With interest rates still at historical lows, the need for a growing income stream as well as capital appreciation over the long term is as important as ever for individuals to meet their retirement goals.
To accomplish this, there are three investment options every investor should consider implementing into their portfolios: Standard & Poor’s 500 index funds, high-yielding dividend stocks or similar mutual or exchange-traded funds, and dividend growing stocks or similar mutual funds or ETFs. When approached prudently and selectively, all three investment opportunities play a unique and important role in maintaining a certain level of spending in retirement.
Here are a few places to get started when looking for these opportunities:
[See: 7 Things to Look for in Dividend Stocks.]
Which S&P 500 index is best? Over the past 90 years, the S&P 500 has roughly returned an average of 5.6 percent per year excluding dividends. Assuming dividends were reinvested, the annual return is 9.3 percent per year and the dividend, on average, has grown 2.2 percent per year. Assuming an annual inflation rate of 2 percent, the growth in dividends has helped keep pace with the rate of inflation in most years.
However, it is important to note that the dividend was cut in 32 of these 89 years, which may have caused investors to sell their investment holdings to sustain their lifestyles.
In the last 10 years, the S&P 500 has delivered an average total return of 7.6 percent per year and the dividend has been cut in 2 years, including a 24 percent cut in 2009.
There are many indices tracking the S&P 500. One option is the S&P High Dividend index (ticker: SPYD), which measures the performance of the 80 highest-yielding stocks in the S&P 500. The index is equally weighted and rebalanced twice a year. Over the last 10 years, this index has delivered an average total return of 7.8 percent per year, which includes an average dividend yield of 4.7 percent. Its expense ratio of 0.12 percent, or $12 per $10,000 invested.
Despite a higher dividend yield, the index was actually 20 percent more volatile than the S&P 500, largely because of the heavy exposure to financial stocks in 2008. Many of these companies ultimately ended up cutting their dividends to zero around this time. In 2009, the dividend from this index fell 24 percent.
High-yielding stocks are often high yielding because of concerns about the underlying company’s ability to sustain a dividend or the amount of debt on their balance sheet.
The S&P 500 Dividend Aristocrats Index ( NOBL), on the other hand, may represent a more attractive opportunity. This index is a measure of S&P 500 companies that have increased their dividends every year for 25 years. The index is equally weighted and rebalanced four times a year. It’s expense ratio is 0.35 percent.
This benchmark has delivered an average total return of 10.4 percent per year for the past 10 years with slightly lower volatility than the S&P 500 and a higher total return (7.6 percent for the same period). The dividend for this index has grown 11 percent a year for the past 10 years. It is important to note that the index experienced one year where the dividend fell by 1 percent. Recall that the index is rebalanced four times a year, so the introduction of a lower yielding stock can lead to a dividend drop.
In short, a basket of dividend growth stocks offers the opportunity of higher total returns, a growing and reliable income stream, and overall lower volatility.
[See: 10 ETFs to Buy for Oodles of Growth.]
Naturally, dividend sustainability and safety is an important consideration, so it is imperative that one considers the health of a company’s balance sheet, the dividend payout ratio and the competitive position of the company.
Companies that have simply piled on debt to repurchase stock and grow their dividend are more likely to cut in the future than companies that have grown their dividend thanks to the underlying growth in their operating cash flow. If the credit markets become less accommodative and companies’ borrowing costs increase, some investors will be surprised to find that instead of growing dividends, some companies will be forced to cut their dividends and will experience both a drop in cash flow and the stock price.
Individual safe, high-dividend yielding stocks. Two companies that have a prior history of strong dividend growth and the ability and willingness to maintain a dividend focus are Microsoft Corp. (Nasdaq: MSFT) and AbbVie ( ABBV). Let’s explore both to see why they represent attractive dividend and capital appreciation plays.
Microsoft has grown its operating cash flow from $17.7 billion in fiscal year 2007 to $39.5 billion in the most recent fiscal year. Dividends paid have grown from $4 billion to $11 billion over this time frame. Its dividend per share has grown from 44 cents annually to $1.68, or a growth rate of 14 percent per year. Cash, net of debt, has almost tripled and the company’s balance sheet is rated AAA by S&P.
While the company isn’t immune from the economy, it has an entrenched customer base, which allows the company to extract a growing stream of cash flow from its customers. The dividend yield is currently 2.3 percent and the price-to-earnings ratio is 22.8 times the next 12 months earnings estimate. While this valuation looks high compared to the valuation range for the company over the past 10 years, Microsoft’s business model has more recurring revenue than it has in the past, so the predictability of cash flow is higher.
Microsoft has steadily increased its dividend for the past 13 years and recently declared a dividend increase of 7.7 percent. While this rate is less than the historical average noted above, it is important to note that the historical rate is calculated from a lower base when Microsoft initiated dividend payments in 2003.
AbbVie has grown its operating cash flow from $5.3 billion in 2009 to $7 billion in 2016. The company has grown its dividend 10 percent per year from $1.60 per share in 2013 to $2.56 per share in 2017. Total dividends paid have grown from $2.5 billion to $4.0 billion over this time frame.
Like Microsoft, Abbvie has an entrenched customer base, which allows the company to regularly raise prices. While 50 percent of sales are derived from a key drug, Humira, which will soon be going off patent, an exact generic substitute has been difficult to replicate. The dividend yield is currently 3 percent and the price-earnings ratio is 14 times the next 12 months earnings estimate.
[See: 10 Ways to Invest in Pharmaceuticals With ETFs.]
While a conversation with your financial advisor about your individual portfolio and financial goals is required before making any investment decisions, these strategies are good places to start when it comes to growing an income stream while taking advantage of opportunities for capital appreciation when planning for retirement in a low interest environment.
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How to Grow Your Income originally appeared on usnews.com
