Heading into late August, more than 40 percent of the year-to-date total return of the Standard & Poor’s 500 index is from dividends.
Although investors are often attuned to intraday price swings, they are missing a significant part of the picture if they overlook dividends.
In the past, retirees were often able to finance a good chunk of their living expenses through stock dividends and interest payments from bonds. Social Security and pensions filled in the rest.
That scenario is not so common these days. Not only are corporate pensions going the way of the rotary phone and the floppy disk, but Americans are living longer and baby boomers have higher expectations for retirement than their parents did. Along with those trends comes a re-examination of the notion that dividends, while clearly important, are the preferred method of financing life in retirement.
Brian Spinelli, chairman of the investment committee at the investment management firm Halbert Hargrove, says dividend investing should be considered neither safe nor stable. Retirees are better off understanding their overall portfolio goals before zeroing in on dividends.
“Yes, a lot of stable companies pay dividends, but short-term market reactions can drag down their prices,” says Spinelli, who is based in Long Beach, California.
“Before an allocation to stocks or risk assets is determined, we need to know the overall asset picture, sources of income and ultimate goals an investor has from their portfolio,” he says.
With that understanding, investors can begin increasing or decreasing their exposure to certain asset classes.
“There is no set formula for allocating to dividend stocks,” Spinelli says. “Investors very close to retirement should understand how they will depend on their portfolio in early retirement.”
He says investors may want to take a more conservative approach around the time of retirement, to avoid having to sell stocks simply to cover living expenses.
Investors should also understand the trade-off for high dividend yields. Typically, the fastest-growing companies invest profits back into projects with high expected returns.
That’s why smaller and newer companies in fast-growing industries, such as technology and retail, don’t generally pay dividends. Those stocks often show more rapid price appreciation than older, established companies. However, the more mature companies tend to pay dividends.
In general, the higher the dividend yield, the lower the long-term growth potential, says Fritz Miller, partner at the Pasadena, California, office of Signature Estate & Investment Advisors. For investors who are several years away from retirement, that’s a particular concern.
“That doesn’t mean you shouldn’t have some dividend focus as you approach retirement,” Miller says. However, he says dividend-paying stocks are simply one element of a properly allocated portfolio.
In a qualified investment, such as a traditional individual retirement account, distributions are taxed as ordinary income. For that reason, Miller says, total return is the primary focus of an IRA.
For an investor in his or her 50s who still has a decade or more before retirement, dividends should not be a central concern. “That person would want to maximize long-term total returns,” Miller says. “You would want to underemphasize the dividend component and not chase dividends in that scenario.”
Chasing dividend yield can be hazardous to portfolio health. In recent years, with interest rates so low, many investors sought stocks with unusually high yields.
For example, master limited partnerships became especially popular. These are publicly traded entities, listed on the major exchanges just like any other stock. Because of their distinct legal structure, MLPs are typically focused in the area of natural resources industries, such as oil and gas. Their dividend yields frequently exceed that of other stocks. Many MLPs have dividend yields in the double digits, something that investors won’t get with any of the blue chip stocks in the Dow Jones industrial average.
But investors must also consider the potential downside of MLPs, says Michael Conway, president and CEO of Conway Wealth Group in Parsippany, New Jersey.
“Master limited partnership stock has become a particularly tempting income source for retirees, as these stocks have historically produced higher rates of return. Unfortunately, MLPs also assume greater risks, leading to short-term volatility that could greatly disrupt a retiree’s portfolio,” he says.
Rather than focusing on one type of income-producing vehicle, such as MLPs, investors are better served by taking the wider view of their portfolio, Conway says.
That includes balancing dividend-paying stocks with other types of investments. There’s good reason to take that approach: When interest rates start to rise, prices of dividend- and interest-paying investments generally decline.
“There are inherent risks in concentrating a portfolio in investments that pay interest or dividends, particularly amid today’s Fed-induced low interest rates,” he says. “Because rates are so low, retirees are looking elsewhere to increase income. If an investor limits their portfolio to assets that offer interest or dividends, such as longer-term bonds, speculative grade bonds, dividend-paying stocks or real estate investment trusts, the risk of the portfolio could increase significantly, especially as the Fed begins raising interest rates.”
Miller also says chasing yield is a mistake. Not only does that put a portfolio at risk as interest rates rise, but it also excludes growth.
“You have to distinguish between stocks that pay outrageously high yields, and those that pay reasonable dividends and also focus on growing the company. Owning the right type of dividend-paying stocks can be a solid strategy and a source of retirement income. There are companies that have proven they can increase dividends year in and year out, while also having share prices go up,” he says.
He cites the Coca-Cola Co. (ticker: KO), Johnson & Johnson (JNJ) and the Procter & Gamble Co. (PG) as examples of companies that meet both criteria.
Today, advisors agree that a laser focus on dividends is generally not in the best interest of most investors. That’s particularly true given the unpredictability of interest rates, says Conway, who advocates diversified portfolios that include multiple asset classes and investment strategies. That’s his preferred method of addressing concerns not only about income, but also about volatility and inflation.
“The total return approach exposes a portfolio to asset classes that are performing well during any given period of time,” he says. “In addition, better diversified portfolios help to suppress volatility over time, an important component to consistency through retirement. Most important amid current market conditions, well-diversified total return portfolios protect from inflation, as stocks have consistently exceeded inflation over the long term.”
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Should Dividends Be the Focus of Your Retirement Income? originally appeared on usnews.com
