Get the Income You Need from High-Dividend Payers

March 09, 2011

You definitely can't fund your retirement with near zero payouts from cash and Treasuries. But with a small stomach for risk, you can earn a decent 4% return on your portfolio.

Whether you're looking to cover your retirement expenses or looking for ways to protect your portfolio against major losses as you systematically save for your retirement years, you really can't depend on the same places you put your money in as you did before. Extreme pessimism on the state of the economy and the financial markets carried investors on a long flight to safety pushing yields on traditional savings vehicles to almost zero. Cash returns are dismal. Rates on money-market accounts and short-term CDs average below 0.5%. Money-market funds are yielding an even smaller 0.04%. Other traditionally safe investments such as Treasuries are yielding record lows. Even a 10-year Treasury note will get you an annual rate of only 2.5%. Typical stocks are also slashing their dividend yields across the board and are at yields that are half their historic averages.

So how can you earn a comfortable 4% on your money without taking on too much extra risk? It is possible as long you are willing to take on a different investment path. Consider combining the investment opportunities of high-quality dividend-paying stocks, and perhaps corporate and foreign debt to reach your financial and investment goals. You have to be creative these days to get 4% out of your portfolio. While 4% is difficult to get in the current market environment especially with the risk profile typical of those who traditionally investing in strictly conservative investments, it is certainly not impossible.

Why are we targeting 4%? Well, it's a good guideline to use when we're talking about retirement. When you're in the savings phase of accumulating your retirement fund, 4% is the target you'll need to beat to outpace the wear and tear of inflation over the long run. And once you are ready to retire, it's the number that should guide your yearly portfolio withdrawals. If you go into your retirement and start withdrawing 4% of your portfolio, you will have a pretty good shot at making your money last your lifetime.

Getting 4% these days won't come easy and risk-free. Corporate and foreign bond prices have increased significantly over the past year because of sharp decreases in interest rates. This can pose future threats as the price run-up starts running out of steam. And if stock prices start falling, returns on high-quality and high-dividend paying stocks could tumble as well.

The following several strategies outlined can be used either individually or in combination to help you minimize the danger of losses by building on a foundation of safe investments.

Get into High-Dividend Payers
Dividend-paying stocks have traditionally been the types of stable and dependable investments that investors have used to achieve conservative growth and good yields. While dependable, they are plain investments and there is nothing exciting about them usually. Recently, however, they have been providing some decent dividend yields, more even than investment grade corporate bonds these days. These dividend payers provide investors with the opportunity to earn payouts up to 4% or maybe a little more. At the same time, dividend stocks provide a much better chance for capital appreciation than bonds and as such enjoy much more favorable tax treatment. At least for now, dividends are taxes at a 15% top rate, while bond interest is taxed at 35%.

Focus on high-quality firms that offer a dividend yield anywhere between 4% and 6%. Even though that's much higher than the average yield on the S&P 500 of 2%, it is not so hefty that companies may be forced to slash their dividend payments. One way to spot these good opportunities is to look for companies that use no more than 50% of their earnings to pay their shareholder. This ratio is usually referred to as the payout ratio. As a result, this allows the company with enough funds to reinvest back into the business without having to be hard-pressed to keep up payments.

Also, look at sustainable and increasing dividend paying companies. These are companies that increase their dividends overtime. Ideally, you want to look at companies that have increased their dividend payouts for the past 5 years or longer.

Build on a strong core
You can put together a stable and solid diversified portfolio that meets the dividend paying criteria with some well-chosen individual stocks and funds. For your foundation, consider allocating money into the SPDR S&P Dividend (SDY), an exchange-traded fund that tracks the 50 highest-yielding stocks in the S&P 1500 index of large, medium, and small companies that have consistently paid dividends for the past couple of decades. Some of its holdings include household products maker Kimberly-Clark (KMB) yielding 4.1%, and components manufacturer Leggett & Platt (LEG) yielding 5.6%.

Also, allocate some money into a handful of individual stock positions that together average over a 5% yield. Great sectors for yields these days are telecommunications and utilities. For instance, AT&T (T), which has a significant cash reserve - almost double since 2006 - was recently yielding 6.2%. Another is Exelon (EXC), one of the largest nuclear power plant operators, which is notorious for increasing its dividend every year is now yielding close to 5.2%.

Spread some of you money across different regions and sectors as well. Pharmaceutical company Merck (MRK), for example, yields about 4.3% and uses only about 40% of its cash reserves to pay out its dividend. Intel (INTC), which is yielding 3.6%, has boosted its yield at 17% annually for the past five years. Another good yielding company is Vodafone (VOD), yielding 7% and its payout ratio is 48%.

Consider exchange-traded funds
If you are not comfortable in making individual picks, speak with a financial advisor to guide you along the way or consider using exchange-traded funds to put together a well-diversified, good yielding portfolio. Again, use the SPDR S&P Dividend ETF as one holding. Add more yield to your portfolio by allocating some of your funds to the two highest-yielding sectors in the market through the Utilities Select Sector SPDR (XLU), yielding around 4.1%, and iShares S&P Global Telecommunications (IXP), yielding at 4.4%. Also, to diversify your portfolio across the globe, consider allocating some of your money to funds such as the Vanguard European (VGK), yielding 4.2% and/or Matthews Asia Dividend (MAPIX), yielding 3.3%.

You don’t have to go at it alone
Speak with an Isakov Planning Group Financial Advisor to help you navigate through the market and uncover opportunities that may help you maintain your current conservative risk profile while still receiving an above-average yield from your investments.