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Use an active investment
management team that chooses
investment opportunities based
upon fundamental research
PART 6 of 7 Series:
The Process of Managing Retirement Income

Over the past eighty-three years, dividends have accounted for approximately 40% of the total return for the S&P 500 Index. The importance of dividends has been an often overlooked part of investing, but will continue to come to the forefront as baby-boomers prepare for retirement and look for high and growing income generating investments.

There are generally two schools of thought regarding how best to fund expenses in retirement. There are many who believe a total return approach is optimal, whereby an asset allocation and total return is targeted for the portfolio and a portion of the retirement assets is sold periodically to cover expenses. While this approach attempts to provide the growth that retirees need to outpace the effects of inflation, they may also be forced to sell assets at an inopportune time.

A cow for her milk. A hen for her eggs,
And a stock, by heck, for her dividends.
An orchard for fruit. Bees for their honey,
And stocks, besides, for their dividends.

                John Burr Williams,
                "Evaluation of the Rule of Present Worth," 1937

The second school of thought follows a high income approach, whereby the portfolio is comprised of high yielding income investments in an attempt to generate sufficient current income to cover expenses. This approach can leave a retiree too heavily exposed to fixed income expenses and the ravages of inflation.

We will explore a third approach, which is a hybrid of the total return and high-income approaches. We will explore how an investment in stocks of companies that provide both high and growing dividend income can benefit a retirement portfolio undergoing the duress of withdrawals. This type of investment strategy can have the potential to provide a growing dividend income stream as well as capital appreciation needed by retirees.

Understanding Yield

When reviewing income generating alternatives, retirees often focus on current yield (the current income divided by the current price). This works well for fixed income investments, which are, essentially, contracts that pay a certain level of income to the bond holder each year and then return the principal amount at maturity. However, for equity investments, where both the income and stock price may appreciate, looking solely at current yield can disguise the growth in the actual dollar amount of the income generated.

Not only can growing dividends help contribute to the retiree's distributions, but the portfolio value may also have the ability to outpace inflation through price appreciation.

Dividend Income in Retirement

For most retirees, developing a growing dividend income stream should be an attractive alternative to the total return or high income approaches described earlier. Having the retirement portfolio generate sufficient income to cover expenses while the portfolio is poised with an opportunity for continued growth should be a goal for every retiree.

Best Practices

Before implementing a dividend grower strategy, there are two improvements that should enhance the portfolio's diversification and selection of attractive dividend opportunities. First, looking for companies around the globe that offer both a high and growing dividend, versus limiting the investment universe to just domestic stocks, may improve results.

Another benefit from using a global approach is the opportunity to improve the portfolio diversification by in by industry sector. In the United States where attractive dividends are typically concentrated in real estate and utilities. Outside the United States, dividend opportunities exist in a multitude of sectors.

The second improvement when implementing this dividend growers strategy would be to use an active investment management team that chooses investment opportunities based upon fundamental research. The decline of dividends for U.S. companies in the S&P 500 Index during 2008-09 has made the headlines recently, and even the Dividend Growers were not immune. It is important to use an active manager who can analyze both a company's willingness and ability to pay a high and growing dividend as a way to try and navigate around some of the dividend declines seen in the broader market.

As the baby boomer generation progresses on the road of retirement, a dividend grower strategy may be prudent addition to their equity portfolios, as part of a core investment strategy. Not only can growing dividends help contribute to the retiree's distributions, but the portfolio value may also have the ability to outpace inflation through price appreciation.

Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index.

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What is a bond?

Bonds are debt investments in which an investor loans money to an entity (corporate or governmental) which borrows the funds for a defined period of time at a fixed interest rate. Bonds are subject to certain risks including loss of principal, interest rate risk, credit risk, and inflation risk. The value of a bond will fluctuate relative to changes in interest rates; as interest rates rise, the overall price of a bond falls.



Quickly liquidate assets
into potentially more
favorable investment markets.
PART 5 of 7 Series:

The Process of Managing Retirement Income

One of the challenges that confronts retirees and their advisors is how to prevent having to sell their hard earned retirement assets at the wrong time. 

We have all heard the age old investment adage "Buy Low and Sell High," which tells us to buy assets when they are out of favor but to time the disposition of the assets when the markets are in your favor.

This timing is even more important for retirees since they are liquidating assets to support expenses and not reinvesting. Therefore, one goal for each retiree and their advisor is how to prevent being in a position of having to sell their retirement assets for less than their potential worth.

