdrawal at the onset of the test. With reasonable dividend growth this option allowed us the flexibility to live off the dividends while also being able to keep compounding our capital with excess dividend income.

Personally I would favor the SCHD portfolio under this test scenario but as they say hindsight is always 20/20.

Here’s an interesting tidbit to add to the prior results.

The 60/40 portfolio, in our test window, would be able to sustain a 21% annual inflation adjustment while never seeing the market value of the portfolio dip below $1 million.

The VOO portfolio would sustain a 30% annual inflation adjustment.

And the SCHD portfolio would sustain a 32% annual inflation adjustment.

What If You Start Your Retirement During A Recession

There are plenty of people calling for the next recession in the near future and some saying it’ll be the worst one yet, similar to the great depression. As far back as I remember there has always been someone forecasting doom and gloom, sooner or later these people will be right. Recessions do happen and they can get pretty ugly.

While the scenarios I tested were very favorable market periods, the next decade may not play out as nicely. I tested the VOO and SCHD portfolios with a hypothetical recession that took place in the first year for each portfolio. To make the doom and gloom as bad as possible I applied a 75% decline in each assets value during the first 12 months of each test.

While the asset values for each portfolio dwindled down close to half a million during the first year. In the long-run each portfolio finished the test with positive results, and market values close to $2 million. The biggest change was that for the duration of this test you would have to sell a significant amount of VOO shares, even in 2024, to sustain the withdrawal rate. Even in the SCHD portfolio the dividend income (also cut by 75% in the first year) did not fully cover the withdrawals in more recent quarters. Overall in both cases you would have to sell shares of each position to sustain the 4% inflation adjusted withdrawals. The SCHD portfolio did have a few quarters where the dividend payouts fully covered the withdrawals between 2022 and 2024.

Verdict

I think there is merit to using a dividend strategy in lieu of the 4% rule. If you can comfortably live on only the dividend income your portfolio generates, and you have an inflation beating dividend growth rate, you can have a very comfortable retirement. Relying on dividend income instead of selling shares of stocks can make it easier to weather negative market periods. It can be pretty scary to sell your shares to fund your retirement while also watching the market value of your portfolio decline heavily. If there is a prolonged bear market, the damage from selling shares can become irreparable, ultimately causing your portfolio to fail to deliver on its sole purpose, funding your retirement.