With a rash of baby-boomers settling into their golden years over the next decade, the funding of a retirement, especially in this era of low interest rates, will continue to be an important consideration for aging Americans. The typical worker who retires in his/her low 60s should be looking to stretch a nest egg, pensions, and Social Security for at least two decades. Those who remain healthy might need to draw out their cash stash substantially longer. William Bengen's 4% withdrawal rule and allocation strategy, posited twenty years ago amidst a much higher interest rate environment, where investment grade bonds and risk-free cash assets provided substantially higher yields, and life expectancy was somewhat lower, doesn't appear to hold as much weight today.
The Social Security Administration currently projects that the average male born in 1950 (now 64 years old) will live to be 86, according to its life expectancy calculator. So, on average, this person will need their money to stretch another 22 years.
Needless to say, every individual or couple will be looking at a different situation in retirement: different amounts of capital to start, different supplementary income being received, different living cash flow needs, and last, but probably most importantly - and perhaps most unpredictable factor - life duration. Given the amount of variables involved, there is no wholesale blueprint of success here.
Is Dividend Growth Alone The Best Strategic Path?
Dividend growth should be a prime consideration for retirement investors. The strategy advocates development of a stream of income that helps meet current expenses, fights inflation, and that won't be outlived. Regardless of whether the market wants to place a historical premium or discount price on corporate earnings, the investor sees an annual, or more frequent, rise in dividend income. This consistent rise in portfolio income helps protect against the omnipresent, silent-but-deadly force of inflation.
Unfortunately, in today's market most "traditional" dividend growth stocks only yield in the 3-4% range. For those with multi-million dollar portfolios and minimal, but incrementally increasing income needs, it might be perceived as a single stop, or dominant strategy for a comfortable retirement. But for most, with not-so-lofty sums of personal capital, they won't be able to get away with dividend growth alone. If you need to generate $40,000 on your managed investments and have accumulated $600,000, 3-4% obviously won't cut it.
But even if you have enough to utilize dividend growth exclusively, just because the strategy looks good on paper does not mean it comes without risk. While long-term investors might expect mid- to upper-single-digit annual dividend increases in their Cokes (NYSE:KO), Procters (NYSE:PG), Phillip Morrises (NYSE:PM), Realty Incomes (NYSE:O), and other large-cap favorites, there is absolutely no guarantee that a focus on equity payouts will prove successful given the somewhat arbitrary, unpredictable nature of corporate dividend policy and the general risks associated with stock investment.
Still, dividend growth should be considered a fairly conservative equity strategy, given the types of companies that tend to be favored. So if someone told me they were in need of an all weather equity strategy that helped then sleep at night and generated at least a modicum of income, dividend growth would probably be at the top of my recommendation list.
Should You Have Satellite Strategies?
Once you come to the conclusion as to whether you could make a go with dividend growth alone, you have to decide if that is your most prudent course of action or not. Other choices would be to include lower yielding stocks or non-yielding stocks with more capital growth potential or higher-yielding stocks that offer more immediate payout satisfaction but less long-term dividend growth. You could also include a bond component with variable yield attainment and a higher degree of capital preservation assuredness, but no dividend growth.
Of course as you add additional asset classes and layers of strategic thought into your portfolio, it means more time and energy to monitor different sectors, specific positions, and corners of the market. To me, having additional layers of diversification within the confines of an income portfolio creates a more secure income stream. But at the end of the day, it can become unnerving when one starts delving into unfamiliar niches of the market.
I think the goal of achieving a self-sustaining flow of income from existing capital is a very worthy one. While many MPT theorists may say that investing for growth or total return and selling shares to support retirement is the better strategy, I would tend to disagree. I believe the odds of a protracted bear market that could stagnate or decimate capital are much more likely than the odds that a diversified portfolio predicated on income production ceases to grow over time. Thus, in retirement, I'd rather lock in my gains through periodic dividends than hope and pray that a growth and/or total return strategy does well enough to get me through to age 86.
