The case for quality dividend stocks in the first five years of retirement. Inside

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1 Perspectives ClearBridge Advisors 65+5+Dividends The case for quality dividend stocks in the first five years of retirement Inside 2 The retiree s dilemma: Living longer, spending more 4 Stay strong: Implications for the first five years of retirement 5 The case for quality large-cap dividend stocks 7 Yielding to opportunity: Non-stock equity/income hybrids 7 Implementing a 65+5 strategy now 10 Conclusion 10 Q&A Diversification does not guarantee protection against investment losses. All investments involve risk, including possible loss of principal. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE Batterymarch I Brandywine Global I ClearBridge Advisors Legg Mason Capital Management I Legg Mason Global Asset Allocation Legg Mason Global Equities Group I Permal I Royce & Associates Western Asset Management

2 2 Q411 Legg Mason Perspectives Executive summary Longer life expectancies, the prospect of future inflation and possible limitations on Social Security benefits are raising doubts about long-held assumptions about retirement portfolio allocation models. Greater allocations to equities in the first five years of retirement could help investors seeking higher rates of portfolio growth to cover larger-than-anticipated costs of living after age 65, particularly now, with Treasury yields at historically low levels. Because they generate income that can be used to cover expenses and exhibit a lower level of volatility than the equity market overall, quality large-cap dividend stocks may be particularly suitable for this role. 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. 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. According to the 2010 Federal Interagency Forum on Aging-Related Statistics, adults age 65 can now expect to live an average of 18.5 more years about 4 years longer than people age 65 did in Women who survive to age 85 today can expect to live 6.8 more years, while men can expect to live 5.7 more years. As a result, planning to cover at least three decades of living costs is not only desirable, it is virtually essential. Inflation Inflation acts as a hidden drag on both 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. In calendar year 2010, the inflation rate was roughly 1.6%, a low level by the standards of the past few decades; yet as shown in the two charts below, even modest levels of inflation have an alarming cumulative effect 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. Another way to look at that is in terms of the real return of a portfolio. As shown below, for $500,000 earning an average of 7%, an inflation rate of just 1.5% reduces the value of the portfolio after 20 years by more than a fifth. 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. The result is a dilemma for retirees, whose investment strategy must take into account the prospect of both rising costs in both nominal and real terms. 1 Federal Interagency Forum on Aging-Related Statistics, Older Americans 2010: Key Indicators of Well-Being, p.24 ( 2 Social Security and Medicare Boards of Trustees, Status of the Social Security and Medicare Programs, page 1, (

3 Legg Mason Perspectives Q411 3 It s common for retirement planning today to focus on investment needs up to retirement rather than through retirement. This conceptual shortfall can easily lead retirees to underestimate the true financial burden involved and the implications for their portfolio allocations, particularly in the initial years. 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. 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. What s more, the actual price inflation experienced by retirees may be more what common standards such the CPI (Consumer Price Index) may indicate. Health care costs occupy a far larger share of the average retiree s spending that is represented in the CPI, especially if long-term care and other specialized services are involved. This trend is widely expected to continue, with health care costs demanding more of a retiree s nest egg. Yet according to the same Trustees study, Medicare s Hospital Insurance Fund is projected to run out of money by No wonder the 2011 Retirement Confidence Survey (RCS) by EBRI, the longest-running annual retirement survey of its kind in the US, found workers to be more pessimistic than at any time in the two decades the survey has been conducted. More than a quarter (27%) of workers now say they are not at all confident about retirement, up 5 percentage points from the previous year. 3 Exhibit 1: Even modest levels of inflation erode wealth over time Loss of purchasing power over 20 years at 1, 2 and 3% inflation rates $500,000 $400,000 $300,000 1% inflation 2% inflation 3% inflation $200,000 1-year 5-years 10-years 15-years 20-years For illustrative purposes only. Does not represent the performance of any Legg Mason product. Source: Legg Mason Exhibit 2: Dragging down real return The impact of 1.5%, 3% and 5% inflation on a 7% return portfolio 7% return 4% real return 5.5% real return (i.e. 1.5% inflation rate) (i.e. 3% inflation rate) 2% real return (i.e. 5% inflation rate) $1,934, $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $1,458, $1, $757, $600,000 $400,000 $200, year 5-years 10-years 15-years 20-years For illustrative purposes only. Does not represent the performance of any Legg Mason product. Source: Legg Mason Retirement Confidence Survey (RCS), 2011 RCS fact sheet, EBRI (

