From the October 2011 issue of Investment Advisor • Subscribe!

POINT: Rising Dividends for Retirement Income

In today’s market, a well-diversified portfolio of dividend-paying stocks may be less risky than a portfolio of high-quality, long-term bonds

The topic of retirement income is on the top of most advisors’ minds these days. With large percentages of investors moving into their retirement years, advisors are wondering how they’re going to meet their clients’ needs for consistent and rising income.

While bonds are traditionally thought of as a good source of retirement income, in today’s markets, you’ll likely find much better income opportunities on the stock side of the market. Ten years ago, however, this wasn’t the case. But market metrics have changed substantially, and you’ll have to change your strategy if you want your clients’ money to last 30 or more years.

Retirement Income From Bonds

In general, I’m a big fan of bonds. In today’s markets and for the next decade or more, bonds will provide an important element of principal protection and some modest income payments, but they won’t solve your clients’ needs for meaningful and growing income.

At the time of writing this article, 10-Year U.S. Treasury notes are yielding about 2.3%, and 20-Year U.S. Treasury bonds are yielding about 3.3%. If you had a client retiring today, with a $1 million portfolio, and you laddered the bonds between 10 and 20 years, you’d have an average yield of about 3%, give or take a tenth of a percent. I don’t expect your client would find a fixed $30,000 taxable income stream a workable solution, especially since the client had to commit a good percentage of the portfolio to longer term bonds.

With the longer term nature of the bonds, the portfolio could look really ugly if inflation picks up. While you can’t predict future inflation rates, if we have inflation of just 2% over the next 20 years, that income stream is reduced to only about $20,100 in today’s dollars. If inflation ran at 3%, the income stream is reduced to $16,600 in today’s dollars.

With interest rates this low, the best you can hope for is low to no inflation. Otherwise, the rising cost of living will ravage the income stream, and if interest rates increase, the portfolio could get hammered by declining values. On the one hand, that’s not a big deal if your client is willing to hold the bonds to maturity, but on the other, it is a big deal because your client can’t do much to adjust to higher interest rates. Given the history of volatile interest rates and inflation cycles, the odds are that your client would experience one or both of those scenarios.

The Cost of Liability Matching

There is another option available with bonds called liability matching that would require you to buy a fixed income security today that will match your client’s anticipated spending needs in the future. For instance, let’s say you think your client will need $75,000 of income 15 years from now. If you wanted to fund that obligation with a zero coupon U.S. Treasury bond, it would cost you about $45,000 in today’s dollars. A 15-year zero coupon bond has a yield to maturity of about 3.5%, so if you invested $45,000 in the bond, it would be worth about $75,000 in 15 years. You could do this sort of matching for every year of your client’s anticipated retirement.

The problem is you can’t be sure how much income your client will need in 15 years. Why? Because you can’t predict inflation rates, and you probably can’t accurately predict your client’s lifestyle needs. If clients need to plan for 30-year retirements, the odds of predicting inflation and lifestyle needs 30 years into the future are pretty small. Plus, who knows how long your clients might live? If they live longer than anticipated, you may well have fully depleted their assets because you didn’t expect to have to match liabilities that far into the future.

Since inflation is an issue, you might think, “Well, I’ll use TIPS to help protect against inflation.” In a normal interest rate environment, that might be helpful. But today, 10-Year TIPS actually have no yield and on some days a negative yield, meaning your client will lose money in TIPS over the next 10 years, excluding the inflation adjustment. So if we were to have low inflation over the next 10 years, the return would be paltry.

In general, the fixed income market is so expensive that trying to fund your client’s unknown, future retirement liabilities with fixed income assets is a gamble on a number of fronts. So an asset that looks safe, poses lots of risks for investors in need of an inflation adjusted income stream.

The next question is, are there better opportunities today? In my opinion, yes; and they are found in the equity markets.

Retirement Income From Dividends

With stock prices declining for the last 11 years and earnings and dividends growing, investors can now secure meaningful yields from a select group of stocks that provide both a higher income payment than bonds and opportunities for growing income.

