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The Major Flaw of Dividend Income Plans

Stocks in this article: DVY VIG

Let's assume a person embarked on a dividend-based withdrawal plan in 2007 or 2008 and bought enough shares of DVY to supply $20,000 in annual dividends in 2008. That person planned on dividends rising by 3% to $20,600 in 2009 to offset inflation. Instead, they received only $13,719 from DVY. They couldn't make up the difference with other dividend ETFs because, as the table clearly shows, most of the others were just as bad, if not worse.

Our dividend investor is left with no choice but to sell some holdings to make up for the income shortfall. To add insult to injury, the dividend streams still have not returned to their prior levels, forcing the dividend investor to sell again in 2010 and 2011. Even if dividends remarkably return to 2008 levels in 2012, our dividend investor has sold off a portion of the portfolio plus experienced four years of inflation, and therefore portfolio level dividends will still be insufficient.

One argument I expect to receive is that these ETFs are not good examples because they don't own the best list of dividend stocks. My counter argument would be that the underlying indexes are created by knowledgeable experts. Any list that you generate today, consisting only of companies that have never cut their dividends, is a list that suffers from extreme survivor bias.

Another argument might be to put it all in the Vanguard Dividend Appreciation ETF (VIG) since it had a smaller decline and has already fully recovered. However, VIG and similar strategies only generate about a 2% yield -- far short of the 4% needed.

If you are going to point out that the yields on these ETFs actually increased in 2009 (their prices fell more than their dividends), my counter argument will be that it doesn't matter to our 2008 retiree. Current yield only matters to new money being invested. By definition, our investor is in withdrawal mode and not accumulation mode. He has no money to invest at these new lower prices and higher yields.

Disclosure: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.

Ron Rowland is the founder and president of Capital Cities Asset Management, a fee-based registered investment adviser in Austin, Texas. He is also the founder and publisher of Invest With An Edge and All Star Investor, where he has been providing market commentary and active investment advice since 1991. Opinions expressed in this article should not be considered personal recommendations to buy or sell any security.
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