When it comes to budgeting an income stream, most people only consider all of the income they need for living their everyday lives. A small group of people live beneath their means, generating consistent savings. An even smaller group retire and keep saving while living beneath their means. So when I plan an account to provide income, I consider the stability of that income to be very important. I do this so that life can go on with little disruption in as many cases as possible. I also consider capital, inflation and risk as well.
Stable income is not hard to find by itself. Just consider:
1. Safe Bonds
3. Interest on cash
4. Quality preferred stock
Each of these things can be part of a strategy to accumulate a safe base of stable income. Social security, pensions and the like are part of the idea as well. But all these things are missing one critical component or another of a total retirement income stream. It needs to be high enough to live on, safe, and self adjusting for inflation, as well as stable. A realistic plan includes as many of these parts as possible while still working for the investor.
If nothing else, dividends are needed for inflation protection. Dividends can also have all the other components and throw in some favorable tax treatment (for now). Let's take a look at dividends for stability with the proper concern for the other needs of retirement income.
People in the stock world like the 25-year mark for dividend increases. Here is a good list from Dividend.com. A long time frame like that would mean a stable and growing income with some safety. It would also mean that price and income can diverge in the case of market downturns like in 1999/00 and 2008/9. In other words, income rises as prices drop. That divergence can and will correct. Think of the income from the companies on this list like an anchor that never lets a ship stray too far off course.
One thing you can see immediately from the list is that the market has priced the dividends at a premium, so they are low yields. Only 12 out of 97 companies are above 4% as of the end of 2011. Just four are above 5%, A mere two are above 8%: Pitney Bowes and Old Republic.
Old Republic (NYSE:ORI) writes insurance on mortgages (ouch) and other things. Pitney Bowes (NYSE:PBI) is a well-known paper mail equipment company. I think it's easy to see that the high yield here is forecasting an imminent end to these companies' 25-year dividend runs. Always watch a high yield -- most likely the market is telling you something.
This is the sector breakdown chart on the S&P 500 Aristocrats:
Look at this diversification. If you are adding dividends to your retirement income, this chart can tell you a few things. First, you'll notice that a few sectors are very stable, like consumer staples with 25% of the Aristocrats (overweight to S&P component of about 12%). Second, it says that good management can make a successful business in almost any sector. It may surprise you to see utilities underweighted on this list . Utilities are good at paying dividends but not so good at raising them. Remember, this list includes companies with growing dividends.
Surprisingly enough, General Mills (NYSE:GIS) is not on this list. It has had some flat years, but companies like it deserve the same consideration. Companies that have more recently started paying and growing dividends, like Microsoft (NASDAQ:MSFT), deserve consideration as well. Fundamental research can lead investors in the right direction when it comes to determining future growth. Do your due diligence.
I use half of the 10-year historical dividend growth rate from these types of companies to model portfolios. I weigh them to get the whole portfolio income growing at least by the government CPI. I know the government stats are wacky, and I'm watching the alternatives.
However, one thing that isn't wacky is risk. What's more, retirement is not a time to take on additional risk. If inflation was as low as the CPI is showing, then I would worry less about a growth component and let the Social Security increases (very small) delay the erosion of purchasing power. Inflation is a real risk for the time frames I'm working with. I'm properly worried, but I'm not giving up income stability for income growth. I'll try for both.