Investors often migrate to vehicles perceived to be more reliable income sources as they approach or enter retirement. Money market funds, high quality bonds and certificates of deposit are a few of these default income vehicles.
Equities are feared a bit by the income oriented investor due to their periodic bouts with volatility.. Statistics can be deceiving when used to the advantage of the story teller, but when referenced properly are very useful for decision making. The statistics related to using dividend paying common stocks as part of a long-term income plan are quite compelling.
Since bonds provide a higher level of certainty for income investors, comparing any potential substitute or complimentary income strategy should be done in the context of comparing the risks and returns to the standard. In this case, the standard would be the 10-year U.S. Treasury Bond.
Bonds, barring a default by the issuer, provide two returns. There is the investment return, which is the interest yield on the bond, and the return of the principal value of the bond to the investor when the bond matures. Today a 10-year U.S. Treasury Bond yields around 2.5 percent and will mature 10 years from the date of issue.
So our task now is to examine the probabilities that investing in a basket of stocks, say an S&P 500 index fund, will provide competitive results compared to the 10-year treasury bond, both from a return on and return of principal standpoint.
Using data obtained from institutional money manager, AllianceBernstein, we think the idea of using equities for income is quite compelling. First, let’s look at the return on principal concept.
Since 1968, the S&P experienced positive dividend growth in 39 out of 46 years. In other words, income rose in 85 percent of the years. A treasury bond’s income is steady for the bond's lifetime, so 2.5 percent would be paid in each of the 10 years with no increases. Today, the S&P 500 Index yields 1.8 percent. Lower than a treasury bond, but if the dividends rise at the historical rate of about 5 percent, the income from the S&P index fund would surpass that of the treasury bond in about seven years.
Many companies in the S&P 500 don’t pay dividends so an investor could certainly put together a portfolio of more dividend focused companies which could provide about the same yield as the bond today, and go up from there.
As far as the potential for the income to drop, the effect tends to be temporary, and not tremendously significant. Even in the 2008 financial crisis, the worst of our lifetimes for impact on dividends, each dollar of income dropped to 80 cents and within four years had rebounded to $1.16, or 16 percent above the level in 2008.
The next big factor is the return of principal – or getting your money back after 10 years. Once again stocks provide favorable characteristics based on a historical review. If the investors in the S&P 500 Index fund spent all the dividend income discussed above (i.e. no dividend reinvestment) in 87 percent of 10-year periods, the stock portfolio was worth more than its initial investment. In fact, the average return of principal after 10 years was $267 for each $100 invested. Remember, bonds deliver no increase in principal returned to the investor.
Of course, there were the few cases where the market cycle didn’t deliver a 100 percent return of principal, but the losses were minor, typically less than 10 percent, which was more than compensated for by the rising dividend income received. It is also important to note that when one of these 10-year loss periods occurred, waiting just a couple more years returned the investor to being whole on their invested principal.
My suggestion, don’t ignore the role that equities can play in an income portfolio.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.