From the December 2008 issue of Research Magazine • Subscribe!

December 1, 2008

Jump Start Your Clients' Retirement Income

Wall Street and its marketing machinery is working overtime to develop new products that will be accepted as the industry's solution for increasing retirees' income. Unfortunately, many of the new financial services industry income products are overly complex, not clear as to their real value, or are merely variations of traditional insurance or annuity products. But, from an advisor's perspective, there is an even larger issue with the design and implementation of these new products -- they attempt to assume the role the advisor traditionally fills with the client. In other words, these new managed income products may become your next competitor.

The Opportunity It is well known that investors will pay premium prices for perceived value. Clients of financial advisors will no doubt pay premium prices for the design and implementation of a truly unique method for solving their income needs. They will also be deeply appreciative if the strategy is one that is transparent, understandable and easily monitored. One of the strategies that meets this challenge is simply a portfolio of dividend-producing stocks. I see a tremendous opportunity for financial advisors to become proactive and learn to build their own diversified dividend portfolios that have the potential to increase dividends (income) and build track records by using many of the funds that are already in the marketplace.

To initiate a discussion of this opportunity with your clients, you should begin with a simple explanation of why now is an excellent time to own a portfolio of dividend-producing stocks. For example: Imagine that you invested $10,000 in the S&P 500 back in 1973. You would have earned only $336 in dividends, or about a 3.36 percent return. Let's say you held the index continuously for the next 33 years, and spent only the cash dividends each year. By 2006, the cash dividend alone would have grown to $1,859, or a yield of 18.59 percent on your original investment... without reinvestment or hocus-pocus.

Even though the current yield of the S&P 500 is not as high as it was in 1973, the yield is now higher than it was just a few years ago when it was experiencing a historical low of around 1 percent.

The Rate of GrowthWhat's more important, however, than the initial current yield, is the rate of growth of the actual dividend being paid. Over those same 33 years, the dividend that started at $336 and ended at $1,859 actually grew at an average annualized rate of 5.32 percent, which is far in excess of the increase in the cost of living. I can't think of a simpler, better solution to the long-term retirement income needs of baby boomers.

It is entirely possible for you to build your own diversified portfolios that have the objective of increasing dividends over time. These portfolios can be built with individual stocks or mutual funds that have historically increased their dividends over time.

This rediscovery of old-fashioned traditional values and strategies may come just in time to provide one solution to the biggest challenge facing millions of retiring baby boomers.

The Good NewsCompany directors have more recently focused on the components of shareholder returns. These returns have always included cash-dividend distributions based on real cash earnings in addition to anticipated market appreciation that may or may not ever materialize. With corporate earnings and return on equity continuing to expand (even in light of the current economic slowdown in real estate and financial companies), boards of directors appear to be becoming more willing to pay out cash earnings in the form of dividends.

This conservative attitude also leads to stronger balance sheets, greater capital adequacy, higher levels of surplus cash, and a surprise. The surprise is that companies with higher dividend-payout ratios have generated higher earnings-growth rates over time. Hence, not only is there the potential for higher income streams, but with higher growth rates there also is greater potential for added capital appreciation opportunities.

Avg. Subsequent 10-Yr EPS Growth

Starting Payout Quartile

Worst

Average

Best

One (Lowest Payout)

(3.4%)

(0.7%)

2.6%

Two

(2.7%)

1.3%

4.7%

Three

(1.6%)

2.1%

6.3%

Four (Highest Payout)

(0.1%)

3.2%

7.0%

Source: Arnott and Asness

The Bad NewsRecently, two investment sectors historically known for paying out high dividends have experienced economic and financial challenges -- the financial sector and the real estate sector. What is interesting, however, is that while these sectors have historically paid out a higher percentage of their earnings as dividends with their stocks exhibiting some of the highest yields, their rate of dividend growth (or potential for increasing payout ratios) has been limited even in good times.

