by Alexander Reed CFP® ChFC®
The switch from wealth building in your working years to wealth income in retirement years seems simple. Common advice is to simply shift investments from growth stocks to dividend-paying stocks and buy more bonds. At first glance, this seems simple, but many retirees are discovering hidden income traps.
Today, let’s look at the two biggest retirement income traps and see how we can avoid them.
Trap # 1: Using Only Traditional Bonds
Remember your mortgage rate when you bought your first house versus the last time you refinanced? How much interest did you earn at the bank 30 years ago? These are not just percentage numbers, but dollars and cents that add up.
Traditional investors used to purchase long-term bonds from the government called treasury bonds. These were effective instruments because they were considered secure and paid a great interest rate called ‘yield’. Back in 1990, a 10-year treasury bond yield was 8.5 percent and the United States government credit rating was AAA. Currently, the same bond today yields only 2.4 percent, and the U.S. was downgraded to AA+ credit rating. This means a retiree will need 3.5 times more money to generate the same income!
The kicker is when interest rates rise, an individual bond value will decrease. So, the more a traditional bond investor moves to new, higher interest rate bonds, the less they make from the sale of the old bond. This is a common retirement income trap that’s hard to see – it’s a jungle out there, watch your step.
Trap #2: Buying Stocks Based on the Dividend Yield
Most people are aware of the current low-interest rate environment, so they decide to invest in dividend-paying stocks. A great choice – or are they?
In order to understand dividend-paying stocks, we need to understand why a company pays a dividend – a partial distribution of profits from a company to the investors (a.k.a., “shareholders”). The dividend amount is determined by the company’s board of directors as a fixed dollar amount per share (not a percentage).
The dividend yield percentage is then determined by dividing the dividend by the current share price. For example, if a company pays a $3.00 dividend per share and the current share price is $100.00, the dividend yield would be 3 percent.
Here’s where it’s easy to lose the logic. If a company is not making a profit, how can it pay a dividend? If a company is struggling to grow and make future profits, how would it be able to sustain the dividend in the future? That’s where the trap is.
Not fully understanding the waters they are sailing, investors often search for and buy stocks based on the dividend yield percentage, not the dividend itself. But if a company’s share price goes down, doesn’t the yield increase? Yes, but the dividend remains the same. When the share price drops to $30, suddenly that $3 dividend becomes a 10 percent yield rather than 3 percent. Sounds pretty good right? Except the payment actually hasn’t changed.
Now that we understand the finer points of dividends, the question is: why is the share price declining for a healthy, profitable company? Where will this go in the long run?
Have you tried to shop at Sears lately? This makes me think of Jack and Rose on the bow of the Titanic with arms spread wide enjoying the ride – everything is good … until it isn’t.
How can we avoid these potential retirement income traps? Consider these two strategies.
Avoiding the Trap: Think Broader for Bond Yield
Low-interest rates do not mean that bonds are not good. It just means we have to work a little harder to find interest income, so think broader. The federal government isn’t the only entity that issues bonds. There are many other bond asset classes such as corporate bonds, municipal bonds, preferred stocks, floating rating loans, bank loans, convertible bonds, mortgage-backed bonds, foreign bonds, real estate-backed bonds and even money markets.
Be open to, and aware of, other alternatives and be strategic in investment allocation to generate additional yield. Since individual bonds are not as easily traded and are typically traded in large quantities at once, it can be difficult for an individual investor to buy and sell in bond markets. Look for a qualified money manager, ETF or fund that has a strategic approach to fixed income.
Avoiding the Trap: Think Dividend Quality
A better bet for long-term dividend yield is looking for high quality, growing companies that pay dividends. If we determined that dividends are generated from profits, then it would make sense that a company that has growing profits will be able to pay even higher dividends in the future.
Income-focused retirees often overlook investing in companies like these because they do not typically pay the highest dividend yield right away. I know, this seems counter-intuitive. Think about it this way: if a company is not paying out a large portion of its profits, it is most likely (or hopefully) reinvesting those profits back into the business. With good management, a company should be able to generate a return on those funds, which increase future profit and therefore, increase the ability to pay a higher dividend. Profit reinvestment should increase the value of the company and therefore the share price.
How Can We Help?
Whether you’re already retired, or preparing for a retirement that may seem a long way off, your Carson advisor is here to help you plan for tomorrow. Our team offers comprehensive planning that shapes your portfolio according to your needs, today and in the future. Call us today for a consultation.
The return and principal value of bonds fluctuate with changes in market conditions. If bonds are not held to maturity, they may be worth more or less than their original value.
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