Pay Yourself Back in Retirement
For all investors, there comes a point when the fruits of their labor need to start working for them. In other words, at some point, lifelong accumulators need to begin drawing income from their investments to pay themselves back in retirement. But making that emotional and practical shift from an accumulator of assets to a decumulator can be complicated and stressful, particularly at a time when markets are highly volatile and income sources are scarce.
The reality is, retirement planning doesn't stop when the last coin hits the proverbial piggy bank. A retirement portfolio needs to provide a growing stream of income – and traditional income sources are coming up dry. The 10-year Treasury yield, a widely accepted benchmark for the bond market, fell below 2% in September and has been in a historic low range for the better part of the past three years. What's an income-thirsty, risk-aware investor to do?
Dividends an Attractive Option for Income-Thirsty Investors
Source: Barclays Capital, MSCI and Bloomberg. Yields as of September 30, 2011. Cash represented by 30-day Treasury bills; municipal bonds by the Barclays Municipal Bond Index; corporate bonds (investment grade) by the Barclays US Credit Index; US equities by the S&P 500 Index; international equities by the MSCI EAFE Index; and global high-dividend equities by the top-decile-yielding stocks in the FTSE World universe. Past performance does not guarantee future results. It is not possible to invest directly in an index.
Chris Leavy, Managing Director and Chief Investment Officer of US Fundamental Equities at BlackRock, sums it up in one simple phrase: "aggressive investment in conservative stocks." What exactly constitutes a conservative stock? "These are primarily the stocks of companies with the financial fortitude to pay and grow their dividends," Mr. Leavy explains. "Dividends should be the cornerstone of a retirement income portfolio today."
Dividends "Pay" in More Ways Than One
The underlying challenge for retirement-minded investors is to manage both investment risk (the risk of loss amid heightened market gyrations) and longevity risk (the risk of outliving their savings).
Many retirees make the mistake of exiting equity markets entirely in retirement, opting instead for the fixed income and relatively lower risk profile of bonds. "The problem is the very high likelihood of outliving your nest egg," says Mr. Leavy. "Dividends can grow; bond coupons do not, so even with moderate inflation, you'll have a purchasing power crisis on your hands if you rely on bonds."
Indeed, once a couple reaches age 65, research shows there is a 50% chance that at least one of the two will reach age 92. Assuming retirement at 65, that nest egg needs to provide for 27 years. So, retirees still need to stay ahead of inflation. Bonds, says Mr. Leavy, simply don't offer that type of total return potential.
"When it comes to investment income, a 4% annual withdrawal is the often-cited magic number to avoid depleting your assets in the decumulation phase. Interestingly," says Mr. Leavy, "this is generally consistent with what global dividend equities are yielding right now. Compare that to the current 2% yield on 10-year Treasuries." (Of course, bond coupons are fixed until bond maturity, whereas company dividends are subject to change with company and market conditions. Dividend actions can be either positive, such as an increase, or negative, such as a cut or suspension.)
Why Dividend Payers Are Different
Not only do dividend-paying stocks offer attractive yields compared to traditional income options, but Mr. Leavy asserts they are also less volatile than the broader stock market, pointing to the historical performance of dividend-paying versus non-dividend-paying stocks in the S&P 500 Index. "This is thanks largely to the ample free cash flow, overall balance sheet strength and greater margin stability of these companies. They are typically high-quality businesses – companies that have a compelling competitive advantage in their markets or operate in an oligopolistic industry structure that allows them to earn attractive returns on capital. That means they can grow their business and still generate a lot of cash, and this can translate into favorable dividend payouts and dividend growth."
Richard Turnill, Managing Director and Portfolio Manager of the BlackRock Global Dividend Income Fund, agrees. "Dividend payers require a strong balance sheet, healthy cash flow and disciplined corporate management in order to maintain and grow their dividend. Over time," he explains, "this has proved to pay off for investors on an absolute, relative and risk-adjusted basis."
