In the U.S., interest rates have remained relatively low for about a decade — since the Great Recession. Low rates are a problem for conservative bonds, traditionally a preferred investment for retirees. Because of low income yields, retirees have sought supplementary income from more aggressive holdings. One such security is the dividend stock.
The typical profile for a dividend stock investor is someone seeking income payouts over the long term, with principal preservation and modest growth.
On the scale of risk, dividend stocks rank pretty low for equities. They tend to be offered by well-established companies in low-growth sectors such as utilities, energy, telecom real estate. They feature relatively high yields and a general increase in shareholder payouts over time. This has enabled income-seeking retirees to have a means to keep pace with long-term inflation.
“Although retirees should have less exposure to equities than, say, a 35-year-old, stocks are an important component of a well-rounded portfolio for investors of any age.”
There are two main advantages to investing in dividend stocks: principal preservation and current income. However, dividend stocks may represent a high-risk allocation for a retirement portfolio and should be carefully considered as part of a well-diversified strategy.
When evaluating specific dividend stocks, check out their long-term track record for dividend growth in addition to the quality of the issue and current price. Companies that issue dividend stocks tend to be more focused on providing long-term shareholder value than growth and expansion.
The primary goal of dividend stocks is current income; equity growth is secondary. Therefore, one of the key components to measure is the stock’s track record for dividend growth.
- First, see if the stock has a strong track record for issuing payouts.
- Next, evaluate whether the stock’s current yield is “timely” — paying out income that is meaningfully above its five-year average.
- Finally, assess if the company itself is positioned for long-term growth.
When a dividend stock meets these three criteria, it may be a good candidate to provide passive income in a retirement portfolio.
Companies that issue high-dividend stocks tend to be well-established and more value than growth oriented. As a result, they tend to sell at a discount compared to other stocks. Generally speaking, when an investor purchases the stock and holds on to it for the long-term, he has a better chance of building up price equity.
It’s important to remember, however, that the true measure of performance includes both capital appreciation and income payouts to gauge total return. Also, be aware that dividend stocks are just as likely to experience periodic fluctuations as more growth-oriented securities.
More than 650 companies offer their current investors a Dividend Reinvestment Plan (DRIP). This plan enables dividends to be automatically reinvested instead of distributed to the investor. The investor can then continue building his or her stock position in the company without having to invest new money. The DRIP program automatically purchases fractional or additional shares of the same stock with little to no trading fees. This strategy offers the potential to generate higher dividend payouts in the future, as well as greater capital appreciation.
Once the investor retires, he or she can stop the DRIP program and begin taking dividend payouts as retirement income.
Hypothetical Long-Term Investment Example
Let’s say Karen is 28 years old with a high-paying job and low cost of living. She is able to invest $20,000 a year in dividend-paying stocks that yield 5 percent annually and grow by the same amount each year. However, instead of taking this income, she reinvests all of her dividends back into those same stocks. Assuming a 4 percent average annual return and an average inflation rate of 3.2 percent, she will have nearly $1.7 million by age 60. (Note that this illustration does not factor in capital gains taxes).
Given increasing economic growth and consistently low unemployment levels, the Federal Reserve is anticipating higher levels of inflation in the near future. As such, committee members have already voted for one interest rate hike this year and are projecting at least two more incremental increases in 2018 and three in 2019.
It’s important to consider current and future dividend stock investments as they relate to a rising interest rate environment. Higher interest rates tend to increase the yield on new bond issues, which in turn makes bonds more appealing. Both government and corporate bonds tend to be less risky than stock holdings and traditionally have been considered more appropriate for a retirement portfolio. Thus, retirees may wish to reconsider their asset mix in the wake of higher bond yields going forward.
Bear in mind that a changing interest rate environment is a good time to consider rebalancing your portfolio. If, in search of income over the last decade, your investment portfolio has become more heavily tilted toward equities than may be appropriate for your age and timeline, it could be a good time to sell and rebalance with a heavier bond allocation.
However, before making any changes to portfolio composition, consider a couple different factors. First, consider whether your personal financial goals have changed. Second, consider whether your current allocation strategy is providing the income you need at the level of risk with which you are comfortable. If both of these objectives are being met, it may not be necessary to make any changes, particularly if your retirement portfolio is well diversified.
As always, it’s best to consult with an experienced financial advisor who is familiar with your personal situation. Remember that dividend stocks are typically very stable income providers, with long-term potential for income growth. They may well be appropriate for retirees who continue to need a growth component in addition to income.