When structuring a retirement investment portfolio, there are two tenets that can be followed which may help achieve this goal.
  • The first is to invest the retirement savings in a well-diversified portfolio that includes cash, fixed income, and equity investments. Preferably, the equity investment allocation should focus on providing a high and growing dividend income stream. 
  • The second is to implement a Cash Flow Reserve (CFR) Ladder that can provide monthly income during retirement and can allow the retiree and their advisor the ability to dictate when to sell assets into the market. 
Historically, fixed income and equity assets have had a tendency to be favorably priced at different times in the market, giving the retiree the ability to time the disposition of the retirement assets when it may be most optimal. Using a ladder structure that includes a cash flow reserve for near-term expenses, and both fixed income and equity assets for intermediate and longer-term expenses, is one structure that may help achieve this goal.

The consequences of not being diversified and then forced to sell into a bear market can be significant.
Structuring a Cash Flow Reserve Ladder

A Cash Flow Reserve Ladder is comprised of three "rungs" that strive to align the least volatile assets to meet the retiree's near-term expenses while giving equity assets the opportunity to grow. This potential growth of the equity investments is intended to offset the eroding effects of inflation on the retirement savings.

Checking Account

On the first of each month, the retiree writes a check from the cash flow reserve and deposits it into the checking account to pay for expenses. This provides a monthly cash flow, which from a behavioral finance perspective is very healthy and allows the retiree to budget for monthly spending accordingly.

Cash Flow Reserve
The cash flow reserve is comprised of two years' worth of spending needs in short-term assets such as a money market account and possibly a limited-term bond fund. The retiree draws a check from the cash flow reserve to deposit into the checking account at the beginning of each month. The relative liquidity of this rung can provide the retiree with the ability to cover two years of spending. Having two years' worth of disposable assets can be key to helping alleviate ill-timed selling into a bear market. At the end of each year, or as the market dictates, the advisor will sell either fixed income or equities from the investment portfolio to refill the cash flow reserve to cover the next two years of expenses.

Investment Portfolio

Fixed income investments have historically performed better when equities are out of favor; therefore, having a balanced portfolio of fixed income and equity investments can help alleviate selling retirement assets at a less opportune time in order to fund retirement spending. In this rung of the ladder, there will typically be enough fixed income investments to pay for an additional four to five years of spending. Also included in this rung is an allocation to equity investments, which have historically been more volatile than fixed income assets but also provide the potential for higher returns over time. While the equity investments may provide the necessary growth to help offset the eroding effects of inflation in retirement, retirees also need to have the flexibility to sell assets when the markets are attractively valuing those investments. The assets from this rung are used to replenish the funds in the cash flow reserve as needed. Again, the goal is to have the flexibility to sell either the equity or the fixed income assets at an opportune time.

Asset Allocation Alternatives
Now that we know the basic structure and operation of a Cash Flow Reserve Ladder, let's discuss just a few of the many ideas for how the retirement assets can be allocated to each rung. The most appropriate investments will vary depending on an individual's needs and investment objectives and should be discussed with a financial advisor.

Retirement Investment Portfolio

The Cash Flow Reserve Ladder approach allows the retiree and advisor time to liquidate assets into potentially more favorable markets.

Using a high and growing dividend-paying stock fund in this rung may provide the double benefits of a growing dividend stream to contribute to the current income needs of the retiree and the potential growth that is historically associated with equity investments.

Utilizing the structure of a Cash Flow Reserve Ladder with a well-diversified retirement portfolio during the distribution phase of retirement can provide retirees with the necessary foundation and discipline to alleviate selling their retirement assets into a bear market. The cash flow reserve has the ability to provide two years of liquidity, thus allowing expenses to be met readily. The investment portfolio has a mix of intermediate-term fixed income and equities focusing on a high and growing dividend income stream that may be liquidated during opportune times in the market to refill the cash flow reserve. Hopefully, this type of structure can help the retiree stay on plan and meet expenses.

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Following this strategy does not assure or guarantee sustainability of a retirement portfolio, better performance, or protect against investment losses.

Investments in a money market are not FDIC insured, nor are they deposits of or guaranteed by a bank or any other entity. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.

Rebalancing - refilling the money market fund with an allocation from the equity account at the beginning of each year, except in 2009, when the decision was made not to replenish and ride through the turbulent equity and fixed income market. No further rebalancing was necessary.

Monthly Cash Flow - monthly check withdrawn from Cash Flow Reserve and assumed placed into checking account at the beginning of each month.

The Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, including food, transportation, shelter, utilities, clothing, medical care, entertainment and other items. The CPI, published by the Bureau of Labor Statistics in the Department of Labor, is based at 100 in 1982 and is released monthly. It is widely used as a cost-of-living benchmark to adjust Social Security payments and other payment schedules, union contracts and tax brackets. Also known as the cost-of-living index.

The S&P 500 Index is an unmanaged broad measure of the U.S. stock market.