TIPS for Your Fixed Income Allocation
While stocks are a necessary ingredient to ensure the longevity of a retirement income stream, bonds remain an important element in any retirement portfolio. Yields are at extreme lows right now, but they won't stay there forever, particularly if the economy picks up speed.
The need to combat inflation in retirement makes a compelling case for investment in Treasury Inflation Protected Securities (TIPS) – i.e., Treasury bonds with built-in inflation protection. Martin Hegarty, portfolio manager of the BlackRock Inflation Protected Bond Fund, finds TIPS prices to be in the fair-value range today. "However, compared to nominal (non-inflation-adjusted) Treasuries and investment-grade corporate bonds, the inflation-adjusted yield provided by TIPS is attractive."
He goes on to say that although the economy remains weak and near-term inflation pressures are muted, "there is no denying that the various economic stimulus measures employed in recent years could eventually result in higher levels of inflation. We believe investors should view their TIPS allocation as an insurance policy against potentially higher rates of inflation in the future." For that reason, they can make good sense in a retirement portfolio.
To learn more about how to make your portfolio retirement ready, discuss these and other investment options with your financial advisor, who is best equipped to help you build a plan suited to your goals and risk tolerance.
Annual Dividend Income Growth Has Outpaced Inflation
Source: BlackRock, Bloomberg. Inflation calculations based on Consumer Price Index (CPI) data. Dividend income based on performance of the S&P 500 Index, dividends not reinvested. The performance of any index is not indicative of the performance of any particular investment. It is not possible to invest directly in an index. Past performance is no guarantee of future results. No investment if risk free. Dollar cost averaging does not ensure profits or protect against loss in declining markets.
BlackRock's LifePath® Retirement Income portfolio
Creating a better retirement future for plan participants.
With the waning of pensions and defined benefit retirement plans, investors are assuming increasing responsibility for their retirement through defined contribution plans, such as the 401(k). But choosing the most appropriate investments for a 401(k) account can be complicated. In 1993, BlackRock invented the first target date fund, which winnowed the decision-making to a single question: When do you plan to retire? Based on that date, a target date fund invests in a portfolio of stocks and bonds and adjusts the asset mix to become more conservative as retirement nears.
Today, target date funds also can address the retirement income challenge. BlackRock's LifePath® Retirement Income portfolio delivers guaranteed monthly income throughout retirement,* while also preserving the simplicity of the target date structure. Instead of investing in bonds as the asset allocation grows more conservative, LifePath Retirement Income buys deferred unallocated annuities. Upon retirement, the annuity income allocation becomes an individual annuity providing guaranteed lifetime income. The balance of the allocation is reinvested in the LifePath Retirement Portfolio to seek continued growth and protection against inflation, as well as provide a flexible source of additional drawdown income or emergency cash.
(The principal value of target date funds is not guaranteed at any time, including at the target date.)
Most investors understand the logic behind dollar cost averaging. By making fixed dollar purchases over time, an accumulator of assets benefits from volatility by acquiring more shares when prices are lower and fewer shares when prices are higher. For the decumulator, the effect is the opposite. It's been referred to as "dollar cost ravaging." Mr. Leavy explains: "The same dynamic that makes volatility good when you're accumulating (the ability to buy more shares at low prices) makes volatility bad when you're decumulating. Essentially, you're selling more shares when prices are low and fewer when prices are high."
To mitigate dollar cost ravaging in retirement, Mr. Leavy believes investors should have a higher percentage of their withdrawal coming from an investment's income component. "An investment's net asset value will fluctuate, so you want to minimize the percentage of your withdrawals that are funded by selling principal. Selling too many shares at the wrong time can devastate a nest egg." Income, he contends, is more stable. "But be careful. Bond coupons are fixed, so too much reliance on income from bonds will result in lower purchasing power later in retirement. In contrast, dividend income offers growth potential that historically has allowed investors to pursue their individual cash flow needs while avoiding the erosive effects of inflation."
Archived articles are current as of the original date of publication.