Dividend-paying Stocks Offer Retirement Investors Income and Potential Growth

Low interest rates are a challenge for retirees seeking income. 

Consider: 10-year U.S. Treasuries offer uninspiring yields and considerable interest rate risk. And high-yield bonds and emerging market debt offer higher yields but significantly higher credit risk than Treasuries. 

Given that, retirement investors seeking income should consider dividend-paying stocks as a viable supplement to core bond holdings. 

Dividend-paying stocks may offer higher yields than bonds and potential growth. The combination of income and growth can help investors stretch their retirement savings through longer expected life spans. The income and potential growth associated with dividend-paying stocks, however, brings higher risk. Dividend payments are not guaranteed, and dividend-paying stocks may be more volatile than government bonds. 

There are significant factors to consider when selecting dividend-paying stocks or funds that have dividend-oriented objectives: 

The highest yielding sectors may not be the best investments: Energy and utilities are among the highest yielding sectors within the S&P 500 index. However, the energy sector faces existential threats from climate change and utilities companies may grow more slowly than other segments of the market. 

“Margin of safety” is an often-overlooked factor: Some dividend yields are “safer” than others. Dividend payments may be suspended by companies facing financial stress. In some cases, dividend payouts are greater than current earnings or cash flows, creating a low “margin of safety” during times of economic or market stress. Cash flow is harder to manipulate and often less variable than earnings; many investors look at the ratio of operating cash flow to dividend payments to assess whether dividend payout can be maintained under stress. The lower the ratio, the higher the margin of safety associated with the dividend. Investors should determine whether a dividend yield is sustainable, or whether high yields may be a signal of financial distress.

The longer the investment time horizon, the greater the importance of dividend growth: The longer the investment time horizon, the greater the importance of equity growth to preserving purchasing power over the duration of retirement. Investors in the early years of retirement should consider the potential for dividend growth as an important factor.  

Diversification can “smooth” the ride for investors relying on dividend income and growth: Identifying dividend-paying opportunities outside the highest yielding sectors may be a prudent diversification strategy. Diversification may smooth the ride in volatile markets, which is an important consideration for investors starting to spend retirement savings. Technology is an increasingly popular sector for dividend-oriented investors, as mature technology companies such as Oracle and Microsoft are distributing more of their substantial cash flow to investors in the form of dividends. Many dividend-oriented investors seek dividend-yield throughout all sectors, finding the “best” players in each sector while paying attention to valuations, margin of safety and growth. 

The distinctions among dividend-paying stocks are relevant to investors picking individual stocks as well as those investors investing in dividend-oriented ETFs.  Some dividend-oriented ETFs are yield-focused; others attempt to combine current dividend yield with dividend growth. 

The largest dividend-oriented ETFs include offerings from Vanguard, BlackRock’s iShares, and State Street Global Advisors (SSgA). SSgA’s S&P Dividend ETF (SDY) has approximately $20 billion of assets, iShares Select Dividend ETF (DVY), has approximately $19 billion of assets and Vanguard Dividend Appreciation (VIG) has approximately $75 billion of assets. The size of these ETFs is an indication of the importance of the dividend category to investors.

iShares Select Dividend ETF (DVY) offers the highest yield, at approximately 3.5% and an expense ratio of .38%. DVY invests in companies with a five-year history of paying dividends; in recent years the ETF’s holdings have yielded more than S&P 500 Index while delivering positive dividend growth. DVY, however, may experience future challenges. For instance, 27% of DVY is invested in the utility sector and 8% in energy. The utility sector is heavily regulated; both sectors face long-term challenges related to climate change and the transition away from fossil fuels. In addition, 22% of DVY is invested in financials, a sector that may rebound with an economic recovery and steepening yield curve, but it’s also a sector that faces long-term business challenges. Many of DVY’s top holdings, including Altria, Philip Morris International, AT&T, IBM, and Exxon, are threatened by disruptive forces.

SDY offers a yield of approximately 2.5% and an operating expense ratio of .35%. SDY invests in dividend aristocrats that have a policy of consistently increasing dividends. SDY is more diversified in sector terms than DVY, potentially providing more protection from single-sector risk. However, SDY also has considerable investments in companies that are vulnerable to disruptive innovation or other competitive threats. ATT, Exxon, Chevron, and IBM are among SDY’s top holdings. SDY’s holdings have delivered negative 3 and 5-year dividend growth.

VIG has approximately $75 billion of assets. VIG offers the lowest current yield among the three dividend ETF leaders, at approximately 1.7%, but may offer more upside growth potential in yield and total return terms. Vanguard’s low-cost structure is helpful, with VIG boasting an operating expense ratio of .06%. VIG invests in a well-diversified portfolio of high-quality companies that offer current dividend yield as well as potential dividend growth. VIG’s holdings grew dividends over the past three years, and include companies with strong cash flows, solid balance sheets and durable business models. Among the top holdings are companies such as Microsoft, Walmart, JP Morgan, Visa, Procter & Gamble, United Healthcare, and Home Depot. VIG is well-diversified at the sector level, offering more sector diversification than either DVY or SDY.  

Dividend stocks are an important component of an income-seeking portfolio but dramatic differences exist among dividend-paying stocks and dividend-oriented funds. Investors who consider factors beyond yield are more likely to achieve their desired results in retirement.