Given today’s low interest rates, a lot of investors are looking for ways to generate stable retirement income. They know they should be moving more of their assets to fixed income investments as they get older—both for the income and to reduce risk—but at today’s rates, those investments don’t meet their needs.
I sympathize with them—investors haven’t faced interest rates this low in over 50 years. But it’s still possible to live on the income from your investment portfolio after you retire without sacrificing safety or your standard of living. You just need a sound strategy.
Below are my top five tips for investors in or facing retirement today.
Retirement Income Tip #1: Fixed Income Isn’t the Best Source of Income
Fixed income investments—bonds, preferred stocks, CEFs and more—are called that for a reason. These investments are securitized debt, and the interest payments on the debt create a nice steady income stream for whoever owns them.
But today, because of historically low benchmark rates (which are set by the government), yields on all types of fixed income investments—from muni bonds to corporate loans—are too low to make them attractive to most investors.
Instead of reaching for yield in higher-risk fixed income assets—like junk bonds—today’s retirees would be wise to turn to the stock market, where dividends are having a renaissance: the yield on the S&P 500 currently exceeds the yield on 10-year Treasuries.
And it’s not the first time that’s happened! Until 1957, the S&P 500 consistently yielded more than 10-year Treasuries. It might seem strange to today’s investors to think of stocks as a better income investment than bonds, but that’s the world we’re living in… again.
Retirement Income Tip #2: Don’t Overvalue “Low Risk”
Retired investors often think they should use a low risk investment strategy because they don’t have as long to rebuild their nest egg if they suffer a catastrophic loss.
The problem that a lot of retirees run into is that they don’t just want to preserve their portfolio until they die—which is the aim of the lowest-risk investment strategies. They also want to grow their investment portfolio, while living on the dividends or other income from it.
These investors are more likely to meet their goals by taking on a moderate amount of risk, at least in part of their portfolio. As the table below reveals, based on data from Fidelity, higher risk strategies not only return more every year on average, they also beat low-risk strategies over the long-term (30-year period).
If you’re happy with average annual returns under 6% (and that’s using historical bond data, not today’s low interest rates), you can opt for a conservative strategy. But if you’re hoping for more growth from your portfolio, a conservative strategy that’s billed as “low risk” may actually disappoint.
Retirement Income Tip #3: Don’t Underestimate the Power of Dividend Growth
Many investors turn to the stock market for income, then ignore 1% or 2% yielding stocks because their yields are “too low.” But stocks in these brackets are often the best long-term income investments because they have greater ability to grow their dividends over time.
Consider a growing stock trading around $32 which pays a 16-cent quarterly dividend, or a 2% yield (To figure out the yield of any stock, just divide the annual dividend payout, in this case, 0.16 x 4, by the stock price which would be 0.64 / 32.00 = 0.02 or 2%).
As that stock grows over time, say, rising from 32 to 130, its yield will fall. But what happens if that stock also increased its dividend every year while it grows, say from 64 cents per year to $1.32 per year? Even though the stock’s yield is now 1%, investors who bought several years ago are now collecting $1.32 per year on a stock they originally bought for $32, for a yield on cost of 4%. This hypothetical actually reflects the real share price and dividend growth that Equifax (EFX) experienced during a five year period several years ago and, in fact, the shares have continued to appreciate and the dividend has risen further. For the past few years, Equifax has paid an annual dividend of $1.56, which is a yield on cost of almost 5%.
Over longer time periods, this effect becomes even more powerful. It’s estimated that Warren Buffett’s Berkshire Hathaway now earns more in dividends from Coca-Cola (KO) every year than it originally paid for the stock… that’s a yield of more than 100%.
Retirement Income Tip #4: Take Advantage of Gifts from Uncle Sam
Another benefit of depending on dividend stocks for income is the special tax status they’ve been granted by the U.S. government. For investors in the 10% to 15% tax bracket on ordinary income, qualified dividends are tax-free. And investors whose ordinary tax rate is between 15% and 37% pay only 15% tax on dividends, while investors in the 37% tax bracket still only pay 20% tax on qualified dividend income.
(You do need to have held the stock for over 60 days, including the ex-dividend date, in order to qualify for the lower dividend tax rate.)
Most U.S. corporations pay qualified dividends, and some Canadian and foreign stocks listed on U.S. exchanges do too.
Retirement Income Tip #5: Yields That Seem Too Good To Be True Probably Are
While dividend stocks are a great source of tax-advantaged regular income—often with potential for growth—you have to be selective about which ones you buy. And looking for dividend stocks with the highest yields is a sure-fire way to get yourself in trouble.
Stocks that offer double digit dividend yields are frequently doing so because their share price has been greatly depressed. This often leaves management in the unenviable position of trying to aggressively manage a turnaround while facing the difficult choice of maintaining that dividend. Frequently, these companies are forced to cut dividends to shore up their balance sheets, which drives away investors that only purchased the stock for the high dividend in the first place.
When you’re invested in this type of company you can quickly find yourself holding shares that no longer pay a dividend and which investors no longer want to buy.
Retirement Income Tip #6: Use Covered Calls to Generate Extra Income from Stocks You Already Own
Here’s one more bonus investing tip, because I couldn’t resist.
If you’re already investing in dividend stocks for income, writing covered calls on your stocks is a great way to generate extra yield from stocks you already own.
Covered calls are the least risky way to trade options, and you can control exactly how much capital you put at risk in each trade. To learn more about generating income by writing covered calls, click here.