An investment in stocks of companies that provide both high- and growing-dividend income can benefit a retirement portfolio undergoing the duress of withdrawals. Understanding Yield
Over the past 83 years, dividends have accounted for approximately 40% of the total return for the S&P 500 Index. The importance of dividends has been an often overlooked part of investing, but will continue to come to the forefront as baby-boomers prepare for retirement and look for high- and growing-income generating investments.
There are generally two schools of thought regarding how best to fund expenses in retirement. There are many who believe a total return approach is optimal, whereby an asset allocation and total return is targeted for the portfolio and a portion of the retirement assets is sold periodically to cover expenses. While this approach attempts to provide the growth that retirees need to outpace the effects of inflation, they may also be forced to sell assets at an inopportune time.
The second school of thought follows a high-income approach, whereby the portfolio is comprised of high-yielding income investments in an attempt to generate sufficient current income to cover expenses. This approach can leave a retiree too heavily exposed to fixed-income investments and the ravages of inflation.
In this paper, we will explore a third approach, which is a hybrid of the total return and high-income approaches. We will explore how an investment in stocks of companies that provide both high- and growing-dividend income can benefit a retirement portfolio undergoing the duress of withdrawals. This type of investment strategy can have the potential to provide a growing dividend-income stream as well as capital appreciation needed by retirees.
When reviewing income-generating alternatives, retirees often focus on current yield (the current income divided by the current price). This works well for fixed-income investments, which are, essentially, contracts that pay a certain level of income to the bondholder each year and then return the principal amount at maturity. However, for equity investments, where both the income and stock price may appreciate, looking solely at current yield can disguise the growth in the actual dollar amount of the income generated.
To illustrate this point, Figure 1 shows a comparison of bond yields versus equity yields over calendar years. At first glance, it is obvious that current yields on bonds are higher, but this higher yield comes with little to no potential for growth.
To show the difference between the growth of income provided from bonds versus a dividend-paying equity investment, in Figure 2, we calculated the amount of income generated annually on a hypothetical $1 million investment made in 1990. While the income from the bond investment steadily declined from 1990 to 2009, the amount of dividend income derived from the dividend-focused equity allocation grew steadily. Although beginning at a relatively modest level compared to the bond investment, the dollar amount of dividend income generated surpassed the bond income in eight years and ended at 153% of the bond income by 2009. For this example, it was assumed that the dividends were being used to support expenses and not being reinvested.
