Retirement Savers Are Turning to Dividend Stocks for Income. Here’s How to Use Them in Your Portfolio.

Dividends also offer a number of advantages beyond income, one being that qualified dividend income is taxed as a capital gain and at a lower rate than ordinary income receives. The top federal capital-gains tax rate is 23.8%. Payouts can also help buffer volatility in tumultuous markets, providing returns even if a stock’s price goes down, and give a stock portfolio much-needed diversification. All of these attributes make dividend stocks an important investment for the diligent retirement saver.

“If done correctly, dividend-yielding stocks are the gifts that keep on giving,” says Lewis Altfest, CEO of Altfest Personal Wealth Management in New York.

Retirees’ need for dividend income—or income of any sort, really—has become particularly acute over the past 30 years or so, as companies have turned away from offering pensions that guarantee workers steady payouts during the course of their retirements. The corporate replacement for pensions, so-called defined-contribution plans like 401(k)s, instead put the onus for retirement saving on workers, and many of them are struggling to turn those savings into streams of retirement income.

Against this backdrop, many companies, policy makers, retirement researchers, and financial firms are trying to develop strategies and products that retirees can draw upon for income in retirement. Among the offerings and ideas: withdrawal mechanisms for workplace retirement-savings plans, “bridges” to maximize Social Security benefits, and an array of annuity offerings.

Now, a growing number of investors are seizing on dividend stocks as a cornerstone of their retirement-income strategy. For these savers, there are two schools of thought on how best to employ a dividend-stock strategy: total return or pure income.

With a total-return approach, investors focus on the growth in their portfolio over time with a variety of asset classes. Total return for stocks includes dividends as well as capital appreciation (or losses) to give investors the ability to take distributions from a combination of yield income and price appreciation. Capital preservation is not necessarily the main objective.

It is “based on a holistic view of the portfolio, matching the asset allocation to [the retiree’s] risk-return profile, [using] diversified investments and [minimizing] costs,” wrote Colleen Jaconetti, a senior investment analyst at Vanguard Group, in a 2016 research note.

With the pure income approach, investors incorporate dividend stocks and often an allocation to bonds to damp stock volatility. It essentially entails setting up a diversified portfolio and living off the dividends in retirement or using them to supplement income from other sources, such as Social Security or, for those who still have them, pensions. A $5 million portfolio with an average dividend yield of 2%, for instance, would throw off $100,000 a year before taxes.

But some caution is necessary when it comes to mixing dividends with retirement-income portfolios. Investors should be wary of chasing high-yielding stocks, for instance, given that a high yield is sometimes a signal of a stock with deeper problems.

“There’s always a reason for that extra yield, and it would be that there’s a lot of extra risk,” says Philip Huber, chief investment officer of Huber Financial Advisors in Chicago.

Investors also should take care not to create an unbalanced portfolio that’s too focused on stock income or too heavy in richly valued sectors, as utilities and consumer staples currently are.

And, especially when investing for the long term, investors with a myopic focus on yield might overlook some well-performing companies that don’t pay dividends, such as Facebook (ticker: FB) and Google parent Alphabet (GOOGL).

What’s more, dividends aren’t guaranteed. While companies typically strive to maintain dividend payments once they’ve been initiated, they can be cut in times of duress. During the financial crisis, for instance, General Electric cut its annual dividend from $1.24 a share to 40 cents. It’s now down to a token sum of four cents a share annually. (GE is a onetime dividend stalwart, with decades of consecutive payout increases until the first cut in 2009.)

Both the income and total-return approach can face problems if a retiree runs out of money and needs to tap principal too aggressively—no small worry considering that life expectancies have been increasing. According to the Center for Retirement Research at Boston College, the average 65-year-old retiree can now expect to spend about 20 years in retirement, up from 13 years in 1960.

Still, proponents of dividend stocks say that a well-executed strategy can provide income and capital appreciation that can stretch savings.

Jeremy Schwartz, global head of research at WisdomTree, says that on a real basis, which takes inflation into account, dividend stocks acquit themselves well relative to other kinds of assets and thus are valuable components of a diversified retirement portfolio. “Stocks are real assets that tend to see dividends and profits grow with inflation over time,” he says.

An attractive trait of dividend cash flow, Schwartz adds, is that it is much less volatile than stock-price movements are. He points out that the WisdomTree US Total Dividend exchange-traded fund (DTD), which weights its 878 holdings by expected dividend streams, recently yielded about 2.9%. Apple (AAPL), with its hefty dividend stream, has the largest weighting in the fund.

On top of that, the fund’s net share repurchase yield—that is, the stock buybacks as a percentage of the underlying holdings’ market capitalization—was 2.2%. That’s a combined shareholder yield of a little more than 5%.

“That’s a pretty attractive equity-risk premium,” Schwartz says, comparing the ETF’s 5% shareholder yield to the 0.21% for Treasury inflation-protected securities recently.

While experts note that not every stock has to pay a dividend in accumulating assets for retirement, they say dividends are a crucial factor in racking up total returns, which combine capital appreciation with reinvested dividends.

John Buckingham, editor of the Prudent Speculator newsletter and chief investment officer at AFAM Capital, agrees that the portion of a portfolio that’s designated to earn returns for five years out and beyond should be pretty much all in stocks, “provided that you have the discipline and patience to stick with it, and that’s a big caveat.”

“There’s just not a lot of excitement in bonds or other fixed-income type investments,” he adds. Dividends typically go up every year, “and that’s likely to increase as corporate profits grow.” Bond coupons, meanwhile, are often fixed.

