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Actionable Items: S&P Dividend ETF (NYSEARCA:SDY)

Conclusion: Not only are pre-retirees not planning for their retirement, they are oblivious with regards to the resource that they’ll need during their “golden years.” Furthermore, they lack the skills to competently invest their retirement funds to accomplish this task — even if they were to clearly articulate their retirement goals.

Moreover, pre-retirees and taxpayers are being misled with regards to the true cost of funding retirement. Accounting and actuarial practices are designed to obfuscate the problem in a time honored practice of “kicking-the-can” down the road for some other policymaker to resolve.

There is really nothing upbeat about the current prospects for retirement. In a feat of reverse alchemy, the “golden years” are being turned into lead. The underlying assumptions regarding a comfortable retirement are being undermined by financial and demographic realities.

Mark Twain was quoted as saying, "The only two certainties in life are death and taxes.” To this we can add: “working in retirement.”

Litany of Woes: These woes range from:

1. A Social Security system that is likely to generate a third less in retirement benefits to its recipients once it has consumed its reserves and becomes a truly “pay go” system (estimate to be in 2038);

2. Employers choosing to drop defined-benefit retirement plans (over two-thirds in the past two decades) and migrate to defined-contribution plans where the beneficiaries are ignorant not only of their retirement needs but the investment strategies needed to achieve their retirement objectives;

3. An environment of low investment returns experienced in the past decade and likely to be repeated in the next decade that are severely underestimating the true retirement resource short-fall.

This latter issue is the one that we’ll address as we believe it is the key variable on which the current retirement system is based.

“Houston, We Have a Problem.” The biggest problem is that future retirees don’t know they have a problem. Over 50% of Americans haven’t tried to figure out how much to save for retirement. Among those who are in the 45 to 59 age group, 51% said they had yet to calculate how much they’ll need. In a 2010 study by the Employee Benefit Research Institute, 40% of the baby boomers are at risk of not being able to pay for basic retirement expenses such as housing and out-of-pocket health care costs.

Systemic Risk: While individuals may be ignorant regarding their personal retirement planning responsibilities, pension funds are burying their head with regards to their own funds’ liabilities.

Buried in Sand? Pension funds are basing their unfunded liabilities on an assumed investment rate-of-return on their funded assets that is highly problematic. The higher the rate of return the lower the unfunded liabilities and the less annual contributions have to be provided.

Historically, that assumed rate of return was targeted at approximately 8.0%. This has been based on the long-term returns generated by equity and debt. According to Ibbotson, the long-term annualized gain for the S&P 500 dating back to 1926 is 9.9%. For bonds, it’s been 5.4%. Based on a 60/40 equity/debt portfolio mix, that produces a weighted average rate of return of 8.1%.

However, that target rate of return is in serious need of revision. As any investor can painfully recount, there has been zero nominal investment return on the equities as measured by the S&P 500 since 2000.

With bonds current yields at 2-3% and long-term equity returns burdened by low economic growth, shifting demographics, high current profit margins — that are likely to contract, and the potentially for no expansion in the market’s price earnings (P/E) multiple, domestic equity return will likely average closer to 6% going forward. This “new math” would generate a new weighted average rate-of-return of almost half the current target at 4.4%.

A Taxpayers’ Burden: According to the American Enterprise Institute for Public Policy Research, public employee pension funds stated they are underfunded by a total of $438 billion. However, The Institute states that a more accurate accounting would demonstrate that they are actually underfunded by over $3.0 trillion dollars. This gap is important because the difference is the potential exposure for which taxpayers could be liable for funding as pension benefits in most state are legal obligations of the state.

Getting Personal: In order to demonstrate the level of magnitude for an individual, we calculated the terminal retirement savings value of a 30 year old employee making an average wage of $41,673 and who begins contributing to a retirement plan at the average rate of 4.63% of wages until the full retirement age at the current target investment rate of 8.1% and the lower forecasted rate of 4.4%.

(Click to enlarge)

The chart demonstrates the impact on the terminal value of the retirement savings based upon the two assumed investment returns.

In our example, the 4.4% assumed investment rate of return would produce a terminal valuation (investment value at retirement) of 40% of the terminal retirement savings that the currently assumed rate of 8.1%.

This could be the difference between the ability to retire comfortably and not retiring at all.

Death, Taxes and Working in Retirement: One thing for certain is retirement for many will likely be postponed and seniors of retirement age will need to continue to work as they will have fewer resources on which to draw to sustain a comfortable and dignified retirement life style.

According to a 2011 report by Transamerica Center for Retirement Studies, more than 3 out of 5 U.S. workers in their 50’s and 60’s plan on working past 65 — and 47% will do so just to fund their health care benefits.

Recommendations: For those approaching retirement and those in retirement, we believe that dividend growth stocks are the best place to invest their retirement funds. According to Forbes magazine, dividends are still an important component of investment return. Between 1900 and 2010, dividends generated a 4.4% average annual return representing approximately one-half of the average annual total return for stock of 9.4%.

For pre-retirees and retirees such stocks are appropriate as they generate a cash yield, that cash distribution will likely grow over time providing a hedge against inflation, and may provide a partial cushion for stock market volatility with a yield cushion.

Standard & Poor's has culled the dividend winners from the also-rans in a list it calls the "dividend aristocrats." These companies have paid and increased their dividend for at least 25 years. These names include the likes of Johnson & Johnson (NYSE:JNJ) that is currently yield 3.7% and over the past five years and grown its dividend at an 11% annualized rate. Or, McDonald's (NYSE:MCD) currently 3.3% and demonstrating a 28% 5 year growth rate.

Making it Easy: We like the S&P Dividend ETF (SDY) that is currently yielding 3.5% and invests in the S&P High Yield Dividend Aristocrats Index. SDY generally invests at least 80%, if not substantially all of its total assets, in the securities comprising the index. This may be an easy way for investors and retirees to benefit from dividend growth stocks in a diversified fashion in a one-stop manner.

Disclosure: I am long SDY, and may initiate a long position in DVY over the next 72 hours. Also investing in closed end fund portfolios: CEFBig10 and CEFMuni10

Source: Retirement Revisited: It's Truly Worse Than You Think