When Planning for Retirement, Choose Dividend-Paying Stocks

In some ways, the road of retirement is like many other road trips you’ll take during your life. To have a successful trip, you need to decide where you’re going, plan the trip, anticipate potential obstacles, pack, and begin your trip. But that’s where similarities end because while a road trip is just one trip in a lifelong series of trips, some good, some bad, the trip on the road of retirement is one lifelong trip where success is measured by your future quality of life.

In a recent article, “Inflation, Interest Rates, Market Volatility and Ukraine. Oh My!”, I suggested that today’s economic challenges are short-term obstacles in your long-term journey to achieving your goals. While that’s true, most investors share a common challenge, remaining confident that their investments will weather today’s economic and investment challenges. But often it’s difficult to truly feel confident when the markets are chaotic, inflation is out of control and the media is stirring up anxiety. That is, unless you’ve anticipated times like these and prepared accordingly.

Inflation, the Long-Anticipated, Uninvited Guest Is Back Again

Those of us old enough to have been working during the late 1970s and early 1980s remember what inflation looked and felt like. It looked like the segments we’d see on the nightly news that featured a retiree on a fixed income who had resorted to eating cat or dog food because “people” food was too expensive. It felt like it was almost impossible to get ahead of price increases.

Sure, we experience inflation every year, but now, 40 years later, “big” inflation is back. On an annualized basis, prices increased by 8.5% during March and by all accounts we’re feeling the effects of higher prices whenever we fill up the tank or make new purchases. While we’re feeling inflation today in real time, it’s important to remember that even when inflation is low, prices creep up little by little each year. The only way to fight long-term inflation is by ensuring your portfolio includes investments that generate income and appreciate over time at a rate that outpaces inflation.

Inflation-Proof Your Investment Portfolio

When investing for retirement, there are generally two schools of thought. Some believe it’s best to create a portfolio of high-yielding income producing investments that will generate income to cover expenses. While often considered “safe,” this approach leaves the retiree limited opportunities for asset growth making the investment portfolio exceptionally vulnerable to the ravages of long-term inflation.

Others believe a total return approach, where the investor builds a portfolio of growth-oriented investments, is the way to go. This approach focuses on growing the asset base at a rate that outpaces inflation so that at retirement there will be a larger base of assets that will generate income or can be liquidated over time to cover expenses.

We believe that a third, hybrid approach that combines the total return and high-income approaches is the best way to go.

Ask any investor to describe their vision of an “ideal” investment and they usually say something like this, “The perfect investment is one that only goes up in value, it generates income today, increases the amount of income I receive over time and appreciates in value.” That’s a tall order, but you’ll be happy to hear that except for the part about not dropping in value, there is an investment that meets three of the four criteria described above-dividend-paying stocks.

Reaping the Rewards of Long-Term Investing in Dividend-Paying Stocks

While we all know that past performance doesn’t guarantee future performance, we’ve done a historical analysis that demonstrates how dividend-payers have performed since 1990.

Figure 1 | Bond Yields Versus Dividend Yields Calendar Year Yields

Source: Bloomberg and Standard & Poor’s. Dividends were not reinvested. Data through 31 December 2021. You may not invest directly in an index.

Past performance does not guarantee future results.

As Figure 1 demonstrates, we first compared bond yields to the yields of dividend- paying stocks. As you can see, since 1990 yields from bonds and stocks have declined from where they were 31 years ago. It’s difficult for today’s investors to imagine a world where bond yields were close to 9% and dividend yields neared 4%, but that’s exactly what the investment environment was back then. If yields were the only measure of investment progress, it would be difficult to make the case for any long-term investing. Fortunately, yields don’t tell us everything.

Figure 2 | Bond Income Versus Dividend Income Annual Income From a Hypothetical $1 Million Investment Made in January 1990

Source: Bloomberg and Standard & Poor’s. Dividends were not reinvested. Data through 31 December 2021. You may not invest directly in an index.

Past performance does not guarantee future results.

It was then clear that using yields as the best way to measure these two types of investments was not the best approach. Instead, we decided to measure how much income was generated by each investment over time because growth of income generated by the investment was one of the criteria we believed was important.

In Figure 2 we compared the amount of income generated annually by hypothetical $1 million investments made in a portfolio of bonds or a portfolio of dividend-paying stocks. As the chart demonstrates, from 1990 to 2021, while the income from the bond investment steadily declined, the amount of dividend income derived from the dividend-paying stock portfolio steadily increased. Although the initial dividend yield of the stock portfolio was modest compared to the income generated by the bond portfolio, after 10 years the income from the stock portfolio surpassed income generated by the bond portfolio.  By 2021, the dividend from the stock portfolio was 912% higher. In both portfolios, we assumed that instead of reinvesting the income, the investor used it to cover expenses.

Finally, because we are believers in the hybrid school of investing, we needed to analyze whether the dividend-growing portfolio was competitive with a growth portfolio.

To determine that, over the same 1990-2021 period we compared the total return of the S&P 500 to the total return of the S&P Dividend Aristocrats Index, a subset of the index comprised of U.S. companies that consistently increased their dividends since 1990.

Figure 3 | Dividends for Retirement Income From S&P 500 Dividend Aristocrats Index

Source: Bloomberg and Morningstar. You may not invest directly in an index.

Past performance does not guarantee future results.

Figure 3 summarizes the findings of our total return analysis. As you can see, any type of investor, not just retirees, would have been much more appreciative of the 12.38% total return from the S&P 500 Dividend Aristocrats Index than the 10.75% total return generated by the S&P 500 over the same period.

Figure 4 | Dividend Yield by Country (2022 Estimates)

Source: MSCI indices sourced via Bloomberg as of 31 March 2022.

Over the course of this 31-year period, investors experienced their fair share of economic ups and downs and challenging investment markets. In the early 1990s there was the banking and real estate crisis, in the mid-to-late 1990s the “internet bubble” which culminated in the 2000-2002 bear market, from late 2007 through early 2009 we weathered the great recession and, just recently, we navigated the market upheaval caused by the COVID-19 outbreak and lockdown.

To give you a flavor for how the two indices performed over shorter periods of time, we broke down the comparison between the S&P 500 and the S&P Dividend Aristocrats Index into six 5-year periods as Figure 4 represents.

In four of the six 5-year periods illustrated in the chart, the S&P 500 Dividend Aristocrats outperformed the S&P 500.  During the 5-year period from 1995 to 1999 it was difficult for any investment to compete with the high-growth stocks that fueled the internet bubble, but the dividend-paying stocks still delivered a very attractive 19.48% total return. The second period of underperformance, by only 35 basis points, occurred between 2015-2019.

As our analysis demonstrates, if you’re one of the millions who intends to take a trip down the road of retirement, preparing for inflation and volatile markets is a must and dividend-paying stocks should get the passenger seat.