Common stock dividends, an old idea for retirement income, are in vogue again

Market Beat

What will you do for income in retirement?

Draw a pension, if you’re very lucky. Collect Social Security. Beyond those two sources of money, most people will have to rely on their savings — bank accounts, investments, home equity or an annuity.

And the challenge for many American retirees won’t just be to generate income from their nest egg, but to generate rising income to keep up with inflation.

Looking for a strategy to fill that bill, some investment advisors are turning to a solution that was familiar to Eisenhower-era retirees but increasingly has been lost on generations since then: common stock dividends from big-name companies, which in this era means firms such as Johnson & Johnson, H.J. Heinz Co. and utility PG&E Corp.

“We’re pushing this idea with clients now,” said Rich Weiss, who as chief investment officer at City National Bank in L.A. oversees about $55 billion. “There’s a great case to be made for it.”

It isn’t difficult to find shares of brand-name consumer products companies with annualized dividend yields of 3% to 3.5%. (A stock’s yield is the dividend divided by the current share price.) Yields on utility shares average about 4.4%.

Those dividend returns compare with an interest yield of about 2.6% on a five-year U.S. Treasury note.

Yet the dividend story is likely to be a very hard sell with many people, for eminently understandable reasons.

Retirement is supposed to be about financial stability and reduced investment risk. After the stock market crash of late 2008 and early 2009 — the worst decline since the Great Depression — equities naturally seem dicier than ever to countless Americans.

That’s why people have turned to bonds in huge numbers, pumping hundreds of billions of dollars into bond mutual funds over the last 15 months.

Agreed, bonds almost certainly will be a safer place for your money than stocks, particularly over any short time period. But if it’s income you’re going to need in retirement, bonds aren’t the slam-dunk answer they may seem to be.

One reason is that, thanks to the Federal Reserve’s cheap-money policies and investors’ rush for havens over the last year, interest rates on many types of bonds are well below where they were for most of the last 15 years. So you’re starting out with a smaller income reward.

More important is that once you buy a fixed-rate bond (or a bank CD, for that matter), your yield is set until the security matures.

As Kurt Brouwer, principal at financial advisory firm Brouwer & Janachowski in Tiburon, Calif., puts it: “The issuer of a bond is never going to call up and say, ‘We want to pay you more.’ ”

What about bond mutual funds? Fund investors’ income can rise over time if market interest rates go up and the fund buys new bonds paying higher yields. But predicting future interest payments on a fund in a rising rate environment isn’t easy because of all the variables involved — including the types of bonds the manager buys, their maturities and whether the fund has more cash leaving than coming in.

And of course you face the risk that higher market interest rates will devalue older, lower-yielding bonds in a fund, depressing the value of your shares.

Dividend-paying stocks, by contrast, can offer what individual bonds can’t: the potential for rising income over time, offsetting or more than compensating for inflation.

Healthcare products company Abbott Laboratories, for example, has lifted its dividend 60% since 2005, from an annual payment of $1.10 a share that year to the current annual rate of $1.76. Johnson & Johnson’s dividend has risen 71% in the same period; Heinz’s payout is up 47%.

All three dividends far outpaced the U.S. consumer price index, which rose about 13% in that period.

But if only the dividend story were that simple, everyone would buy into it. Although your income may rise with a dividend-paying stock, there is the ever-present risk that the share price itself, in the short run or long run, could lose far more than any dividends you’ll earn.

The other major risk is that companies can cut their dividends. Some very big firms, including General Electric Co., Macy’s Inc. and CBS Corp., did exactly that in 2008 and 2009 as the recession devastated their earnings.

Worse, many banks either slashed or eliminated their payouts altogether. The financial industry had long been one of the favorite sectors of dividend-seeking investors.

So why take a chance on dividend-paying stocks now? Because amid the economy’s recovery more companies are boosting their payouts. A total of 284 U.S. firms lifted their dividends in the first quarter, up from 193 in the year-earlier quarter, according to Standard & Poor’s. And the number of firms reducing or omitting their dividends plunged to 48 last quarter from a horrid 367 a year earlier.

Also, the Obama administration has signaled that it wants to largely preserve the favored tax treatment of dividends as put in place by President George W. Bush. The Bush tax cuts expire at the end of this year, but Obama supports keeping the dividend tax rate at 15% for couples earning less than $250,000 a year.

For investors who own stocks and bonds outside of tax-deferred retirement accounts, the Bush tax cuts gave dividends a huge advantage over bond interest, which is taxed at ordinary rates.

Josh Peters, who tracks and recommends dividend-paying stocks for investment research firm Morningstar Inc. in Chicago, says his frustration at the moment is that he views most solid dividend-paying stocks as fairly priced, at best — meaning it’s hard to find genuine bargains after the market’s 13-month surge.

That means the same would be true of the dividend-focused mutual funds and exchange-traded funds that offer an easy way for small investors to invest for dividend returns, albeit without the level of control they’d have by building a portfolio of 15 to 20 individual stocks.

Still, Peters expects that some of his favorite dividend-growth plays, including Waste Management, food-service-industry products distributor Sysco Corp. and payroll-services firm Paychex, will be able to boost their dividends at least 7% a year over the next five years.

He believes that more investors nearing retirement will begin to focus the power of dividend growth in a diversified portfolio.

“I think baby boomers will realize that if they need growth of income they can’t just do the bond thing,” he said.