By Massi De Santis, Ph.D., CFP
I met with a new client recently who told me that she was happily invested in AT&T stock because of its dividend yield above 7%. She saw it as a way to generate a steady income by cashing in the dividend while not having to worry about market volatility given the relative perceived safety of a big company like AT&T. She thought this was a good idea particularly because of the low interest rates, which are making bonds less attractive. But, is investing in high dividend stocks to generate retirement income a good idea?
The short answer is no, and for these reasons:
· Total return matters for generating income, not the dividend yield
· High yield stocks are not necessarily safer than other stocks, and individual stocks are riskier than a broadly diversified portfolio
· The dividend is not guaranteed. Dividend-paying companies cut or eliminate dividends in times of uncertainty and recessions.
· Income mutual funds are not an efficient way to build an income-generating portfolio.
Let’s review them in turn.
A Total Return View
Just like my client, people cite two main reasons for seeking yields in stocks:
1) They want to receive income over time, and many stocks generate higher dividend yields than bonds these days.
2) They feel safer knowing that stocks pay a dividend and that less of the return comes from growth. Growth is risky while they view the dividend payment as safer.
We can analyze the validity of these statements by breaking stock returns into the two sources:
Total Return = Dividend + Appreciation
Consider this example. You buy a stock at $40 today, it pays a dividend of $2 over the next year, and you sell it at $45 a year later. Your total return is $7 ($2+$5), or 17.5%. Your dividend yield is $2/$40 or 5%, while your capital appreciation is $5/$40 = 12.5%.
Compare it with a second stock that pays no dividend but appreciates to $47 at the end of the year. The total return in this second case is also $17.5%, however, it’s all driven by capital appreciation.
Which is a better option for income? The right answer is that they are exactly the same. In the latter case, you can generate the 5% income by simply selling some of your shares to get an equivalent amount. The point is that what matters to an investor’s ability to generate income is the total return of an investment, not whether the returns come from a dividend payment or from the increase in value. Over time, you can generate more income from stocks or stock portfolios that have higher total returns.
As a real example, consider AT&T over the last 5 years. Its dividend yield has been between 5% and 7%. However, its annualized total return, including dividends has been about 3%. How can it be? The stock lost about 16% in value over the last five years (a loss of about 3% per year). In contrast, the S&P 500 index returned about 15% per year over the same period, including dividends. This difference in total returns (3% vs. 15%) means that with the same initial investment, the S&P 500 returns could have generated twice the income of the AT&T stock, and ended the period with a greater account value.
The point of the example is not to avoid AT&T as an investment, and the S&P 500 index includes AT&T. The point is to highlight that yield is not a reliable gauge of potential income from a portfolio. What counts is your total return.
Risk and Return Considerations
When we talk about stock returns we have to consider the corresponding risks. You may accept a lower return, like in the AT&T example, if the risk of that investment is lower or, alternatively, accept a higher risk if the return is higher. However, economics suggests you should seek the highest level of return for a given level of risk, or minimize the risk of your portfolio for a given level of return.
Individual stocks are about three times as volatile as market indices, on average, and some are much more so (see the evidence in Bali et al, 2016, chapter 15). If you think that investing in a more established stock that can pay a higher yield may be a relatively safe bet, you should know that historical evidence is not on your side. Even if companies do not like to cut dividends, they do it when they have to, as they do in times of uncertainty.
Many companies cut dividends due to COVID-19 in 2020, including companies like Harley Davidson and Gap, Inc. Overall, the U.S. experienced a 22% decrease in dividend payments, as some companies completely eliminated or reduced dividends. Even broader and greater reductions occurred during the global financial crisis of 2008-2009.
So don’t concentrate your investments in a single stock to generate income, because you may be disappointed, and avoid lists like “5 safe stocks with high yields” (or even 25) and the like.
Income equity funds for income?
There are many equity funds available with the word “income” in their name. These typically include more than a handful of stocks, and some have well over 100 stocks. Keep in mind that only a few stocks have high yields of 6% to 8%, and high yield across stocks these days can be anything above 1-1.5%. So income funds tend to have a lower yield than you may think based on headline stocks.
As fund managers look for yield, what stocks do they end up including in their funds? First, they include only companies that pay dividends, which cuts the universe of U.S. stocks by about half. The companies that are cut out will likely include some very good growing companies. Tesla does not pay a dividend. All successful companies start without paying a dividend.
Dividend-paying companies tend to be larger companies that have been around longer. Generally, larger companies do tend to have lower volatility than smaller companies. However, the dividend yield depends on both the dividend and the price of a company (the yield is the ratio of the two). Companies with persistently poor performance or in financial distress can have a high yield as a result of a very low price relative to their dividends. These are the riskier, “value” companies, and have higher volatility.
Because income funds combine lower-volatility large companies and higher-volatility value companies, they are similar in volatility to index funds. However, by investing only in companies that pay a dividend, income funds may miss out on valuable growth opportunities relative to index funds. In addition, some equity income funds may be actively managed and have high fees.
If the goal is to generate income from a portfolio, income funds may not be your best bet. A broad investment fund that includes all stocks is a better strategy.
Efficient Ways to Generate Income
Consider these three general levers to generate more income from your portfolio:
1. Improve the overall efficiency of your portfolio for your goals
2. Consider partial annuitization for necessary spending
3. Have a tax-efficient withdrawal strategy
You can improve the efficiency of your portfolio by maximizing the benefits of diversification and using your goals and risk preferences to tailor your portfolio. For example, how much of your desired income is used for necessities versus discretionary expenses? You want to be conservative with the former and you can afford to take more risk with the latter. (We provided steps to build an asset allocation from your goals in a previous post.)
When it comes to stocks, build a global portfolio of stocks, which allows you to diversify across countries and stocks of all sizes and other characteristics. Your bond portfolio should also depend on your goals, see our guide.
If Social Security or a pension isn’t enough to cover your basic necessities every month, consider annuitizing a portion of your investments. Annuities typically have higher yields than bonds because they aggregate the longevity risk across many annuitants. So a combination of stocks, bonds, and annuities can be more efficient than a combination of only stocks and bonds for certain goals. And consider both immediate and deferred annuities, which start payments at a predetermined time in the future. Deferred annuities are an efficient way to manage the risk of outliving your savings.
Finally, you can generate more income for yourself if you reduce the portion that goes to the government in taxes every year. Your income is likely to come from different sources of retirement savings, including Social Security, taxable accounts, tax-deferred accounts like your 401(k) or IRA, and tax-exempt accounts like your Roth IRA or HSA. Having a strategy that efficiently combines the different sources can make a big difference to your take-home income in retirement.
About the author: Massi De Santis
Massi De Santis, Ph.D., CFP, is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
Generating income using high yield stocks can sound plausible at first, but it is not a good way to generate sustainable retirement income and can be hazardous to your wealth. Instead, our proposed three levers provide a rigorous and efficient approach to generating sustainable retirement income.