4 4 Q411 Legg Mason Perspectives 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 our Baseline scenario 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 3: Early returns have lasting impact Impact of 1 percentage point gain in return in first five years of 20-year retirement period versus 2 percentage point gain in the final years of the period Scenario 1 Scenario 2 Scenario 3 Year Return Balance Return Balance Return Balance $1,000,000 $1,000,000 $1,000, % $997,500 6% $1,007,000 5% $997, % 945,000 6% 1,014,420 5% 945, % 939,750 6% 1,022,285 5% 939, % 934,238 6% 1,030,622 5% 934, % 928,449 6% 1,029,653 5% 928, % 922,372 5% 1,028,636 5% 922, % 915,990 5% 1,027,568 5% 915, % 909,290 5% 1,026,446 5% 909, % 902,254 5% 1,025,269 5% 902, % 894,867 5% 1,014,279 5% 894, % 878,662 4% 1,002,851 4% 878, % 861,808 4% 990,965 4% 861, % 844,281 4% 978,603 4% 844, % 826,052 4% 965,747 4% 826, % 807,094 4% 952,377 4% 822, % 787,378 4% 938,472 6% 818, % 766,873 4% 924,011 6% 815, % 745,548 4% 908,972 6% 811, % 723,370 4% 893,330 6% 806, % 700,304 4% 877,064 6% 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

5 Legg Mason Perspectives Q411 5 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 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. 4 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. 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 low-yield 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. Business sectors traditionally associated with this asset class include utilities (electric, gas, water); oil & gas; pharmaceuticals; food and beverages; banks; and telecommunications. Such firms tend to be solid but unglamorous, with well-established markets and strong competitive positions versus rivals. 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 wellestablished businesses. While 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 1-year, 3-year, 5 year and 10-year periods. Exhibit 4: Total return data: S&P Dividend Aristocrats vs. S&P , 3-, 5- and 10-year performance (as of 12/31/11) Annualized total return % S&P year 8.35 S&P 500 Dividend Aristocrats years years For illustrative purposes only. Does not represent the performance of any Legg Mason product. Source: Bloomberg. 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 years 4 Saving for Retirement: Striking the Right Balance, Legg Mason Global Asset Allocation, February, 2011

6 6 Q411 Legg Mason Perspectives Today, the yield is actually higher than that of fixed income in general, as depicted by the Barclays US Aggregate Bond Total Return Index. Exhibit S&P 5: Yield 500 Dividend (%) (through Aristocrats 12/31/2011) Barclays Capital U.S. Aggregate Bond Index S&P 500 Barclays Capital U.S. Treasury Index S&P 500 Dividend Aristocrats Barclays Capital U.S. Aggregate Bond Index Barclays Capital U.S. Treasury Index 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. The difference is also evident when the comparison is to small-cap stocks, even to small cap dividend stocks, as represented by the Russell 2000 Dividend Achievers index. S&P 500 Exhibit 6: Lower volatility than the S&P 500 over 1-, 3-, 5- and 10-year performance periods (%) Exhibit 7: Lower level of volatility for quality large-cap dividend stocks vs. small-caps (%) As of 12/31/ year standard deviations for small and large cap equities as of 1/31/2011 Standard deviation S&P S&P 500 Dividend Aristocrats year standard deviation year 3-years 5-years 10-years 0 Russell 2000 Russell 2000 Dividend Achievers S&P 500 S&P 500 Dividend Aristocrats 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. Data is shown as of 1/31/2011 to provide consistency for last available date for Dividend Achievers standard deviation. 10-year standard deviation for Dividend Aristocrats as of 12/31/2011 was 14.35%. 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: Russell Investments, Bloomberg

7 Legg Mason Perspectives Q411 7 Yielding to opportunity: Non-stock equity/income hybrids The liquidity and visibility of large cap dividend stocks make them the natural standard-bearers for generating income through equity investing. However, these are not the only securities that combine measurable yield with the potential for appreciation. The following investments may also be used to pursue an equity income strategy, albeit in most cases as satellites to a core dividend stock holding. In the case of REITs and MLPs, certain tax advantages may apply, as well as a relatively low correlations to the prices of common stocks. Preferred stocks may pay a fixed dividend. They have a higher claim than common stockholders on corporate assets in the event of bankruptcy, and in certain circumstances that status may translate into investment opportunity. While they may have a lower potential for appreciation, preferred stocks tend to trade in a tighter range than common stocks, enhancing portfolio stability. Real Estate Investment Trusts (REIT) may be publicly traded, with shares representing direct investment in real estate properties or mortgages. While they can provide substantial yields, REITS are nonetheless cyclical, subject to the same market pricing and regulatory risk as the underlying real estate sector. Master Limited Partnerships (MLP) combine the tax benefits of a limited partnership (paying taxes only when shareholders receive distributions) with a higher degree of liquidity. Investment sectors are narrowly defined: approximately 90% of its earnings must flow from real estate, natural resources and commodities. This market is primarily accessible both via closed-end funds, but mutual funds and exchange-traded products have also emerged that allow individual investors to participate. Note: REITS are subject to illiquidity, credit and interest rate risks, as well as risks associated with small- and mid-cap investments.

