As many advisors know, the biggest challenge facing millions of retiring baby boomers is income (or lack of) as they necessarily begin to rely on their assets to generate the income they no longer receive from their paychecks. Retirement leads to a predicament for many investors, particularly those who either have no pension or retirement plan to replace their lost income, or just haven’t saved enough for retirement. Both situations create an income gap that needs to be filled, and either way, your clients are going to be asking you, their advisor, to make up for any shortfall they may encounter.
In the previous decade of higher interest rates and significant market growth, an advisor’s job was much easier. You could load up your retiring clients with higher-yield bonds for their income needs and just about any equity fund for growth.
But there’s much more uncertainty in today’s markets, and as for the future, who knows where yields will go and how equities will perform? Instead of waiting for the securities industry to come up with “solution products” to the retirement income problem, advisors should begin to develop their own investing strategies for income based on products currently available in the marketplace. This article will show how you can build a strategy for increasing your clients’ income by designing diversified portfolios that pay increasing dividends.
Why Dividends Are More Appealing to Companies
In light of corporate accounting regulations and the recent pension legislation, this decade has emerged as one in which corporations are being held to a higher standard of accountability for the earnings they generate. Today the issuance of stock options must be expensed, with the result that companies can no longer attempt to make earnings look better by omitting employee compensation expenses in the form of stock options from their income statements. This greater transparency of corporate earnings also contributes to better stewardship of corporate assets and revenues.
This creates a new opportunity–one based on time-tested, proven investment theories and that can result in companies having more cash available to pay dividends. The rediscovery of these traditional values may come just in time to provide a solution for retiring baby boomer clients. Because of those new accountability standards, company directors will be thinking more about shareholder returns based on real cash earnings rather than anticipated market appreciation that may never materialize. Moreover, with corporate earnings and return on equity expanding at high growth rates, boards of directors are likely to be more willing to pay out cash earnings in the form of dividends. In other words, their ability and willingness to pay dividends should continue to increase. This conservative attitude also leads to stronger balance sheets, greater capital adequacy, and higher levels of surplus cash.
A Short History of Dividends
As indicated on the chart above (Dividends Looking Up), the history of public companies paying dividends has been a roller coaster. Between 1980 and 1993, at least 80% of the firms in the Russell 1000 paid dividends, but the number declined throughout the ’90s as more companies elected to repurchase their stock instead of paying dividends. There were numerous reasons for this: reducing the number of shares outstanding increased earnings; the tax rate on capital gains was favorable compared to the tax rate on dividends; and in a bull market, share appreciation was the main driver of total return. Now that there is no tax advantage for investors in favor of capital gains versus receipt of dividends, a lower return market environment, and greater accountability for corporate earnings, the trend has turned significantly upward, with more companies paying dividends.
There was an enormous shift between 1998 and 2000, when the number of companies paying dividends dropped from 700 to just over 500 firms, indicating investors’ and managements’ preference for alternatives other than dividends. But the pendulum appears to be swinging back–capital discipline fostered by a management commitment to paying dividends appears to be supportive of subsequent earnings growth. The end result is that corporate willingness, evidenced by the number of companies paying dividends, has resurfaced, creating an opportunity for investors to generate additional streams of income from their investment portfolio. In light of these trends, fund managers and investors must shift their focus to finding companies with both the ability and the willingness to increase dividend payments as contrasted to just seeking capital appreciation.
Since the passage of the 2003 tax bill, which lowered maximum tax rates on dividends to 15% (see sidebar, The Tax Advantage), several leading U.S. companies have started redirecting their earnings to fund increased dividend payments, as contrasted with repurchasing outstanding shares in the marketplace.
Dividends and Global Diversification: Future Growth
The second chart above (The Benefits of Going Global) shows the benefits of global diversification in relation to dividend payments. Dividend yields and payout ratios for Australia, the U.K., Europe, Asia, and Latin America all exceed the ratios for the U.S. and Japan. Clearly, there is an advantage of diversifying client portfolios into foreign dividend-paying stocks where yields and payouts are higher.
Another aspect of dividend paying securities is that, contrary to popular belief, companies with higher dividend payouts as a percentage of their earnings are actually generating higher earnings growth rates.
Companies with lower payout ratios generated negative real earnings growth over subsequent 10-year periods, while companies with higher dividend payout ratios generated higher earnings growth rates over those same periods. A side benefit of an increasing dividend strategy is that capital appreciation often follows a stream of higher dividend payments, as the yields of the stocks and portfolios maintain their historical rates. Therefore, it would appear that the potential for additional total return is greatly enhanced by investing in companies with higher dividend payout ratios since they have historically grown earnings faster.
How to Do It
With that kind of evidence, how can you build a diversified dividend portfolio for your clients? Follow these steps:
1. Look past the obvious. Scrolling down the agate type in The Wall Street Journal, looking for the highest dividends is not always the best strategy.
Don’t mistakenly think investing in dividend-paying stocks means only buying stocks in the real estate investment trusts (REITs) or utilities sectors or other traditionally high-yielding sectors. Unfortunately, dividends paid by REITs and master limited partnerships do not qualify for the 15% tax rate since they are not, by definition, qualifying dividends.
2. Use mutual funds to build diversified dividend-paying portfolios. Mutual funds that own any dividend-paying companies have an opportunity to receive an additional yield boost with tax advantages. Thanks to President Bush’s tax law changes, a mutual fund manager can reduce the tax liability on all non-qualifying income by allocating that income to cover fund expenses. This result is a greater proportion of qualifying dividend income from portfolio investments being allocated to the mutual fund shareholder dividend stream. In addition, mutual funds greatly simplify the task of owning international securities.
3. Diversify in sectors. For current dividends as well as the potential for future dividend increases, investors must look to additional sectors beyond the traditional high-yield areas. These include financials, energy, and consumer staples. While over time these sectors 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.
4. Diversify geographically. Foreign markets provide another opportunity for dividend diversification. Because foreign firms tend not to hoard retained earnings as much as their American cousins and tend to share more earnings with shareholders, yields outside the United States tend to be better.
As demographic statistics indicate that a majority of Americans may be underfunded for their retirement income needs, the target market for a dividend income strategy is potentially huge. Key considerations when building a portfolio include:
Corporate Ability to Pay;
Corporate Willingness to Pay;
Tax Advantage of a Mutual Fund.
Corporate America has responded 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, providing tangible benefits to shareholders seeking a stream of dividend income. You do not have to wait for the next grand income strategy to come along before beginning to provide an income solution to retiring baby boomers. Take advantage now of the new willingness to pay dividends accompanied by an increased ability to pay dividends as the economy expands and corporate earnings recover.
Ken Ziesenheim, JD, LLM, CFP, is a managing director of Thornburg Investment Management, president of Thornburg Securities, and a past Chairman of the National Endowment for Financial Education (NEFE). He can be reached at Kziesenheim@thornburg.com. For more on dividends, visit, www.thornburg.com/IIB.