It’s OK to spend your income, but never, ever dip into capital.
Remember that old financial commandment? It was discarded long ago as a fuddy-duddy rule that doesn’t work in our low-yield world. But as I ponder retirement, focusing on dividend-paying stocks, so you don’t have to dip so often into capital, looks better and better—for seven reasons.
Low bond yields. While stocks aren’t cheap, bonds frighten me more. The 10-year Treasury yields about 2.6%, almost double its 2012 bottom but still historically low. There isn’t much room for interest rates to fall, and they could rise sharply, especially as the Federal Reserve scales back its bond purchases. If rates climb, bondholders could suffer painful declines in their portfolio’s value.
Less risk. Instead of investing for dividends, investors have been encouraged in recent decades to create their own dividends by occasionally selling shares. But recall those two huge bear markets we’ve had over the past 14 years. If you needed to create your own dividends, you could have found yourself selling stocks at deeply depressed prices. By contrast, dividends aren’t nearly as volatile as share prices, though they too have had some notable declines. Five years ago, as the Great Recession took its toll, the S&P 500 companies slashed their dividends by 24%. It was particularly grim during the Great Depression, when dividends were cut 47%, even after adjusting for that period’s deflation. In both instances, however, the decline in dividends wasn’t nearly as severe as the decline in share prices.
Still, those severe cuts suggest that, even if you could afford to live solely off your portfolio’s dividend yield, you need a safety net. One possibility: You might combine investing for dividends with, say, a cash reserve that you could draw on when economic crises hit and dividends get scaled back.
Inflation protection. Over the long haul, dividends have handily outpaced inflation, potentially providing retirees with a growing stream of income. Consider some numbers based on data from the website of Yale University economics professor Robert Shiller. Over the past 100 years, the dividends from a diversified collection of U.S. stocks would have grown an average of 4.4% a year, easily outpacing the 3.2% average inflation rate. Even as you collected your dividends, your shares would have been climbing in value, notching price gains averaging 5.6% a year.
Intriguing funds. Unless you have a huge portfolio, you would find it tough to live off the S&P 500’s 2% yield. But what if you bought high-dividend stock funds? For instance, among exchange-traded index funds, you can currently collect yields of around 3% from iShares High Dividend ETF HDV, Vanguard High Dividend Yield ETF (VYM) and WisdomTree Equity Income Fund DHS. For further diversification, you might add foreign stocks. Check out funds such as iShares International Select Dividend ETF and WisdomTree DEFA Equity Income Fund.
Favorable tax treatment. While interest from bonds is taxed as ordinary income, qualifying dividends are taxed at the long-term capital-gains rate. For everybody except those in the top federal income-tax bracket, that will mean paying 15% or less. One caveat: While dividends from most blue-chip U.S. stocks should qualify for this tax treatment, you may find that dividends from some U.S. stocks and foreign shares are taxed as ordinary income.
Value effect. Research suggests that bargain-priced value stocks have, over the long haul, outperformed fast-expanding growth stocks. High-dividend stocks are usually value stocks, so they could perform better than average if the value effect persists.
More discipline. In recent years, companies have eschewed dividend increases in favor of stock buybacks. But companies are quick to halt buyback programs when their finances get tight, whereas they’re loath to cut dividends. Indeed, paying a large, regular dividend provides managers with a healthy dose of discipline and forces them to think more carefully about how they spend the company’s remaining cash.
This isn’t to say you should bet your retirement solely on high-dividend stocks. The financial world is too uncertain for that. But tilting toward high-dividend stocks deserves a place alongside other retirement-income strategies, including delaying Social Security, annuitizing a portion of your savings and holding a hefty cash reserve.
If you’re collecting 3% in dividends and your goal is the often-recommended 4% portfolio withdrawal rate, you will need to augment your retirement income by dipping a little into capital and doing some occasional selling. But thanks to the dividends, you won’t have to do much selling—which means you can watch those stock-market swings with far greater equanimity, while you wait for your next dividend check to arrive.