8 8 Q411 Legg Mason Perspectives Implementing a 65+5 strategy now The unusual conditions that define 2011 s financial 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%). 5 Additionally, in bonds investors confront an asset class where the risks are highly 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. 5 Source: Bloomberg, U.S. Treasury.

9 Legg Mason Perspectives Q411 9 Setting a dedicated allocation to dividend stocks Given the compelling rationale for high-quality dividend stocks, it makes sense to establish a dedicated allocation to equity income strategies in the implementation of a 65+5 strategy. This allocation can be gradually reduced over time to align with an investor s changing risk tolerance as they progress into the later years of retirement. In practice, this would mean maintaining a significant allocation to the equity income allocation for the first five years of retirement, before gradually transitioning to a lesser percentage over the next 10 to 15 years in a way that addresses an investor s particular need for yield as well as capital appreciation within the context of their individual risk tolerance. Legg Mason Global Asset Allocation (LMGAA), the group that drives the investment strategy for Legg Mason s target date funds (e.g. funds whose allocations are tied to a particular target retirement), has considerable experience in this area. The following model allocation was developed by LMGAA specifically for the implementation of a 65+5 strategy with the goal of generating income as well as an expected return sufficient to compensate for the longer life expectancies of today s retirees. Half of the large cap allocation is focused on quality large cap dividend stocks. In order to compensate for the value bias inherent in this class, LMGAA pairs this allocation with an equal percentage in growth stocks, represented in the analysis for this model by the Russell 1000 Growth Index. The effect is to mitigate the style bias of a large cap dividend allocation which tilts toward mature, well-established companies with a bias for distributing cash as dividends rather than reinvesting it to expand the scope of business operations. Exhibit 8: LMGAA 65+5 portfolio allocation model Total Equity US Quality Large Cap Dividend 8.94 US Large Cap Growth 8.94 US Small Cap 4.75 International Equity Emerging Markets Equity 3.97 Total Fixed Income US Core Fixed Income US High Yield Fixed Income 2.79 Global Fixed Income Total Inflation (TIPS) 5.00 Total Real Estate (REIT) 4.75 For illustrative purposes only. Asset allocation does not guarantee a profit or protect against a loss.

10 10 Q411 Legg Mason Perspectives Conclusion As millions of baby boomers begin to reach age 65, swelling the already immense ranks of U.S. retirees, the pressure is growing to find workable solutions that can help this key segment of investors to address the challenges of longer life expectancies, inflation and uncertainty surrounding the future of Social Security. Given this challenge, financial advisors and intermediaries have little choice but to explore a spectrum of range of solutions to help generate income while positioning those 65 and over to generate the kind of appreciation in the early years of retirement that will enable them to meet their future spending and legacy goals well into their 80 s and 90 s. A dedicated allocation to quality dividend-paying stocks during the first five years of retirement known as a 65+5 strategy represent an approach that can 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 shortterm performance may be. Q&A with Hersh Cohen 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 priceto-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. Hersh Cohen Senior Portfolio Manager and Chief Investment Officer ClearBridge Advisors

11 Legg Mason Perspectives Q Why could these stocks make sense as an option in retirement 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 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. What is the best way to achieve meaningful diversification within an equity portfolio that seeks to deliver income for investors? Although we believe strongly in the value of high-quality stocks with an attractive dividend profile, we also think targeted investments in preferred stock, convertible bonds, REITs, MLPs and fixed income securities can be important sources of diversification and may enhance a portfolio s yield. These investments are sufficiently different in correlation and in combination have the potential to help smooth volatility over time.

12 About ClearBridge Advisors Legg Mason s largest equity manager, ClearBridge offers investment opportunities for institutional and individual investors in a broad range of styles, market capitalizations and vehicles, with a common focus on seeking out high-quality companies through a fundamental-driven approach. ClearBridge traces its asset management strengths back over 45 years to a number of prominent and well-established firms that have made meaningful contributions to our modern-day culture and investment philosophy. Visit us Follow us 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 Morgan Stanley Capital International (MSCI) EAFE Index is an unmanaged index of equity securities from developed countries in Western Europe, the FarEast, and Australasia. Morgan Stanley Capital International (MSCI) Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. Barclays Capital Global Aggregate Index Ex-U.S. is an unmanaged index used as a broad measure of the international-grade bond index, excluding U.S. securities. The Barclays Capital High Yield 2% Issuer Cap Index consists of all domestic and Yankee bonds with a minimum outstanding amount of $100 million and maturing over one year. The FTSE NAREIT US Real Estate Index Series represents the commercial real estate space across the US economy, offering exposure to all investment and property sectors. The Barclays Capital US TIPS Index represents the value of all publicly issued, U.S. Treasury inflation-protected securities with at least one year remaining to maturity, rated investment grade, with $250 million or more of outstanding face value Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC and ClearBridge Advisors, LLC, are subsidiaries of Legg Mason, Inc MIPX /12 FN