The low interest rate environment of recent years has presented challenges to retirees who rely on bonds to supplement retirement income. Low rates and sustained equity outperformance have made stocks more attractive. However, while the stock market has returned impressive gains over the past eight years, retirees historically have been reluctant to maintain a high equity allocation in their retirement portfolios. Dividend stocks offer an appealing alternative.
Dividend stocks boast relatively high yields and the ability to increase shareholder payouts over time. Not only does this offer a viable alternative to low-interest bond payments, but income growth gives retirees the opportunity to keep pace with cost of living increases. Thus, dividend stocks offer retirees an additional source of passive income throughout retirement.
Dividend stocks are generally designed for two purposes: preserving principal over the long-term and providing reliable and relatively safe retirement income. But because they are higher-risk investments than corporate and government bond issues, it’s a good idea to incorporate them as part of a diversified income portfolio.
In fact, to help ensure that a dividend stock is a good fit for a retirement portfolio, it’s important to focus on quality and price as well as yield. Fortunately, companies that issue dividend stocks tend to focus on providing long-term shareholder value and are therefore less likely to engage in high-risk ventures or overexpansion.
It is worth noting that dividend stocks are better known for income than appreciation. While equity growth is a secondary goal, it’s more important to measure a dividend stock by its dividend growth.
There are two key ways to evaluate the quality of a dividend stock. First, check if the stock has a strong track record for issuing payouts and is positioned for long-term growth. Second, determine if the stock is issuing a timely yield, which means that the current payout is well above its five-year average.
Companies that issue high dividends usually are well established and in low-growth sectors. Because of this, they tend to sell at a discount to other sectors. Be aware that the stock prices for these companies are just as likely to experience periodic volatility as others. However, the ideal investor profile is someone looking to buy in at a reasonable price, receive income payouts over the long term, and preserve principal with modest growth. The enticement isn’t equity growth; instead, it’s long-term income with the potential for income growth. This why dividend stocks are a good option for retirees and less attractive to growth investors.
Many companies that issue dividend stocks also offer a Dividend Reinvestment Plan (DRIP) to investors. Instead of taking cash payouts, a DRIP enables the investor to automatically reinvest his dividends to purchase fractional or additional shares of the same stock. Over time, these additional shares can accumulate as part of the overall investment in the security—producing the potential for both higher dividend payouts and greater capital appreciation.
Once an investor retires, he can terminate the DRIP program and take the dividend payouts as retirement income.
Rising Interest Rates
The Federal Reserve has already initiated one interest rate hike this year; currently, the federal funds rate stands at 1.75 percent. The Federal Reserve is currently expected to raise rates to 2 percent in 2018; 2.5 percent in 2019; and 3 percent in 2020. Higher interest rates are likely to make bond yields more appealing, which in turn could spur retirees to rethink the dividend stock allocation in their portfolios.
When re-evaluating holdings, it’s important to focus on your personal financial goals. If you’ve purchased quality stocks and found that dividends are adequate, reliable and have increased over time, they might be worth retaining. However, for any stocks that do not meet these criteria, rising interest rates create a prime opportunity to sell and use the proceeds to further diversify your retirement portfolio with low-risk, high-yielding bond issues at low a price point.
As always, consult a financial professional to help you make the best decisions for your situation.