From a financial planning standpoint, we generally encourage clients to be debt-free in retirement so that when their earned income stops, so do their debt payments. Exceptions may be made for situations with reasonable levels of debt at extremely low interest rates or for loans with short remaining terms.
In retirement, clients generally have a mix of stocks, bonds and cash in their investment portfolios. It is important to select an asset allocation that suits your individual situation and risk tolerance and to stick with that mix of assets through various market conditions. We counsel our clients to avoid market timing, or shifting large amounts of assets in and out of the stock market based on the mood of the day.
Bonds, or fixed income, provide a limited amount of current income and serve as a source of retirement spending when stock prices are lower, historically about three out of every 10 years. However, you never know when these negative years will come. As of the end of 2020, only two of the past 18 years were negative for large company stocks. But, there were three negative years in a row before that (2000 to 2002). Still, that interest income on a bond portfolio will increase gradually along with the overall level of interest rates. This occurs as individual bonds (or bonds within a bond mutual fund) mature and the proceeds are reinvested at higher rates. But the increase in interest rates usually comes in tandem with inflation, or an overall increase in prices. By its very nature, we do not expect capital appreciation in a bond portfolio over long time periods, though it has happened historically in periods of falling interest rates.
Since there is typically some level of inflation in the economy, retirees need to have some investments that provide rising income over time in order to preserve their purchasing power and offset the effects of inflation over time. For that, we focus on stocks, particularly those that pay dividends.
Modern financial theory holds that the value of any investment is the sum of the present value of its future cash flows. This logic applies whether the investment is a publicly-traded stock, a piece of commercial real estate or a hot dog stand. With a dividend-paying stock, you are getting a return on your initial investment each quarter rather than relying purely on future earnings growth to make a profit. While short-term volatility can be considerable, over longer time periods stock prices historically follow rising earnings and dividends.
The current dividend yield on the S&P 500 index is about 1.5%. We believe that dividends help put a floor under the value of an individual stock, because you are receiving an ongoing stream of cash flow from the time that you make your investment.
Total return is comprised of two components: income and price appreciation. Since 1926, the income component of total return has represented about 38% of the overall return of the stock market and has always been positive (by definition, the income component can’t be negative). However, the variability of the income return has been much lower than that of the appreciation component. Over that same period, the annual standard deviation or volatility of the income component was only about 1.6% versus over 19% for the price or capital appreciation component.
By focusing on those companies that we believe are likely to have consistent dividend growth over time, particularly for those of our clients who are retired and spending from their portfolios, we are setting up a condition where there is less uncertainty about a significant component of their overall return.
Growth stocks, which pay lower or no dividends, must earn their total return exclusively from a change in price. All else being equal, a company that does not pay a dividend must have a higher expected growth rate than a dividend-paying stock to command the same valuation.
We believe it is important to consider both the level and sustainability of dividends. The S&P 500 currently has a dividend payout ratio of about 42%. This means that for every $1.00 in earnings, companies are paying an average of about $0.42 in dividends. Significant levels of debt or off-balance sheet obligations like underfunded pension plans or post-retirement health care benefits may restrict a company’s ability to pay dividends in the future, since these are competing claims on the company’s cash flow. When evaluating individual stocks for inclusion in client portfolios, our research committee considers the current dividend yield, the company’s historical track record of dividend increases, and the dividend payout ratio. A high dividend payout ratio of 75% or more may indicate that the dividend is at risk of being cut in the future. An unusually high dividend yield is also a sign that the dividend may not be sustainable. If something seems too good to be true, it usually is. At the same time, there are many well-known companies that have increased their dividends every year for 25, 35, 50 or even 60 consecutive years. You may already own some of these companies, especially if you are a Parsec client. We want to focus on companies with sustainable and increasing dividends to provide a source of retirement spending.
The traditional theory taught in universities and graduate schools worldwide used to be that the lower the dividend payout ratio, the higher the earnings growth rate in subsequent periods. More recent studies have demonstrated exactly the opposite: that higher dividend payouts actually resulted in higher future earnings growth. This relationship was shown to hold true across a number of different countries and time periods. If this continues to hold true, it would be a double win for investors, since they would capture both a higher current dividend as well as higher future earnings growth by investing in dividend-paying stocks.
Why not buy all dividend-paying stocks? Different clients with different investment objectives may have different levels of dividend-paying stocks. A retiree who is spending from their portfolio, in addition to likely having an allocation to fixed income (bonds), may have more dividend-paying stocks than a younger client in the accumulation phase. As we review client portfolios for potential improvements, increasing portfolio income is one factor that we consider.
Also, a cornerstone to our investment philosophy is broad diversification among growth and value companies, small, medium and large companies and international companies. We never know what the future holds, so we want to have a mix of assets that will perform well under a variety of market conditions. If we focused exclusively on dividend-paying stocks, we would be forced to underweight sectors of the economy like technology that we believe have attractive future growth prospects.
For our client portfolios that include individual stocks, we focus on high- quality companies with the potential for rising earnings and dividends. We then combine 30 to 40 such companies into a well-diversified portfolio, including mutual funds and ETFs for small companies, mid-sized companies, international companies and about half of the allocation to large-cap U.S. companies.
Regardless of what happens in the stock market over the next year, your portfolio income should be higher each subsequent year. The management teams of high-quality companies with long track records of dividend increases are very reluctant to cut their dividends. Even in a recessionary environment, more companies should increase their dividends rather than maintain or cut them.
We encourage our clients to focus on this concept of rising portfolio income to meet their investment goals and help provide peace of mind during the inevitable corrections and bear markets that we will all experience at some point.