The Retiree s Dilemma: Living Longer, Spending More

Transcription

1 65+5+Dividends: The case for quality dividend stocks in the first five years of retirement Sponsored Content Legg Mason ClearBridge Advisors April 24, 2012 The Retiree s Dilemma: Living Longer, Spending More Conventional wisdom has long held that people nearing retirement should make a significant reallocation from equities to fixed income, sacrificing a historically higher average annual return of equities to seek reduced volatility and a regular stream of income. A 50%, 60% and even 70% allocation to fixed income upon retirement is not uncommon in model recommendations as well as target date funds timed to shift allocations by age. Implicit in this approach is the recognition that even well-off retirees may not have the time horizon needed to rebuild a portfolio from a market pullback, especially if they are making regular withdrawals to fund current expenses. Yet new realities are calling into question how quickly this transition should take place. Three key factors longer life expectancies, future inflation, and the possibility of reductions in government benefits like Social Security have the potential to dramatically raise the ante on the real cost of retirement. Longer life expectancy It s common for retirement planning today to focus on investment needs up to retirement rather than through retirement. Yet thanks to medical advances and healthier lifestyles, adults who retire at age 65 are now far more likely to live well into their 80 s and 90 s. Inflation Inflation acts as a hidden drag on wealth and investment earnings by reducing their real purchasing power. While inflation has not been extremely low in recent years, even minimal levels can significantly erode value by undermining both cumulative returns and real returns over time. Over 20 years, even 1% inflation reduces the purchasing power of a $500,000 portfolio to roughly $435,000; at 2%, the value is actually under $400,000. Social Security The funding pressure on the Social Security system is well documented, with a $46 billion projected current deficit cited in an August 2010 report from the Social Security and Medicare Boards of Trustees 1. After 2014, the study warns that deficits are expected to grow rapidly as the number of retiring baby boom beneficiaries grows substantially faster than the number of covered workers. 1 Social Security and Medicare Boards of Trustees, Status of the Social Security and Medicare Programs, page 1, (

2 Start Strong: Implications for the First Five Years of Retirement With the bar raised on the financial burden of retirement, it s worth asking whether moving too far and too fast into fixed income could have a cost later on. The concern is whether the lower average return associated with fixed income compared to equities could fail to deliver sufficient return to sustain the portfolio if regular withdrawals are taken to cover living expenses. Of special importance here is the impact that the returns in the first five years of retirement have on the future growth of a portfolio subject to regular withdrawals. Consider a hypothetical $1 million portfolio that earns a 5% average return in the first ten years, and a 4% average return in the second ten years (Scenario 1). In addition, assume that the portfolio owner intends to withdraw $50,000 annually to cover retirement expenses. Now, consider the impact of +100 basis points improvement in average return in the first 5 years, raising it to 6%. That modest adjustment turns out to have a substantial impact over time, representing a swing of more than $200,000 by the end of the period. That difference could be significant to the investor, as a source of funding for future expenses and as a potential legacy to leave to loved ones or a favored cause or charity. Consider, then, the impact of gaining that 6% return in the final 5 years of the 20-year period (as shown in Scenario 3). That represents a +200 basis point improvement in those years compared to Scenario 1 twice the enhancement provided in Scenario 2. Yet this advantage is not enough to overcome the timing of the enhancement coming in the final years of retirement; the final balance is actually $75,000 lower. Exhibit 1: Early Returns Can Have Lasting Impact Impact of 1 percentage point difference in return in the first five years of a 20-year retirement period versus 2 percentage point gain in final years of the period Assumes $50,000 annual withdrawal after first year Scenario 1 Scenario 2 Scenario 3 Year Return Balance Return Balance Return Balance $1,000,000 $1,000,000 $1,000, % % % 997, % % % 945, % % % 939, % % % 934, % % % 928, % % % 922, % % % 915, % % % 909, % % % 902,

