As chief analyst of Cabot Dividend Investor, I hear from a lot of retired investors seeking investing tips in today’s low interest rate world. 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.
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Below are my top five tips for investors in or facing retirement today.
Investing 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 is now comparable with 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.
Investing 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.
Investing 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.
Five years ago, Equifax (EFX), one of our Cabot Dividend Investor recommendations, was yielding just about 2%. The stock traded around 32 and paid a 16-cent quarterly dividend. (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. So EFX’s yield five years ago was 0.64 / 32.00 = 0.02 or 2%.)
Over past five years, EFX has done very well, rising from 32 to 130, and its yield has fallen from 2% to 1%. But EFX has also increased its dividend every year over this time period, from 64 cents per year in 2011 to $1.32 per today. Even though the stock’s yield is now 1%, investors who bought five years ago are now collecting $1.32 per year on a stock they originally bought for $32, for a yield on cost of 4%.
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%.
Investing 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 39.6% pay only 15% tax on dividends, while investors in the 39.6% 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.
Investing 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.
At the beginning of November 2015, Seadrill (SDRL), an offshore drilling contractor, yielded a whopping 18%. The company had long been a great dividend payer, often yielding as much as 7% or 8%. But after a dramatic drop in oil prices and offshore drilling activity, the dividend—and the company’s very survival—were suddenly in jeopardy. Between the beginning of September and mid-November, SDRL slid from 37 to 20, sending the normally high but sustainable yield to nearly 20%.
For most of the fall, Seadrill’s management assured investors that the dividend was safe through 2015, but ultimately they suspended the dividend on the day before Thanksgiving 2014.
That 16% yield was suddenly 0%, and the worst wasn’t over yet. SDRL fell from 20 to 10 within a week, and now, two years later, trades around three dollars.
Investing 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.