Frank, a 79-year-old retiree from Marblehead, Mass., promised it would be a simple question.
“I’m not looking for sky-high returns,” he said, “I just want to invest so that I generate enough income to live comfortably. Where have all the good dividend stocks gone?”
While everyone raves about the brave new world of the stock market, with its seemingly never-ending ability to maintain new heights, it has become a confusing and changed world for people who invest for income, especially if they pursue dividends on stock investments.
People like Frank, who believe they have enough money to generate an income they can live on but who fear the go-go tendencies of the stock market, cannot invest in the old ways. Gone are the days when it was easy to put together a portfolio of stocks yielding a big fat 8 percent. Sure, there are some companies, most notably utilities, still paying reasonable dividends, but there are fewer of them every day.
This trend is forcing older Americans to reevaluate the way they expect to manage money in retirement.
Here’s why:
As recently as 1990, the Standard & Poor’s 500 index pumped out a cash yield–annual dividends divided by market price–of 4 percent. Today, that number has fallen to 1.4 percent, the lowest in history.
Those higher yields of yesteryear had a big impact on the total return of investments. Ibbotson Associates, the Chicago-based market research firm largely responsible for convincing investors that stocks return an average of 10 percent per year, notes that dividends made up about one-third of that annualized return. Today, dividends represent less than 1/20th of the total return of the market.
There are some good reasons for this trend, not the least of which has been the country’s insatiable demand for stocks.
Even in cases in which dividend payouts have remained stable, price inflation has pushed yields down. That’s not a problem if you set up a portfolio years ago that was built around stocks that paid out nice dividends and haven’t cut back, but it’s a problem if you are shopping for dividend growth today.
Tax law, too, has contributed to this phenomenon. Dividends are taxed as ordinary income, meaning that Uncle Sam can claim up to 39.6 percent for his own, depending on your tax bracket.
But if the stock does not pay dividends and instead reinvests profits for the good of the company, the stock price is likely to rise. This price appreciation creates capital gains, and long-term gains are taxed at a maximum rate of 20 percent.
Moreover, the investor decides when to realize those gains and pay the taxes, rather than getting a dividend and a tax bill every year.
As a result, the general populace has not been clamoring for higher dividends. (And corporate management, spurred by the fact that their compensation is frequently tied to stock price, certainly has gone along.)
Instead, growth has been the order of the day, which is why many companies that pay little or no dividend use the money that could have been distributed to buy back stock, thereby increasing demand and taking prices higher.
That gives investors their gain in what is arguably a better form.
But the argument comes from someone like Frank, who wants those high-dividend stocks.
The shift away from dividends is particularly noticeable in mutual funds. Growth-and-income funds are badly misnamed these days, with virtually all of their returns coming on the growth side of the equation.
While there are plenty of experts willing to debate how the dearth of dividends could lead to a collapse in the stock market (and potentially the return of good dividend stocks during some future recovery), the arguments do nothing to change the effect on investors.
Specifically, investors will have to figure out how to get the income they need in their retirement years without having great income-producing vehicles to do it. If bond yields and inflation stay low, standard fixed-income instruments are not likely to be the answer.
“Baby Boomers and others hoping to live off a substantial nest egg may find it disconcerting to see themselves as being very rich on paper and very poor in income,” says James M. Griffin, investment strategist at Aeltus Investment Management in Hartford, Conn. “People can’t just think that they will live off the income and never touch their principal. It’s not that simple anymore.”
The idea, therefore, is to develop a retirement portfolio that mixes investment vehicles, allowing some certainty of income–possibly from bonds, but perhaps from the few available dividend stocks–and mixing it with capital appreciation, and then culling those winnings each year to flesh out the income.
“People really need to think of their retirement portfolio on a total return basis,” says Derek Sasveld, a senior consultant at Ibbotson. “Rather than just targeting a stream of income, they need to build a portfolio that grows at an acceptable rate. Then, they dip into that portfolio.
“No one should feel boxed into a strategy of trying to find things that pay 5 or 7 percent. They can buy stocks that grow at that rate or hopefully better and then live off the profits.”
Still, that is not much consolation for guys like Frank.
He fears the effect of dipping into the principal. “I can live off the growth in my stocks, but what happens if they don’t grow for a year or two,” Frank says. “I still need that money, and I have less in the account to grow the next year.”
And if he sticks with income investing, he fears not having enough income, and that he will lose purchasing power to inflation.
The concerns of Frank and others like him must be balanced against the realities of diminishing yields. Most of the no-brainer, low-risk, hard-to-mess-up strategies of the past are gone, and they won’t be back anytime soon.
That puts a premium on sound management, on risk assessment and on developing a plan that looks at total return rather than at income, and crafts a strategy that lets the income investor sleep at night.
It’s not easy, and may be what causes many people to turn to financial advisers for help. But it can’t be ignored forever.
“I didn’t think I’d have to worry about this stuff at my age,” says Frank. “I thought I had enough to be set for life, but now I am not so sure.”
Join the club, Frank. There are a lot of people out there who just want to make a comfy 7 percent, and who no longer have a simple, straightforward way to do it.
