The Major Flaw of Dividend Income Plans

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- There is a raging debate regarding the best way to live off your portfolio. Young adults are told, by those older and wiser, to save and invest for retirement. There is never a shortage of ideas and suggestions on how to build a nest egg. For those lucky enough to have accumulated a nest egg large enough to meet their financial needs, the dilemma is determining the best way to tap that egg.

When it comes to defining the best solution for this task, there are two major camps -- and they rarely see eye-to-eye. In one corner are the total return proponents. They believe the optimum approach is to manage the portfolio for total return. They assume the income generated by the portfolio will not be sufficient to cover retirees' annual financial needs and therefore some holdings will need to be sold to make up the shortfall.

In the other corner is the dividend income camp. That camp believes the optimum approach is to invest strictly in dividend-generating securities that kick out the required income without ever having to sell any holdings. The dividend camp makes some compelling arguments, but that is a subject for another article.

Today, I want to focus on what I see as the single largest flaw of the dividend crowd: They do not acknowledge the fact that dividends can and do experience declines. This failure results in not having a thoughtful plan for those occurrences.

Let's take some real-life examples. We need some basic assumptions, so we'll start with the widely accepted 4% rule for first year withdrawal. If you are not familiar with the rule, it puts forth that to minimize the chance of outliving your nest egg the most you can withdraw from your portfolio balance the first year is 4% and that amount can be adjusted upward each year for inflation. There are numerous variables and it won't work for every situation, but it is a good starting point. If you start with $1 million and assume a 3% inflation rate, then the 4% rule says you can withdraw $40,000 the first year, $41,200 the second year, and so on. The withdrawal amount is independent of your portfolio balance in subsequent years.

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