For years, you’ve built up your IRA, 401k, and investment accounts so they could provide extra income when you retire. Now you’ve gotten to the point where you want to start seeing that income. You’ve heard about dividend producing stocks and wondered what part they should play in your retirement financial plan.
To help us understand what dividend producing stocks are, how they work, and how they should be used, we turned to a financial planning professional. Todd Schanel is a Certified Financial Analyst, Certified Financial Planner, and Certified Public Accountant. Along with Jackie Goldstick, CFP, he provides financial planning advice through Core Wealth Management in Jupiter, Florida. Mr. Schanel answered a series of questions to help you decide what role dividend producing stocks should plan in your retirement financial plan.
Q: For those who aren’t familiar with dividend producing stocks, what’s the range of return that can be reasonably expected?
Mr. Schanel: I’m not aware of any evidence that the level of dividends paid by a company is an important determinant of stock returns. In other words, we would expect a portfolio of high dividend paying stocks to produce about the same returns as a portfolio of stocks that pay low or no dividends, but are otherwise very similar. In 1961, Nobel Laureates Merton Miller and Franco Modigliani wrote a paper entitled “Dividend Policy, Growth and the Valuation of Shares” where they demonstrated that the level of dividends is irrelevant to stock returns. This theory still holds up today.
One way to think about why this is the case is to consider the source of a company’s dividend, the company’s cash on hand. So, when a company pays a dividend, the company’s cash balances are reduced. In other words, the payment of a dividend effectively reduces the value of the company by the amount of the dividend. If a company did not pay the dividend, an investor could generate “homemade dividends” by selling shares at the higher price.
Q: Companies aren’t required to pay a dividend, but most that do pay one try to stay consistent. Are there warning signs that a company could reduce or eliminate their dividend payments?
Mr. Schanel: You could look at the dividend payout ratio, which is the percentage of earnings (or better yet, cash flow from operations) that is paid out in dividends. You could also analyze the company’s leverage or liquidity using a variety of financial ratios. But perhaps the single biggest warning sign would be an excessively high dividend yield (dividend expressed as a percentage of current share price) as compared to an industry average or its own history. An unusually high dividend yield would be a market signal that something is wrong and perhaps a dividend is in trouble. The problem with this approach is that the reason for the high dividend yield is usually because of a sharp decline in the stock price. Therefore, selling a stock after the spike in dividend yield can be a losing strategy.
Q: Investors traditionally have looked at dividend paying stocks as being a fairly safe investment. But in these days of volatile markets is that still true?
Mr. Schanel: Dividend stocks have historically been less volatile than non-dividend paying stocks, but I would not describe them as “safe” in the same way we might describe a Treasury Bond or bank CD. Dividend stocks are subject to the same risks as other stocks, share prices can drop abruptly and companies can cut dividends whenever they want. For example, in 2009, 57% of dividend paying companies across 23 developed countries either reduced or eliminated dividends.
Q: Diversification is always important in any investment plan. Is there a maximum amount of dividend producing stocks that retirees should own?
Mr. Schanel: There is no set maximum, but this question gets to the real danger of focusing too much on dividend stocks. In an effort to boost dividends, investors tend to exclude non-dividend or low-dividend paying stocks, thus narrowing their portfolio to only high dividend paying stocks. The result is a less diversified, much riskier portfolio.
Q: Are individual dividend producing stocks or mutual funds that invest in dividend stocks better suited for retirees?
Mr. Schanel: The big advantage of mutual funds is that it allows for diversification at a very low cost. A mutual fund provides more diversification than individual holdings. However, broad diversification across stocks and, more importantly, across assets classes reduces volatility, and that is crucial for a retiree drawing an income stream from a retirement portfolio. Therefore, in our opinion, a retiree should focus more on owning a broadly diversified portfolio than on whether or not the stocks they own pay dividends.
Q: For the retiree who’s looking for income, what other alternatives to dividend producing stocks should they consider?
Mr. Schanel: The primary alternative is to take a “total return” approach to investing. A portfolio’s total return includes dividend income, interest income, and capital appreciation. A total return approach allows a retiree to invest in a broadly diversified portfolio of stock and bond mutual funds, collect the dividend and interest income, and produce additional cash flow by selling shares. A reasonable withdrawal rate combined with regular rebalancing is more likely to produce a better result over a multi-decade retirement than an approach that focuses solely on dividends.
Todd Schanel CFA, CFP, CPA serves as founding principal and investment advisor at Core Wealth Management, a Registered Investment Advisor firm in Jupiter, Florida. Core Wealth Management offers unbiased financial planning advisory services, independent investment management, and comprehensive, integrated wealth management solutions for clients in Florida and across the United States.
Gary Foreman is a former financial planner and purchasing manager who founded TheDollarStretcher.com website and newsletters in 1996. He’s been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money and he’s a regular contributor to CreditCards.com. Visit TheDollarStretcher.com for 4 beginner investment mistakes to avoid.