3 10 5% % % 894, % % % 878, % % % 861, % % % 844, % % % 826, % % % 822, % % % 818, % % % 815, % % % 811, % % % 806, % % % $802,079 For illustrative purposes only. Does not represent the performance of any Legg Mason product. Analysis assumes single $50,000 withdrawal at beginning of each year. Source: Legg Mason While this example may be simple, it demonstrates the principle that in retirement planning, the sequence of returns is hugely important in determining the wealth available to an investor in their 80 s (assuming that a retirement age of 65). The reason is the expectation that funds will be withdrawn each year. It illustrates how the first few years of retirement can become a critical transition period when accepting a higher level of risk to gain additional reward could help extend the life of the portfolio assets. The use of a five-year window here is admittedly arbitrary, but consonant with research conducted in 2011 into optimizing retirement investment glidepaths for target date funds by Legg Mason Global Asset Allocation. 2 As a rule of thumb for individual investors, however that five-year window has the real advantage of being easy to understand and remember. Given that the problem of insufficient retirement funding applies to investors of widely varying levels of financial literacy, referring to this critical period as 65+5 offers a useful shorthand that could help more people recognize the need to plan accordingly. 2 Saving for Retirement: Striking the Right Balance, Legg Mason Global Asset Allocation, February 2011 * Note: Yield and dividends represent past performance and there is no guarantee they will continue to be paid. While dividends may cushion returns in down markets, investments are still subject to loss of principal amount invested. Dividends represent only one component of an investment and there are other factors that should be considered, including investment objective, risks, fees and expenses before making an investment decision. While dividends may be consistent, stock prices may fluctuate

4 The Case for Quality Large-Cap Dividend Stocks The obvious question once you accept the value of a larger allocation to equities early in retirement is: what kind? Given that few retirees will want to push the envelope on risk at this point in their lives, equities with historically lower volatility are an obvious choice. The prospect of receiving a regular source of income is also one with obvious appeal for those seeking to cover ongoing expenses, and one that has particular resonance in today s lowyield environment. An obvious solution that satisfies both objectives is quality large cap dividend stocks from companies that can afford to consistently reward shareholders in cash. The S&P Dividend Aristocrats represents an excellent proxy for this type of investment. This index is composed of companies in the S&P 500 Index that have increased dividends every year for at least 25 consecutive years, characterized by higher yield, lower risk and greater total return. These are first tier companies with strong balance sheets and free cash flow, characterized by experienced management and well-established businesses.* Judged on price appreciation alone, the Dividend Aristocrats are not substantially better than their large-cap brethren. However, with dividends reinvested, they deliver a substantial premium in total return over the large cap stocks when you look at 3-year, 5 year and 10-year periods

5 Exhibit 2: Total Return Data -- S&P Dividend Aristocrats vs. S&P ,3-,5- and 10-year performance as of 12/31/11 For illustrative purposes only. Does not represent the performance of any Legg Mason product. Source: Bloomberg Today, the yield is actually higher than that that of fixed income in general, as depicted by the Barclays US Aggregate Bond Total Return Index

6 Exhibit 3: Yields Through 12/31/11 For illustrative purposes only. Does not represent the performance of any Legg Mason product. An investor cannot invest directly in an index.source: Bloomberg. Barclays index yields based on yield to worst. Yield for S&P 500 Dividend Aristocrats calculated as unweighted average yield of stocks in index. S&P 500 represents trailing 12-month dividend yield. Historically, high-quality dividend-paying large-caps have delivered slightly lower volatility levels of volatility than large-caps in general, with the difference most pronounced over a 1-year performance window

7 Exhibit 4: Lower volatility than the S&P 500 over 1-,3-5-and 10- year performance periods For illustrative purposes only. Does not represent the performance of any Legg Mason product. Standard deviation measures the volatility of an investment s return over a particular time period; the greater the number, the greater the volatility.source: Bloomberg Implementing a 65+5 Strategy Now The unusual conditions prevailing in the fixed income markets offer an unusually opportune entry point to implement a 65+5 equity income allocation. With bond yields at their lowest levels in decades thanks to the Federal Reserve s stimulative monetary policies, the traditional reliance on bonds as income generators in the initial years of retirement is far less productive than in most time periods. In fact, many stocks today offer compelling dividend yields relative to Treasuries some say the best since the 1950s. As of 12/31/2011, the S&P 500 dividend yield, at 2.15%, was notably higher than the 3-month T-bill (0.02%), 2-year T-note (0.25%), and 5-year T-note (0.83%). 3 3 Source: Bloomberg, U.S. Treasury

8 Additionally, in bonds investors confront an asset class where the risks are asymmetrical. With yields so low, there is little room for price appreciation; however, there is no such limit on the downside. The potential for depreciation should interest rates rise faster than expected is an elephant in the room, and is perhaps most acute in the case of Treasuries and other bond sectors traditionally seen as safe haven investments. What s more, cash on corporate balance sheets is at levels far higher than in any recent decade. Many companies are consistently in good enough financial shape to increase dividend payouts and respond to growth opportunities as they arise. Conclusion A dedicated allocation to quality dividend-paying stocks during the first five years of retirement has the potential to help boost return as well as having an easy and intuitive appeal for individual investor. By delivering a steady current income stream, potentially enhancing total return over the long haul with relatively reduced volatility, a 65+5 strategy can help retirees lay the groundwork for an extended future. After all, it may not be possible to predict what the future holds for today s or tomorrow s retirees, but the prepared investor has arguably the best chance to realize their financial and retirement goals over the long term, whatever the shifting sands of short-term performance may be