The Highest U.S. Yield Stocks are Found in a Few Sectors

Top 100 Dividend Yieldsin Russell 1000 Index

Top 100 Dividend Yieldsin Russell 2000 Index

REITs

47%

78%

Utilities

34%

9%

Banks

6%

2%

Other Financials

2%

1%

Cons. Staples

5%

3%

Telecom

3%

0%

Materials

2%

2%

Health Care

1%

0%

Cons. Discretionary

0%

4%

Industrials

0%

1%

Energy

0%

0%

Technology

0%

0%

Source: Baseline, as of December 31, 2003

Despite the fact that many of these companies have recently cut their dividends, there are many other investment sectors that offer a greater potential for dividend growth.

Has the Trend Changed? From 1980 to 2000, the number of companies paying dividends continued to decrease. This was the result of a tax policy that incentivized the realization of capital gains over the receipt of cash dividends. As a result, a great many companies engaged in share repurchase programs which increased earnings per share and the potential for capital gains. But with a change in tax policy in the early 2000s, dividends and capital gains were placed on an even footing where the tax rates were the same. About that same time, the number of companies paying dividends increased for the first time in years, and that trend appears to be continuing today, in spite of current economic challenges.

During the last bull market, dividends were being de-emphasized in favor of "reinvesting for growth." This was evidenced by the enormous shift that occurred between 1998 and 2000 when the number of companies paying a dividend dropped from 700 to just over 500 firms, indicating investors' and management's preference for alternative uses of corporate cash other than dividends.

As we move forward throughout the 2000s, the pendulum appears to be swinging back.

So how do you build your own diversified portfolio that pays increasing dividends? Instead of hunting in The Wall Street Journal for the highest dividend funds, try the following four-step plan.

Step 1: Look past the obvious. Most investors mistakenly think investing in dividend-paying stocks means buying stocks only in the real estate investment trusts (REITs) or utilities sectors. For current dividends and the potential for future dividend increases, investors must look to other sectors, including financial, energy, technology and consumer staples. While they have not historically paid out the highest percentage of their earnings, they have historically raised their dividends at a faster rate. Technology companies may become the newest sector to begin paying out substantial dividends, especially if they convert some portion of their stock repurchase programs to dividend payments to shareholders.

Step 2: Foreign markets can provide another element for dividend diversification. Because foreign firms have historically tended not to hoard retained earnings as much as their American cousins, while also paying out a higher proportion of their earnings as dividends to shareholders, yields and payout ratios outside the United States tend to be better. Look at the two charts below: the global dividend payout ratio and global diversification.

What do these two charts tell us? That international firms' willingness to pay is higher than in the U.S. and that yields are often better.

Step 3: Revisit and understand the 2003 tax reform bill. Know the difference between qualifying and non-qualifying income for purposes of the 15 percent tax bracket. Specifically, mutual fund managers can reduce the tax consequences of their dividend distributions by allocating certain types of non-qualifying income to cover fund expenses. Qualifying dividend income from portfolio investments can then be allocated to the mutual fund shareholder dividend stream at the preferred lower dividend tax rate, enhancing the after-tax returns of the dividends.

Step 4: Explain this logic to your retiring clients. There is no question that there have been a number of positive events within the past several years concerning traditional dividend distributions from equities and that corporate America has responded to these trends, both through the increasing number of companies that pay dividends and by the increase in the relative payout ratios and rate of increase from year to year.

By constructing a portfolio focused on providing increasing dividend income, you will be meeting one of the biggest challenges facing retiring baby boomers. In addition, this strategy incorporates full transparency by using traditional securities, easily understood by most investors. And, finally, this strategy's benefits only increase over time as the power of compounding rate increases becomes more evident. The portfolio has the potential added benefit of providing an income stream that outpaces the increasing cost of living while also providing tax efficiencies by taking advantage of current tax law.

By developing and managing this portfolio strategy, you will be adding value to your clients, further strengthening the relationship with your clients. Both you and your clients will rest easy knowing this is a strategy that has worked time and time again, not just a fad or the creation of Wall Street marketing departments.

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Ken Ziesenheim, JD, LLM, CFP, recently retired managing director for Thornburg Investment Management and president of Thornburg Securities Corp., now serves in the capacity of a senior advisor to Thornburg. He can be reached at ken.ziesenheim@raymondjames.com.

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