This was supposed to be the year interest rates on Treasury bonds and bills would finally begin to rise, making it easier for retirees to generate more income from those relatively safe investments. It hasn’t panned out that way though. The Federal Reserve hasn’t increased rates since a 25-basis-point hike in December, and Fed Chairman Janet Yellen has been measured in her statements about possible future increases.
With rates likely to stay low for a while, retirees need a Plan B for deriving income from investments. And part of that Plan B could rely on stocks, specifically those that pay dividends.
The good news: Given that people are living longer, allocating more of a portfolio to stocks is a necessary shift for many retirement-age savers anyway. “Increasingly you are seeing investors looking to equities as a source of income as well as a source of return,” says Richard Turnill, BlackRock’s global chief investment strategist. And the fact that retirees will be holding stocks longer can let them feel a bit safer in beefing up the equity portions of portfolios, Turnill says. In other words, if someone is retired for two decades, a portfolio can weather some damage from a long downturn and still bounce back.
Dividends, of course, are payments that companies make to their shareholders (usually out of their profits). Turnill says that equity dividends grow broadly in line with earnings growth, which in turn typically outpaces inflation.
But strong companies usually have enough free cash to keep paying dividends even if earnings growth is weak. That’s why investors should be discerning, Turnill notes, distinguishing between “high quality” payers the deliver dividends consistently over long periods of time, and “cyclical” companies that pay dividends when they can. Some cyclical companies can pay extraordinarily high dividends when the economy is strong—but that’s not the kind of stock you want right now. “If you look back to 2007, the highest dividend yielding stocks were financials,” he says. “In 2008 and 2009 many of those dividends weren’t paid.”
Identifying the “high quality” dividend paying companies is the tricky part. It’s a good sign when a company has not only paid dividends, but increased them regularly for decades. (Multiple examples of such stocks are included in the S&P 500 Dividend Aristocrat index.) For example, health-care company Johnson & Johnson (JNJ) has paid out a dividend for over 50 years. Other key factors to consider, Turnill says, include a company’s overall cash flow and, in particular, a company’s debt level.
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Kera Van Valen, portfolio manager for MainStay Epoch Global Equity Yield Fund, screens stocks to find those that are long-time dividend payers and also have the type of debt structure that enables them to free up cash for shareholders.
She focuses on the stock “yield” – its dividend divided by its stock price. That yield typically falls when a stock rises—a steep drop can be a sign that the stock is becoming overvalued.
One stock Van Valen likes is consumer-products company Kimberly Clark (KMB), which is growing free cash flow by cutting costs. Her fund bought the stock in 2009 when it had a 5% yield. The yield recently fell as the price rose, so she trimmed the position, but still likes it overall.
Fidelity recently published a report that underscores the need to be patient with dividend stocks. According to the report, investors who bought companies in the top 20% of the S&P 500 as measured by a combination of the highest dividend yield and lowest net-debt-to-equity ratios, they would have outperformed the broader market by an average of 2 percentage points a year from 1991 through 2015. However investors would have beat the index in only 51% of the 12-month periods within that time frame. “You would have to have a strong stomach to deal with periods of underperformance” without panicking and selling, says Naveed Rahman, institutional portfolio manager on Fidelity’s equity income team.
Rahman and the report’s co-author, Scott Offen, co-manager of the Fidelity Equity Dividend Income and Fidelity Strategic Dividend & Income funds, note that investors do much better if they leave selection of companies to the pros. That said, their report highlights medical-device maker Medtronic (MDT), insurer Chubb (CB), and tech giant Cisco (CSCO) in particular as dividend-paying companies they liked last year; all three are still among the top 10 holdings of the Equity Dividend Income fund.
If broad mutual funds are more appealing, Todd Rosenbluth, director of mutual fund and ETF research at S&P Capital IQ, suggests the iShares Core Dividend Growth ETF, which has an expense ratio of only 0.12%. For investors interested in owning both dividend-paying stocks and bonds in a single income fund, Rosenbluth suggests the Mairs & Power Balanced Fund, which has 65% in equities and an expense ratio of 0.73%.