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Dividend Investing: A Smart Equity Retirement Solution

​PIMCO sees inflationary risks looming over the secular horizon. A growing income stream may offer a solution for the growing liquidity needs retirement plans face today and going forward.

To target their retirement goals – in other words, to build and preserve purchasing power needed to sustain their lifestyles throughout retirement – investors may consider many options for their asset allocations, including equities. While equities’ potential returns are a key consideration, individuals preparing for (or already in) retirement must also evaluate and manage the associated risks.

PIMCO believes dividend investing – specifically, a global equity strategy that seeks attractively valued dividend growth – may provide solutions to three of the biggest risks equity investors face as they plan for retirement:

  • Scarce return: Given the uncertainties in the secular outlook, investors may not be able to rely on equities’ price appreciation alone to provide the returns required for retirement plans over the long term.
  • Capital loss: Capital preservation is a key objective for retirees, whose portfolios likely have less time to recover from an ill-timed loss in a volatile equity market.
  • Inflation’s corrosive effect: One of the biggest threats to retirement savings is the risk of inflation, which can significantly diminish purchasing power over time.

Retirement investors can look to a well-designed dividend portfolio to help meet all these challenges.

Retirement risk: scarce return
Without the rising tides of decades past, we believe dividends will make up a larger portion of equity returns in the future. Since 1931, dividends have accounted for a significant portion – over 40% – of the total return of large capitalization stocks in the U.S. (see Figure 1). In fact, during some decades, dividends actually made up a greater portion of the index’s return than capital appreciation – in the 1930s, 1970s and the 2000s (the last a decade of zero capital appreciation).

Many of those saving for retirement today experienced the bull market of the 1980s and 1990s and remember the impact rapid market appreciation had on their portfolios. Indeed, the vast majority of total returns during this period were driven by price appreciation. Remember, however, that a relatively benign economic and market environment prevailed in those decades.

Today, the environment is more turbulent and we no longer have the tailwinds of falling interest rates and increasing leverage. Given PIMCO’s more modest global growth and equity return outlook, we believe it is likely that price appreciation alone will fail to deliver the strong performance of the 1980s and 1990s, and dividends will be a greater portion of investors’ total equity returns, as they were in the 1970s and 2000s. Because of this, PIMCO believes dividend stocks should be a part of an equity allocation.

Retirement risk: capital loss
One of the top concerns retirement savers have is the risk of broad market declines in the midst of heightened volatility. PIMCO’s secular outlook projects slowing global economic growth and unresolved macroeconomic risks that are likely to result in such volatility. Equity investments tend to be among the more volatile components of an asset allocation, and for that reason retirees and investors nearing retirement should pay careful attention to how equities might contribute to their total risk.

While those early in their retirement saving process likely have decades to ride out volatility, those in or approaching retirement should consider equity investments that offer some element of capital preservation, or lower volatility. While past performance is not a guarantee, another feature and potential benefit of dividend investing is that it has historically exhibited less volatility than the broad equity market (see Figure 2). While over the past four years or so, the stocks of companies that pay a dividend have been only slightly less volatile than those that do not (primarily because financials, historically a dividend-oriented sector, were responsible for much of the market volatility), over the long term dividend stocks have delivered lower volatility than non-dividend paying stocks as represented by the S&P 500. Active investment managers who can avoid the more volatile dividend stocks have the potential for still lower volatility.

One likely source of near-term volatility is the what-looks-to-be-certain increase in U.S. dividend tax rates. We believe the stocks at greatest risk of a selloff are those with large U.S. shareholder bases susceptible to the tax increase, because higher tax rates will make dividend yields less attractive, promoting a flight toward better-yielding assets and heavily discounting these stocks. Specifically, near-term volatility in dividend stocks is likely to affect the narrow spectrum of U.S. dividend payers with greater than 3% yields that investors have crowded into, including U.S. telecoms and utilities. The risk to those two industry sectors is amplified by the fact that they are already richly valued relative to the broad market.

This dividend tax circumstance reinforces the case for being an active, global dividend investor. Global companies have diverse and international shareholder bases. Because these international investors are not affected by changes in U.S. tax rates and dividend yields are still attractive in the current global environment of financial repression, we do not anticipate a flight from global dividend-paying companies. Conversely, most U.S. investors have a home-market bias, and their dividend stocks and mutual funds are therefore more likely at risk.

Retirement risk: inflation’s corrosive effect
Investment yields are quoted as an annual percentage figure. On one hand, this makes sense because it allows investors to compare yields across a range of options. On the other hand, individuals do not spend percentage points each year to pay for their expenses – they spend real dollars, and they need that income for more than just one year. And, because of inflation, their annual costs have the potential to rise each year. This is where dividend growth can play a pivotal role in an investor’s portfolio: helping preserve purchasing power in retirement.

A growing dividend means the cash flow an investor receives this year will be greater than it was last year. Ideally, a company that is growing its dividend is doing so out of the growth of its earnings, as opposed to being driven by increasing debt, decreasing balance sheet cash or an increased payout ratio. In this way, a company’s dividend growth has a greater potential to be understandable, repeatable and consistent.

Perhaps the most important potential benefit of dividend growth is its impact on the real income a portfolio can generate, and because of this dynamic, a growing dividend can be a powerful hedge against inflation. For example (see Figure 3), in 1970 the average single share in the S&P 500 was worth $92, and its average $3.13 dividend represented a 3.4% yield. Over the next 40 years, as the dividend grew, the yield on that original cost grew as well. In 2011, the dividend was approximately $27 – an almost 30% yield on the original cost basis. Whereas inflation grew by 4% per year over this period, S&P dividends grew at an annual rate of 5%, a meaningful difference over such a long period.

Again, an active approach can target dividend growth in excess of both the broad market and inflation, and aim to provide even greater hedging against a rising cost of living. The bottom line: PIMCO sees inflationary risks looming over the secular horizon. A growing income stream may offer a solution for the growing liquidity needs retirement plans face today and going forward.

Investment implications: balancing risk and return
Investors saving for retirement and those already dependent on their retirement savings likely need equity investments for the potential returns they can provide, but they should also demand an investment approach that provides a way to manage the inherent risks. Specifically, in an environment of slowing global economic growth and unresolved macroeconomic issues, PIMCO sees modest equity market returns, market volatility and inflation as key risks to retirement investments. PIMCO believes that dividend investing, particularly strategies that emphasize total return, lower volatility and dividend growth, can help investors navigate these risks.    

The Author

Raji O. Manasseh

Equity Strategist

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Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their financial advisor prior to making an investment decision.

Charts provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Alllianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2012, PIMCO.