One of the most common problems retirees face is how to create an income stream from their retirement savings.
In decades past, bonds were the tool of choice to solve this problem. Retirees looking to turn their retirement savings into an income stream would buy bonds and live on the interest. This worked well back when investment-grade bonds provided substantial returns above inflation. This changed dramatically after the Great Financial Crisis of 2008, when interest rates plunged to historic lows. Since then, it has become increasingly difficult for investors to find bonds that provide a reasonable return. Like all investments, even investment-grade bonds are risky. It only makes sense to own them if the investment returns compensate you for that risk. Bonds still provide diversification and stability, and because of that they have a place in a balanced portfolio. The days when bonds could be a primary source of retirement income are long gone.
For retirement savers and retirees, dividend-paying stocks are a great alternative to bonds. A portfolio of high-quality dividend paying companies can provide growth while you are saving, income in retirement, and protect your savings against inflation.
What are dividends?
Shares of stock represent a slice of ownership in a company. When you buy a stock, you become an owner of the company. As the owner of a business, you should expect to receive a portion of the earnings of the business. When a company pays a dividend, it is passing a portion of the company’s profits to its owners.
Not all companies in the stock market are profitable, and many profitable companies do not pay dividends. For retirement savers, the best investments are companies that consistently earn profits and pay out a portion to shareholders as a dividend.
Historically, dividends are responsible for over 30% of the total return in stocks.
Dividends provide a cushion during bad years, and an income stream in retirement. Stocks never go up in a straight line. History tells us that, although stocks are up more often than they are down, bad years can and do happen. Sometimes dividends can be the difference between ending a year with a gain and ending it with a loss.
For retirees, a portfolio of dividend-paying stocks can provide the income needed to live in retirement. Unlike interest payments on bonds, dividends of high-quality companies tend to grow over time. This means that retirees who buy high quality dividend-paying stocks for retirement income can expect their “paycheck” in retirement to continue growing as long as they hold those stocks.
A high dividend by itself does not make a company a good investment. Underlying earnings are also important, as well as the other fundamentals of the company. Sometimes companies that get into financial trouble continue paying dividends they can’t afford. When this happens, the dividend must ultimately be cut, leading to disappointment for investors. Wise investors look for well-run companies with strong earnings and a history of paying good dividends even when the economy is in a recession.
For retirees, a carefully crafted portfolio that is hand-curated and filled with high-quality dividend-paying companies could be the right way to provide income in retirement.
Matthew A Treskovich | CPA/PFS, CITP, CMA, CFP®, AEP®, MBA, CLU, ChFC
Chief Investment Officer