December 21, 2010

Outlook 2011, Retirement Income: Opportunities for Higher Yields, but They Won’t Come Easy

Clients can’t rely on asset values as sole source of distributions, says Northstar Investment Advisors

(Charles J. Farrell, an AdvisorOne Guest Contributor, is a principal with Northstar Investment Advisors LLC in Denver.)

While most investment outlooks focus on price changes in the markets, advisors need to understand what the income outlook is for 2011 if their clients are retired.  Why? Because price changes are random, and they can’t simply rely on the possibility of increasing asset values as a source of distributions. They also have to focus on areas where they can generate consistent and hopefully growing income for clients.

Since the credit crisis began, income for investors has generally been on the decline. Dividends in the S&P 500 were cut by about 23% during the market collapse, and interest rates declined by about 95% on the short end (money markets) and by about 25% for intermediate term holdings. In a nutshell, income has taken a beating in this market meltdown.

But 2011 should offer rising income opportunities for investors. If the economy continues to grow, we see interest rates rising an additional 0.50% to 0.75% for intermediate term holdings. That means investors should see opportunities in the 3.75% to 4.50% range for both Treasury bonds and high-quality corporate bonds. That’s an increase of over 1.25% in yield from the lows in the third quarter, or an increase of 40% to 50% in the cash flow. On a $1 million portfolio, rising rates would add more than $12,500 a year of cash flow. 

On the short end, with the Fed’s focus on near zero rates, don’t expect too many opportunities. Money market funds will likely remain well below 1%. Most clients will need to commit their fixed income holdings for a longer period of time if they want to generate some cash flow.

If Build America Bonds (BABs), which die on Dec. 31, but make a comeback in some form in 2011, that will offer investors in tax-deferred accounts opportunities to secure yields in the 4.25% to 4.75% range for intermediate term holdings with very high credit quality. In 2010, BABs offered healthy spreads above Treasury bonds and high-quality corporate bonds. With state and local governments needing more cash, we expect to see some form of the BABs program return in 2011.

On the equity side, dividends for the S&P 500 continue to grow. We see dividend increases for the broad market in the 7% range, and rolling annual dividends going from about $201 billion at the end of the third quarter 2010 to the $215 to $220 billion range for 2011. Given that inflation is running at about 1.1% on a year-over-year basis, that’s a significant raise in terms of a real return. For the 12 months ending December 2010, approximately 95% of dividend actions were increases, while only 4% were decreases or suspensions. Clearly the trend is for more dividend income.

Moreover, in the third quarter of 2010, companies paid out approximately $51 billion in dividends, but spent $79 billion on stock buy-backs. There is certainly more room for increasing dividends, but management doesn’t seem to value the dividend payment as much as the shareholders do. Over time, we expect that to change as shareholders, especially baby boomers, demand more income from their stocks, as opposed to stock buy-backs that do little to enhance investor income.

If advisors are more selective on the equity side, not only could they see healthy dividend increases, but they can generate more initial cash flow. To do so, they haveto get away from the broad-based market indices and focus on more selective stock holdings or index approaches. 

The yield on the S&P 500 is about 1.9% today. But if advisors remove troubled financials from the index, and remove those firms that don’t pay a dividend (or pay a token dividend), they can see average dividends in the 3% range for large, multinational corporations. And many of those firms are expected to grow their dividends in the 7% range going forward. The sector that generates the largest amount of dividends in the S&P 500 is consumer staples, then health care, energy andindustrials

Then there are more focused sectors such as utilities and telecommunications that can deliver yields in the 5% range. If clients are a bit more adventurous, master limited partnerships can produce yields in the 6% to 7% range. The dividend growth rate for these sectors is lower, but if they need more current yield, the lower future growth prospects may be worth the trade-off.

If clients prefer immediate annuity payments, as interest rates rise the payouts from immediate annuities would also rise.

The bottom line is 2011 will offer greater income opportunities for clients, but investment advisors will need to work harder to find higher yields.

See AdvisorOne's Outlook 2011 calendar to find the publishing dates for, and links to, other categories in the Outlook series.

Charles J. Farrell is a principal with Northstar Investment Advisors LLC in Denver. Farrell is the developer of the Farrell-Northstar Retirement Income Index.

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