9 Appendix: Q&A with Hersh Cohen, Senior Portfolio Manager and Chief Investment Officer, ClearBridge Advisors What qualities do you look when evaluating a dividend stock? Consistent dividend growth speaks directly to the quality of a firm s business; we look for the ability to consistently increase cash flow over time. When we look at these types of companies now, we see many in the best financial shape in decades. Their balance sheets are awash in cash, and dividends have been raised, often sharply. Coming out of the worst downturn in memory, with valuations compressed, we cannot help but believe that these high-quality businesses offer extraordinary opportunity for investors now. Which economic factors argue in favor of quality dividend stocks now? With bond yields at historic lows, stock dividend yields can be relatively compelling, especially for stocks with low price-to-earnings (P/E) ratios. We believe it will take longer than is generally expected to return to more normal conditions and prefer to take our risks in established companies that have come through the recent economic gauntlet with their balance sheets intact. When asked how to get more income with no risk, we reply that, unfortunately, it is impossible. However, by focusing on high-quality companies, we do feel the potential rewards outweigh the risks. How do dividend-paying stocks help offset volatility? Compared to the overall market, dividend-paying blue chips have a history of lower volatility. Clearly, stocks can never guarantee a particular yield or rate of return, but sometimes the risk/reward pendulum favors stocks. We can buy a variety of stocks with current dividend yields that we believe can grow over time, well above the risk-free rate of return. That is a rare occurrence, one we have not seen since the 1950s. Why could these stocks make sense as an option in retirement when the emphasis during a stage of life generally focused on fixed income? Most investors, regardless of their age or financial goals, need investments that produce income, but that also have the potential for capital appreciation. Income can enhance a portfolio s total return potential, as well as help to temper volatility. But with longer life expectancies, possible reductions in Social Security benefits, rising health care costs and the potential for continued inflation, investors have a vested interest in seeking meaningful growth over the long term

10 Important Information: Past performance is not indicative of future results. All investments involve risk, including possible loss of principal. The 65+5 concept is simply a strategy for investing during retirement. It does not take into account salary increases or the rate of return on a participant s investments over time. There is no guarantee that following the 65+5 strategy will allow a participant to accumulate retirement savings sufficient to meet his or her retirement income needs. Any statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of the information cannot be guaranteed. The information provided in this document should not be considered a recommendation by Legg Mason, Inc. or any of its affiliates to purchase or sell any security. Legg Mason, Inc. and its affiliates are its employees are not in the business of providing tax or legal advice to taxpayers. These materials are any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any tax payer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the promotion or marketing of the transaction(s) and matter(s) addressed by the materials, to the extent allowed by applicable law. Any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. S&P 500 Index is an unmanaged index of common stock performance. The S&P 500 Dividend Aristocrats index is composed of companies in the S&P 500 Index that have increased dividends every year for at least 25 consecutive years, characterized by higher yield, lower risk and greater total return. The Barclays Capital U.S. Aggregate Index is a broad-based bond index comprised of government, corporate, mortgage and asset-backed issues, rated investment grade or higher, and having at least one year to maturity. The Barclays Capital Treasury Index is a measure of the public obligations of the U.S. Treasury. Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies. The Russell 1000 Growth Index is an unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation. The Russell 2000 Dividend Achievers Index represents dividend paying companies from across the U.S. small cap market. The views expressed are those of ClearBridge Advisors as of October 20, 2011 and are subject to change and may differ from other portfolio managers or the Firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Securities and sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision

11 The information provided is intended solely to describe the manager s management style, investment strategies and securities selection process, and does not have regard to the specific investment objectives, financial situation and particular needs of any specific person who may receive it. INVESTMENT PRODUCTS: NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE Diversification does not guarantee protection against investment losses. All investments involve risk, including loss of principal. ClearBridge Advisors, Legg Mason Global Asset Allocation, LLC and Legg Mason Investor Services, LLC are subsidiaries of Legg Mason, Inc. Legg Mason Perspectives is a registered trademark of Legg Mason Investor Services, LLC 2012 Legg Mason Investor Services, LLC, member FINRA, SIPC. 4/12 FN For a free subscription to the Advisor Perspectives newsletter, visit: