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April 13, 2008

Wages of Ownership -- the Retirement Years
by Richard Shaw

The wages of work have not been so great for most Americans in the last few years -- barely keeping up with published inflation, which we all know is far below real inflation when energy and food are included.

The wages of ownership, however, have been much better. Over the past 45 years or so, dividends paid to investors by the S&P 500 index have risen by an average of about 6%.

Except for unusual 11+% dividend growth in the last 5 years, dividends have grown on average between 5.5% and 6.5% per year; depending on how many years you look back.

That's good news for retirees with dividend oriented stock portfolios. Retirees face inflationary cost spirals just like everybody else, but all too often find themselves on fixed incomes from pensions or bond holdings or annuities that they purchased so they would not "outlive their assets". The problem with fixed incomes is that inflation ravages them.

We think retirees need to include equity income (dividends) in their retirement portfolio mix. Each person's situation is different, but dividend income should at least be considered for part of a retirement asset allocation.

While the price level of the S&P 500 index has been volatile, the actual number of Dollars paid by the index has not been volatile. It has risen rather smoothly over the years.

Dividends did decline slightly in 5 of the past 47 years, averaging -1.7% per decline, as follows:

• -1.54% in 1970
• -0.94% in 1971
• -0.12% in 1986
• -2.63% in 2000
• -3.26% in 2001

Those are miniscule in comparison to the declines seen in earnings or the index price level.

The index earnings declined in 11 of the 47 years, and averaged -9.1% for those declines, the greatest of which was a -14.9% decline.

The index price level declined in 12 of those 47 years, and averaged -13.3% for those declines, the greatest of which was -29.7%.

When you think about predictability of earnings, dividends and index price levels, it may be useful to take note of who controls the outcomes. Investors control the price level of the index. Management and company directors control dividends. Earnings are controlled by a combination of management, general economic conditions and customer decisions about the products or services provided by the companies in the index.

Clearly, investors are a more skittish and fickle group, making index price levels the most volatile. Management and directors are conservative in letting go of cash flow to pay dividends, and in creating precedents and expectations that they will be expected to repeat or beat in future years - that makes dividends non-volatile and most predictable. Earnings are controlled by multiple forces, only one of which is management, putting earnings between index price levels and dividends in predictability and volatility.

Most retirees with fixed amounts of capital need to think about predictability and volatility in their investments more than younger people. That's why they tend to focus on bonds or fixed payout annuities -- and why they tend to nervous about stocks.

However, if retirees looked at large-cap stock indexes instead of individual stocks, and at the dividend income more than the price level, they might give stocks more consideration.

Dividends are reasonably predictable, and unlike bond interest, they have a tendency to grow and overcome the ravages of inflation.

For example, if a retiree was earning $100,000 in dividends from a stock portfolio, and that was sufficient to cover the full cost of living for that retiree, how important would it actually be if the stock portfolio paying those dividends declined by 20% one year? Not really very much. If the retiree believes the dividends are secure, the price level of the portfolio isn't a primary concern.

Virtually all of the media reporting, and the majority of the fund reporting is about price levels with comparatively little about dividend income levels.

We think people with income orientation are looking through the wrong end of the telescope if they focus on stock price levels. They should be looking first at their portfolio dividend income, and the dividend payout ratio from earnings - putting price level last, not first. If the payout ratio is reasonable and the dividend yield is attractive, then the price of the stocks can gyrate without harming the retiree.

If a retiree can live entirely on dividend income and not invade capital, then price level drawdowns aren't as important in the question of outliving your assets as the dividend growth level versus inflation.

Of course, for retirees, who must utilize both income and capital to survive, price level is important, because multi-year price declines combined with fixed dollar consumption of capital can deplete a portfolio. Those investors are at higher risk of outliving their assets.

The S&P 500 index through proxy funds such as SPY and IVV pays a current dividend yield of about 2.1% ($21,000 in annual dividends per $1 million invested).

Of the 500 stocks in the S&P 500, fully 384 pay dividends (averaging 2.59% yield) and only 114 do not pay dividends. That provides strong protection against the inevitable stinker that pops up unexpectedly in most portfolios, such as Bear Stearns or Washington Mutual as recent examples. Diversification is key to reducing stock selection risk and to improving predictability of results.

The highest yielding portions of the S&P 500 index are financials (proxy XLF, 3.70%) with banks in particular paying high yields lately (proxy KBE, 6.44%), plus telecommunications (proxy VOX, 3.22%) and utilities (proxy XLU, 3.04%).

One way to increase portfolio dividend yield is to add some higher yielding sector funds to a core S&P 500 or other broad index portfolio. Alternatively, there are the high dividend stock funds (proxies DVY, 4.29%; SDY, 4.00%, as examples).

Be aware that any high dividend stock fund will tend to be biased toward the high yield sectors: banks, telecom, and utilities; but they can capture members of other sectors which pure sector funds will not do.

If you are retiree which ample capital, give some thought to a dividend oriented stock allocation in your portfolio along with your consideration of bonds and annuities.

Richard Shaw
QVM Group LLC

Copyright © 2008 QVM Group LLC

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