Dividends: A Baby Boomer’s Best Friend?

By Neil McCarthy and Emanuele Bergagnini

The yield on a 10-year U.S. Treasury note is close to 2%, the interest rate on many CDs is below 1% and inflation is running above 3%. What is an income-seeking investor to do? The current environment appears to favor equities with a track record of paying and growing dividends. What’s more, dividend-paying stocks look even more attractive given the lack of income-generating alternatives in a low rate world and currently attractive equity valuations. In today’s rapidly changing retirement landscape, we believe that investors in search of income—most notably Baby Boomers—may find dividend-paying equities to be a suitable option.

Why dividends are more important

The latest data point to tepid U.S. economic growth for at least the remainder of the year. While we still don’t expect a double-dip recession, near-term demand will continue to be constrained by weak job growth, a depressed housing market and consumer deleveraging. We also believe massive U.S. budget deficits and a growing probability of tax increases, as well as increased regulation of the market and economy, have the potential to hinder growth prospects over the medium to long term. The Federal Reserve has responded to ongoing economic weakness by stating that it will not raise its Fed funds rate well into 2013 and implementing “Operation Twist”—an effort to lower longer term interest rates, in part to drive capital out of U.S. Treasuries and into riskier assets.

We believe investing in stocks that pay dividends, particularly those with consistently growing dividends, is a potentially attractive income-generating option. More than 80 stocks in the S&P 500 Index offer a dividend yield at or above the 3.5% annual rate of inflation as measured by the Consumer Price Index in August. In comparison, 10-year U.S. Treasuries offer a yield a little over 2%. Since companies may be able to pass along higher costs to customers, there is the potential for them to keep growing while paying dividends.

A smarter source of retirement income?

As millions of Baby Boomers enter retirement, we expect demand for income-paying securities to grow. In the past, retirement income needs drew on three main sources for funding: defined benefit pension plans, Social Security and savings. Today, fewer investors can count on pensions as a reliable source of retirement income, and uncertainty surrounds the long-term future of Social Security. As a result, more investors will likely need to rely on their personal savings and investments to help pay for retirement.

Bonds have been and will continue to be a retirement portfolio mainstay. However, we believe today’s low rate world makes dividends look increasingly appealing as a source of income. First, investors may risk a loss of purchasing power, since U.S. Treasuries are currently lagging inflation. Second, yields can scarcely fall any lower, potentially exposing investors in longer maturity bonds to capital losses, when and if yields eventually rise.

Conversely, U.S. companies today collectively hold a record level of cash on their balance sheets and are generating high levels of free cash flow. Companies clearly have the means and the motive to pay dividends since returns on cash are currently so low. In addition, if and when interest rates rise, it will likely occur as a result of improving economic fundamentals, which may support stock price appreciation. However, there is no guarantee that the issuers of the stocks held by mutual funds will declare dividends in the future or that, if dividends are declared, they will remain at their current levels or increase over time.