Contemplating High-Yield Equity
In a recent article, I took up the notion of whether high-yield equity was necessarily riskier than dividend growth. While I stated and continue to believe that the answer is not clear cut, high-yield can present advantages. If we take two equities, let's say General Electric (NYSE:GE), currently yielding 3.3%, with an assumed 8% dividend growth rate and Prospect Capital (NASDAQ:PSEC), with a 12% yield and only 1% dividend growth, it would take 17 years for GE to eclipse 12% yield on cost. While the odds of a dividend disruption at PSEC over 17 years may be higher than that at GE, the current yield advantage of 900 basis points is a rather compelling data point for an income investor.
So the question of whether to utilize higher yielders could partially come down to if there is a specific need for elevated income or it could also come down to the belief that owning both GE and PSEC with a blended 7.75% yield entails less overall risk than owning one or the other alone.
Also, specific nuances or undiscovered gems within the high-yield space can provide alpha opportunities. Prospect Capital, for example, carries a tremendous amount of floating rate debt in its loan book. As President Grier Eliasek told me in a recent interview, the company is poised to specifically benefit from a rising rate climate. With higher rates looming, I feel the stock is a good one to own for a variety of reasons.
NorthStar Realty Finance (NRF), which I pounded the table on through 2013, when it yielded in the neighborhood of 10 percent, has now more than doubled in a little over a year and continues to garner attention. So don't necessarily let double digit yields intimidate you - often times there is value. But you must be selective, do your due diligence, and not invest based simply on yield alone.
Why You Should Get To Know Bonds
While many income investors seem to be shunning bonds in favor of dividend equity in the current environment, fixed-income, like high-yield equity can bring value, diversity, and stability to an overall income portfolio. I would argue that if and when rates trend higher, bonds will certainly regain favor with retired investors. Even today, attractive yields surpassing those found in dividend equity can be found, intermediate term, in the low end of investment grade. If one wants to delve into junk, the yields are even more attractive.
Building a passive bond ladder is a sound strategy that takes the guesswork out of where interest rates are headed. Ladders typically involve purchase of a group of bonds, with the attainment of a blended yield and maturity. The consistent replacement of maturing paper with long-term issues provides a bond machine that is agnostic to the rate outlook. Today, you could probably build a 20-year investment grade bond ladder with blended yield in the mid- to upper-four percent range. If you delve into junk bonds, you could get another 100 basis points. If you go with a levered junk bond CEF selling at a discount, you could get better than 8 percent.
I don't have a crystal ball into where short- and long-rates are headed, but I think it's fair to say that as bond rates rise and investor interest returns, the allure of dividend equity may wane symmetrically. So while I certainly wouldn't necessarily recommend an overweight position in bonds right now for most investors, still, having scant exposure to the space, with a strategy in place to scale as rates rise, would be prudent in my opinion.
The obvious downside to bonds is that interest never grows. The upside is that assuming you hold an individual issue to maturity and the issuer does not run into a liquidity crisis, your capital is preserved and returned, which is something one can never say about equity. My advice has been - and continues to be - is to build an individual bond ladder with mostly investment grade paper, perhaps sprinkled with some higher-grade junk. I advise reserving the majority of junk exposure to closed-end funds. I continue to like Alliance Bernstein Global (NYSE:AWF) and Prudential Global Short-Duration (NYSE:GHY).
Some investors may view pensions, Social Security, and/or other secured sources of passive income currently as a bond proxy, and that's fine. But if interest rates rise, it could still be sensible to migrate an overweight position in dividend equity towards fixed-income.
Though many retirees have gravitated to dividend growth recently as a core strategy - and rightfully so - dividend growth by itself may not represent the best possible investment solution in all investors' circumstances. I would argue that the most secure of income streams is one generated by diversified layers of multiple asset classes, constantly refined and rebalanced as market and macroeconomic situations dictate.
Disclosure: I am long AWF, PM, PSEC, GE, NRF, GHY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.