How to Keep Cash Coming in Retirement

Glenn Ruffenach

Chances are good you have a large-cap fund as part of your nest egg -- say, one based on the S&P 500. So, two quick questions: First, what direction has that fund been going in the past few months? (Up? Down? Sideways?) Second, what's the yield on the S&P 500? The fact that many investors can answer the first question -- and are clueless about the second -- reveals what's wrong with retirement finances today.

In short, we focus most of our attention on price movement or capital gains at the expense of income. That's no surprise. The bull markets of the past three decades, with gains of 30 percent or more in a single year, made us "greedy," says Jack Gardner, president of Thornburg Securities in Santa Fe, N.M. "We became so tilted toward growth that the whole discussion of income has virtually disappeared."

Well, let's talk. Recent history has taught us that we can go a decade or more without capital gains. That's less of a problem during our working years, when we're drawing a salary and don't need to sell off bits of our nest egg to pay the mortgage. But once we start living off our portfolios, depending on capital gains and liquidating assets to meet expenses is a game of luck. If you happen to retire at the start of a nice, long bull market, you win; your savings likely will grow and last as long as you do. If you retire at the onset of a nasty bear market, you lose. Unless you enjoy the thought of moving in with your kids.

Income, then, should be Plan A in retirement, and capital gains, if they happen to come your way, a backup. The challenge, of course, is to pick the right investments to generate that income. Annuities? Dividend-paying stocks and equity funds? Bonds and bond funds? Preferred stocks? Master limited partnerships? Rental property? Ultimately, there are two deciding factors: stability (what won't fall apart in down markets) and growth (what will keep up with and outpace inflation).

A good litmus test comes from Charles Farrell, a principal with Northstar Investment Advisors in Denver, whose investment strategy starts with an asset allocation of about 45 percent equities and 55 percent fixed income. The latter, a mix of corporate debt, Treasury bonds and agency bonds, provides a healthy dose of defense against another crash, he says. On the equities side, he aims for roughly four dozen dividend-paying stocks, domestic and international, in 10 sectors, including energy, health care and consumer staples. When sizing up prospects, Farrell and his partners look first for a current "meaningful" yield and second for a company's ability to increase its dividend faster than the rate of inflation. An index he developed (which can be found at offers some specifics: The companies it holds -- Coca-Cola, General Mills, Intel and Wal-Mart, among others -- feature an average dividend yield of 3.5 percent and a five-year historical dividend growth rate of about 11 percent.

Such a combination delivers both stable income (bond interest) and growing income (stock dividends). There's also the bonus of principal protection -- again, from the bonds -- and the potential for capital gains from the equities. For most investors, these building blocks should look familiar: a relatively conservative asset allocation, diversified holdings and a buy-and-hold approach. The objective isn't price appreciation but generating steady cash.

Don't like the idea of individual stocks? Try mutual funds or exchange-traded funds that focus on dividends. Vanguard's Dividend Appreciation ETF tracks the Mergent Dividend Achievers Select index, some 140 firms that have increased dividends in each of the past 10 years. Want more security? Stephen Horan, head of private wealth at the CFA Institute, a nonprofit group of investment professionals, likes longevity insurance, an income annuity that kicks in with regular payments at, say, age 85: "It helps manage the biggest risk facing most retirees -- outliving your assets."

The larger point is this: The rapidly growing number of income products (there are now 116 fixed-income ETFs alone, double the number from just two years ago, according to Morningstar) gives you the opportunity to make cash flow from your nest egg. And given that most Americans haven't saved enough money for retirement, says Drew Denning, vice president of retiree services at The Principal Financial Group, "you have to look at every product that can help maximize income."

Of course, investing for income carries risks. Dividends can be slashed (think BP). Bonds are vulnerable to rising interest rates. Annuities typically require ceding control of a chunk of your savings. And rental property...well, we won't get into leaky toilets. What's more, if equity markets take off again, the income crowd, with its modest yields of 3 and 4 percent (however steady), will have to sit quietly, hands folded, while everyone else at the party is dancing to double-digit returns.

On the plus side -- and this is a big plus -- investing for income offers a measure of predictability. If markets and prices are random, why gamble on price appreciation? A diversified basket of income-producing securities -- bonds, dividend-paying stocks, annuities, even CDs -- is simply a higher-probability way of investing. You get a much better sense of what the downside exposure is, what the upside capacity is and what your income flow will be.

And the earlier you can start -- say, 10 years before retiring -- the better. Consider, for instance, the compounding effects of dividend growth, says Farrell. If the yield on your stocks was 3 percent at age 55, and if the dividends grew by 6 percent a year for 10 years, then your "yield on cost" (one of the most important but least understood metrics in investing) would be 5.37 percent by age 65.

If all this sounds like the thinking 50 years ago behind widow-and-orphan stocks -- producing a dependable paycheck each and every month -- you're right. And today in particular, "dependable" looks pretty good. "I remember my grandparents sitting around the table, talking about living on dividend income," says Thornburg's Gardner. "That was old-school. There's still a place for it."


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