Norton said that Morningstar found that both strategies can support a retiree’s income needs, but a total return approach results in higher end balances on average and a higher probability of success.
“Naturally, all of us would not want to sell something if we could just take income from the investment, but what we don’t think about is the cost of doing that,” said Norton. “When the income is the bulk of the return of the security, if you take that money out, you’re losing a lot of the capital returns.”
Currently, many investors are eschewing traditional sources of portfolio income like bonds and annuities for dividend-paying equities, noted the panelists. Growing online communities are dedicated to both dividend yield investing, which tries to create a stable income stream by targeting a stock’s yield, and dividend growth investing, which attempts to capture a growing income stream by finding companies who have the capacity to increase their dividend payments over time.
Both dividend strategies invite more risk into retirement portfolios, according to the panelists. Adding equities into a retirees portfolio increases its sensitivity to market volatility, and concentrates investors into U.S. stocks at a time when valuations are still elevated, said Norton.
Investors also ignore the correlations that dividend payers have to other asset classes, said Lee.
“Dividend payers are highly correlated to interest rates. They’re just as sensitive to rates as bonds, actually,” said Lee. “Overweighting dividend yield around retirement when you already have a slug of fixed income can lead to unintended risks in your portfolio.”
Yet dividend payers are also correlated to value equities, an underperforming area of the market, said Norton. If an investor has a bias to U.S. stocks, dividend payers may actually be a more reasonable place for them to look.
Lee also warned that income-producing investments like dividend payers may encourage complacency.
“A lot of times dividend producers are viewed as safe, but how many retirees bought General Electric because they thought it safe? Then they saw its dividend cut in half,” said Lee. “Without a continual look at the portfolio and what it’s holding, the question becomes whether that dividend is safe. Buying a stock with a high yield usually means the market has already sniffed out that something is wrong with the company.”
If income must be derived from a portfolio holding, the panelists recommended that advisors and investors focus first on a more conventional source of cash flow: fixed income.