It wasn’t all that long ago that retirees could count on decent yields from stable, fixed-income investments. Ten years ago, it was easy to find 5% yields even from short-term government treasury bills. This arguably made retirement planning easier than it is today: Retirees could count on rock-solid payouts and protection of principal. All they needed to do was plug the numbers into a retirement planning program to see if they had the resources to retire. They didn’t need to worry much about fluctuations in asset prices or cuts in dividends.
Forward a couple of years to 2008, and the picture had changed dramatically. The stock markets crashed, of course. But something else was going on then too. Fixed income yields got really stingy. No more 5% T-bill yields. They were more like 1% or 2%.
This became the perfect storm for a lot of retirees. People just heading into retirement around this time in search of more income naturally turned to the stock market. Watching their principal get cut nearly in half was surely unnerving enough. But when what they thought would be a solid source of income–blue-chip stock dividends–started getting cut, it was life changing, in a very bad way.
It may sound counterintuitive, but part of the problem for some of these investors was too much diversification. Investing in a stock fund or ETF, even one that invests largely in dividend-paying stocks, means you’ll be buying companies that will–quite reasonably–decide to cut (or halt entirely) their dividend payments during tough times. Prudent capital management for the company; disastrous for investors counting on the income.
What today’s income-oriented investors need instead is a smaller basket of companies that have a record of doing anything they can to preserve that dividend payout. Such companies will cut capital spending, postpone large projects, borrow money, and even lay off employees before they will consider a dividend cut. If you can identify such companies and put together a portfolio of them, you should be able to worry a lot less about stock price fluctuations, knowing with reasonable certainty that the dividends will come almost no matter what.
Putting It To The Test
Let’s consider a hypothetical, risk-averse, 45-year-old couple that would like to retire at 65. They have managed to save $400,000, investing all of it in long-term treasury bonds yielding 2.4%. Half of the funds are in an IRA, with the other half in a regular taxable account. We’ll call inflation 2% annually.
Even assuming the couple can put away another $5,000 a year until retirement and live on only $50,000 a year once they are retired, this plan isn’t going to work out for them. After putting the numbers into our publicly available WealthTrace Financial Planner and our Retirement Withdrawal Calculator, we can see that they are projected to run out of funds only 13 years into retirement:
In The Red: That 2.4% risk-free yield doesn’t look so risk free after accounting for 2% inflation.
This couple has done one thing right, though: They’ve saved. That’s the most important thing. All they need to do is make an adjustment to where they’re putting their money.
The Dividend Alternative
Things look a lot rosier if, instead of treasuries, we go with dividend stocks. We’ll assume a 7% annual total return, half of which comes from dividend payouts. Here’s how it looks in WealthTrace:
That’s More Like It: No shortfalls using a portfolio made up of dividend-paying stocks.
With dividend payers instead, there’s no shortfall–and a portfolio that actually goes up in value during retirement:
In The Green: Dividends keep investment balances moving in the right direction.
The Right Stocks
OK, sure. Stocks are going to outperform treasury bonds over time–no news there. But they’re riskier, in the sense that their returns can swing much more wildly. How can you mitigate that?
Let’s have a look at one solid dividend-paying stock, Procter & Gamble (PG). Check out the dividend payment history in this graph:
They Don’t Make ‘Em Like That Anymore: Procter & Gamble’s long history of dividend increases.
It’s not just a history of dividends year in and year out; it’s a history of dividend increases year in and year out.
As of this writing, P&G yields a respectable 3.2%. Not only that, its dividends have grown by an average of 6.9% annually for the past five years, and its payout ratio (the percent of net income paid out as dividend) is around 68%, which means there is still room for dividend growth. Even during the recession of 2008-2009, P&G boosted its dividend. Impressive.
Gathering A Few Eggs For Your Basket
You can put together a dividend-oriented portfolio yourself. Here are a few tips for doing so:
Don’t put too much faith in streaks: P&G has increased its dividend every year for an incredible 60 years running. Genuine Parts (GPC) has managed to do the same; Coca Cola (KO) is not far behind, having raised its dividend for 54 years straight. These streaks tell you at least something about a company’s priorities, and they are not to be dismissed.
But you can’t bank on every company doing what it has always done. General Electric cut its dividend in half in 2009 after years of increases. ConAgra cut its payout in 2006 after 26 years of dividend growth; Diebold cut after 60 years in 2013. This is still the stock market after all: The unexpected and unprecedented will always happen. Some diversification is needed to reduce company- and industry-specific risks. Which brings us to our next point:
Diversify, just not too much: In your early savings years, putting your investment dollars into index funds or ETFs that in turn invest in hundreds of different securities is a great move. But later, as your needs shift to income, picking and choosing income-producing stocks could be the way to go. Just make sure to diversify across companies and industries.
Here are the beginnings of a nicely diversified portfolio of income-oriented stocks. Note the diversity of industries. In the real world, we would probably want more stocks than this to prevent against too much company risk–that is, the risk of, say, an accounting scandal at one of the companies that could lead to permanent capital impairment (think Tyco)–but it’s a good start:
Name Ticker Yield Industry
Compass Minerals International CMP 3.5% Metals & Mining
Duke Energy Holdings DUK 4.0% Electric Utilities
Emerson Electric EMR 3.6% Electrical Equipment
Microsoft MSFT 2.9% Software
Procter & Gamble PG 3.2% Household Products
Spectra Energy SE 4.8% Oil, Gas & Consumable Fuels
Wells Fargo WFC 3.2% Banks
Welltower HCN 4.7% Real Estate Investment Trust
Data as of June 21, 2016
If it looks too good to be true, it probably is: As of this writing, most blue-chip yields top out at around 4.5% or so. Also, for reference, the Vanguard Dividend Appreciation ETF (VIG), which includes about 25 big-name stocks that have increased their dividends for at least 10 straight years, yields around 2.2%. So if you see a stock with a yield in the range of 7%, 8%, or even higher (and they’re out there), don’t just pile in. In fact, it’s probably best to stay away. Which brings us to our next point:
Valuation, dividend growth, and payout ratios should be considered: If you’re going to mostly rely on dividend income, the valuation of the stock–that is, whether it’s cheap or not when you buy it–will be of less concern. After all, the dividends should get paid out no matter how the shares might bounce around. Still, it probably makes sense to have a glance at certain valuation metrics to see how the stock is trading relative to how it has traded in the past. P&G, for example, nearly always trades at a premium price/earnings ratio relative to the S&P 500, but it currently trades at a larger premium than normal, potentially indicating that the stock is overvalued.
TTM = Trailing 12 Months. Source: Morningstar
Ditto for dividend growth and payout ratios. If, over time, a company’s dividend growth is slowing while its payout ratio is increasing, you’ll probably want to find out why. This data is available for free in a lot of places, including Morningstar.com and finance.yahoo.com.
Income-oriented investors at or near retirement are having to change tack, but it needn’t be a terrifying experience. A portfolio of solid dividend-paying stocks could be just the thing to make up for lost income from fixed income investments.