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Dividend growth investing, retirement
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In the previous article in this series, I stated that in conventional retirement planning, there are three critical steps:

  • Maximize your capital before you retire.

  • Make your capital a lot “safer” as you approach retirement.

  • In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.

Coincidentally, AAII Journal ran two articles in their July, 2010 issue that address all three of those bullet points. Or I should say that it mentions them—they took all three bullet points above and used them as unquestioned truisms. From this foundation, they built two entirely contradictory models for asset allocation before, at, and after retirement.

Under Modern Portfolio Theory (MPT), it is said that proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. It is commonly accepted that your selection of individual securities is secondary to the proportions in which you allocate your investments in stocks, bonds, and cash. I believe that the rule of thumb is that 70% of your investment results will come from asset allocation, not from what securities you pick.

Asset allocation for retirement is a hot topic. On June 18, The Department of Labor and SEC held a joint hearing related to target date funds, many of which underperformed the S&P 500 in 2008-09. Target date funds have rapidly gained popularity since they were introduced in 1996. At the moment there are nearly 300 of them, with $176 Billion in assets. Their attraction is that, once you designate your retirement date, they offer the automatic achievement of the first two bullet points above.

  • They maximize your capital via diversification and an ideal stock/bond ratio while you are in the accumulation years of your life. Investors with different risk profiles can select from among funds that are more or less aggressive. “Aggressiveness” is always equated with what percentage of stocks the fund contains. At a young age, the most aggressive fund may contain 90% or more stocks. Even at retirement, an aggressive fund may still contain 75% stocks.

  • They make your nest egg safer as retirement approaches by automatically shifting from equities to bonds as you grow older, theoretically arriving at a perfect mix just in time for your retirement. “Safety” is always equated with holding more bonds and fewer equities.

When the market crashed in 2008-09, some of these target-date funds looked very inept. Losses were more severe than they should have been, especially for “I’m nearly retired” funds with short-term horizons. Either many of them did not keep the promise of shifting to bonds, or they did not do it fast enough, or it just plain did not work. “Target date funds have produced some troubling investment results,” said SEC Chairman Mary Schapiro in a June 2 speech before the subcommittee on Financial Services. “[The] varying strategies among these funds produced widely varying results. Returns of 2010 target date funds ranged from minus 3.6 % to minus 41%.” Obviously, retirees who lost 41% of their nest eggs in 2008-09, when they were expecting to retire in 2010, were catastrophically affected--especially when the third step of conventional retirement practice, namely selling off some of your nest egg each year, came into play.

In MPT, the hypothesis is that stocks are riskier than bonds, but that they hold the promise of better long-term returns. As the AAII says in its beginning investor series, “Stocks are more volatile than bonds, but have historically provided higher long-term returns.” Historical data supports this. It is hard to find a 30-year period, ever, that stocks have not outperformed bonds. But at shorter timeframes, stocks are considered riskier because of their price volatility. Thus the conventional wisdom is that the way to make your portfolio safer as you approach (or are in) retirement is by switching from stocks to bonds in your overall allocation.

As I stated in the last article, the problem I have with that thinking is that (1) it presumes that all retirement income will come from selling off assets, and (2) it ignores the fact that some stocks generate income themselves.

In the two AAII articles, there is not a single mention of dividend stocks as a separate asset class that may have different risk characteristics from all stocks as a class or bonds as a class. There is not even a suggestion that they might form a different category of stocks. The omission is puzzling, because stocks are traditionally sliced and diced into so many categories that supposedly offer different risk/reward profiles within the broad classification of “stocks.” Thus you get categories like U.S. Large-cap, Mid-cap, Small-cap; Foreign stocks, often nowadays themselves divided by size, country or region of the globe; Emerging markets; Value vs. Growth; and so on. But the simplest, most obvious categorization of all—do they pay a dividend?—is ignored.

It’s an important distinction. Dividend-paying stocks tend to move less (in both directions) than the market, meaning that they have a different risk/reward profile. Their dividends yield positive income even when their prices are falling. The companies that raise their dividends regularly tend to keep doing so even when the market as a whole is falling. The dividends themselves, being always positive (there is no such thing as a negative dividend), change the risk/reward profile. And studies show that the best overall returns come from dividend-raising stocks.

So the question begs to be asked: If the goal of a retirement nest egg is to provide its owner with sufficient income in retirement, and some stocks provide rising income streams by their very nature without the necessity of selling them, then why are those facts ignored in conventional retirement planning? Why are they ignored in asset allocation discussions?

It is certainly a paradigm shift to think of dividend stocks as a separate asset class, but for purposes of this article, that’s just what I am going to do. Here’s why: Traditional methods of classifying assets divide them into three major realms: Stocks, bonds, and cash. Stocks are evaluated on their prices; and bonds are evaluated on their yields. But dividend stocks have both characteristics: Their prices vary (but in a more muted fashion) with stocks generally. And their yields provide income, but with a growth kicker that most bonds don’t have—dividend-growth stocks are rising income instruments rather than fixed income investments. (In some texts, you will see the phrase “fixed-income investment” used interchangeably with “bond.”)

It’s almost like MPT has a huge hole in it. It does not miss the obvious income-producing ability of bonds—after all, that’s what a bond is, a debt instrument. The income it produces is interest on the money lent. MPT does not miss the price-appreciation potential of stocks, nor the short-term volatility they have displayed over the years. So why does MPT miss the income-producing ability of dividend stocks, the rising income-producing ability of habitual dividend-raisers like the Dividend Champions, or the muted price volatility that is characteristic of dividend stocks?

I cannot answer that question. But my conclusion is that for those who get it, dividend stocks, especially dividend-growth stocks, should not be lumped in with all stocks when it comes to making asset allocation decisions. A retiree’s portfolio can safely contain a higher percentage of dividend stocks than is normally associated with the low level of risk tolerance of a retiree. And the reason that is true is precisely because the dividend stocks throw off a continuing income stream and do not have to be sold to produce retirement income. Thus, maintaining a fairly high percentage of your retirement portfolio in well-selected dividend stocks is not too aggressive or risky for a retiree. It is safer.

Disclosure: No positons mentioned.

Source: Financing Retirement: Asset Allocation