Jump Start Your Clients' Retirement Income

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 [email protected].