There are many “blue chip” companies today that have dividend yields above 3% and that have prospects of growing those dividend payments at 5% or more a year into the future. While dividends are by no means guaranteed, if you construct a well-diversified portfolio of dividend-paying stocks, you have fairly good odds of maintaining and growing your dividend income stream into the future. Plus, as the income grows, you’re likely to see price appreciation down the line. Compare that to bonds where you won’t get any income growth or any capital appreciation (assuming you hold the bonds to maturity).

Let’s say you could buy a stock for $100 that paid a $3 dividend and that dividend payment was expected to grow at 5% per year. Twenty years from now, that stock would be producing almost $8 in dividends for the $100 invested, or an 8% yield on your cost. If you created an entire portfolio of companies with this type of dividend structure, you could have a $1-million portfolio that produced $30,000 of dividends today growing to $80,000 20 years from now.

Now, if you had a $1-million portfolio of stocks producing $80,000 of dividends, what do you think the odds are that the price of those stocks would have increased over those 20 years? Pretty high, because as the income grows, it tends to pull up the stock price over the long term. Investors would see the growing dividend and bid up the price of the security to match other income opportunities in the market. Now, this is not a one-for-one move, but over extended periods of time, rising stock dividends are highly correlated with rising stock prices.

In today’s market, a well-diversified portfolio of dividend-paying stocks may be less risky from an income standpoint than a portfolio of high-quality, longer term bonds.

You might be wondering what the history of dividends looks like for some blue chip companies. Here is one example to help illustrate the point. In 1993, Johnson & Johnson paid a dividend of about 25 cents a share and traded at about $12 a share, for a then-current yield of about 2.1%. Over the next 17 years, JNJ raised its annual dividend per share from 25 cents to $2.11 in 2010, or an increase of about 750%, well outpacing the increase in inflation over those years.

Now, if the JNJ stock price had stayed at $12 a share, it would have been yielding about 17% given the $2.11 dividend. But over the years, the stock price has risen such that today JNJ trades in the mid-$60s range and has a dividend yield of about 3.6%.

There are many other examples of companies that meet these historical dividend metrics. And if you focus on acquiring these types of companies for your retired clients, you can build an income stream that has a high probability of being both stable and growing, plus tack on the opportunities for capital gains.

Northstar Retirement Income Stock Index

Several years ago we started focusing more heavily on building retirement portfolios with a specific type of dividend-paying stock. We were looking for companies in all of the 10 major market sectors that paid both meaningful dividends and had a high probability of growing their dividends faster than the rate of inflation. We felt so strongly about the approach that we created the Northstar Retirement Income Stock Index (NRISI) to track the returns of stocks that we felt retired investors could live off of. We enlisted the help of Standard & Poor’s to create and run the custom index for us.

The Index was created on June 30, 2008, and we of course had no idea what the markets were about to experience over the next three years. As it turns out, that market cycle was about as good a stress test as we could have imagined. Over those three years, our NRISI had an annualized return of 9.4%, compared to the S&P 500 at 3.3%. The Index also has a healthy dividend yield of about 3.5% today, and the dividends for the stocks in the Index have been growing on average at about 7% per year over the last few years.

The NRISI consists of 48 different companies in all 10 of the major market sectors, and the holdings are equally weighted. The diversification and equal weighting have helped provide both more pricing and income protection for the securities in the Index than the S&P 500.

While we in no way are abandoning bonds for our retired clients, we view them primarily as securities that will provide clients with principal protection in down markets and a modest amount of income. We see certain aspects of the equity markets providing better long-term prospects for growing income and capital gains. With all of the uncertainty modern financial markets pose, coupled with the uncertainty of a client’s joint life expectancy and future spending needs, opportunities for growing income and capital gains are critical for our clients’ long-term odds of retirement security.

Charles Farrell is a principal at Northstar Investment Advisors LLC. He can be reached at cfarrell@northstarinvest.com.

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