TOTAL-RETURN STRATEGY

Huber, a proponent of total-return investing to build a retirement nest egg, advocates an approach in which portfolio assets are periodically rebalanced (from better-performing asset classes to underperformers, for example) and occasionally sold to supplement income for retirees.

“It’s hard to retire and live solely off the income of dividend-paying stocks and high-quality bonds,” he says.

He generally favors dividend-growth stocks, or ones that are regularly increasing their disbursements, over higher-yielding names. Dividend growers, he says, have “more of a quality bias” and are “more defensive in a downturn.”

Jaconetti, though, prefers holding a balance between those broad types of dividend stocks. “The markets are cyclical, and nobody really knows what’s going to happen,” she said in a recent interview.

She is skeptical of overweighting dividends, in part because traditional equity-income sectors such as utilities and consumer staples have been bid up, leading to higher stock valuations. Those sectors, and stocks, could be vulnerable to a selloff, their dividend support notwithstanding.

“Dividend-focused equities tend to display a significant bias toward value stocks,” she says. Until recently, value stocks had underperformed growth names for many years. “You may not realize you are changing the composition or risk profile of your portfolio if you are doing it for the sole purpose of cash flow.”

One fund that has had success with a total-return strategy: the Columbia Dividend Income fund (LBSAX). Its 10-year annual return of 12.2% places it in the top 15% of its Morningstar category. The fund recently had its biggest weighting in information-technology stocks (21%), followed by financials (19%) and industrials (14%). Its top holdings included JPMorgan Chase (JPM), which yields 2.8%; Microsoft (MSFT), 1.4%; Johnson & Johnson (JNJ), 2.9%; and Merck (MRK), 2.6%.

“We continue to focus on identifying companies with free-cash-flow and balance-sheet strength, which we believe becomes more important as the economic cycle progresses,” the managers wrote in their outlook following the third quarter.

DIVIDEND INCOME STRATEGY

Charles Lieberman, chief investment officer at Advisors Capital Management in Ridgewood, N.J., dislikes the total-return approach.

For starters, there’s the “sequence of returns problem,” which is a commonly cited concern among retirement researchers. If, say, an investor’s portfolio runs into a cluster of down years as retirement approaches, it can mean a much lower base of assets on which to generate income.

Making portfolio withdrawals to raise cash when the market is declining is particularly vexing to him, partly because it can mean tapping principal—something many investors are loath to do. “When the market goes down sharply, you have to sell off more assets,” Lieberman says. “When the market recovers, the portfolio is operating on a smaller base, and it potentially never recovers.”

The so-called safe annual distribution, or withdrawal, rate for a retirement portfolio is around 4%, says Lieberman. But even at that rate, he says, there’s a chance a retiree can run out of funds. (Many retirement researchers these days are encouraging a more fluid withdrawal rate.)

So one of his firm’s strategies aims to produce income that keeps up with inflation. The strategy typically has about 80% of its holdings in stocks, in many cases including higher-yielding master limited partnerships and real estate investment trusts, with the remaining 20% in fixed income and preferred shares. Since its inception in 2001, the strategy has had a net annual composite return of 6.8%.

One REIT that Lieberman holds is Medical Properties Trust (MPW), which develops and leases health-care facilities such as hospitals. It yields 5.2%.

Lieberman doesn’t worry about the notion that emphasizing income-producing stocks can lead to dangerous overweightings in value stocks. “I have sufficient knowledge to be able to make some judgments about what sectors—and what companies—can safely provide income,” he says. “I don’t feel like I am required to invest in every sector proportionally.”

David Blanchett, head of retirement research at Morningstar, says there are times when the income approach—even one that’s less diversified—makes sense in retirement.

“Portfolios focused on income are likely to be less diversified than their total-return counterparts, but tend to produce higher levels of income, and may be attractive alternatives to total-return strategies for investors focused on current consumption,” he wrote in a 2015 paper that he co-authored in the Journal of Portfolio Management.

DIY STRATEGIES

Many investors sort out these retirement-income strategies with the help of an advisor or wealth-management firm. But what about do-it-yourselfers?

One option that growing numbers of investors are pursuing is to assemble a portfolio of dividend-paying stocks. To properly execute this difficult and potentially expensive strategy, a lot of research is required to fully understand the companies and how durable their dividends are.

Among the dividend stocks that Buckingham thinks are undervalued—but that pay a yield greater than that of 30-year U.S. Treasuries—are Royal Caribbean Cruises (RCL), which yields 2.7%; Cisco Systems (CSCO), 3.1%; Amgen (AMGN), 2.6%; AT&T, 5.2%; KeyCorp (KEY), 3.9%; Synchrony Financial (SYF), 2.4%; and Prudential Financial (PRU), 4.3%. The 30-Year U.S. Treasury’s yield is about 2.3%.

“We are not buying dividend stocks just for the sake of dividends,” says Buckingham. “We’re seeking capital appreciation, as well.”

Instead of assembling a dividend-stock portfolio, a likely safer and less-expensive option is a mutual fund or a combination of funds. “A fund would be more efficient. They have the opportunity to buy on a larger scale,” Jaconetti says.

One of the top performers is the $39.5 billion Vanguard Dividend Growth fund (VDIGX), which reopened to new investors in August. Its annual expense ratio is 0.22%. Run by longtime manager Donald Kilbride, the fund aims to invest in high-quality and defensive companies. The fund’s top recent holdings included Coca-Cola (KO), Medtronic (MDT), and McDonald’s (MCD), and its benchmark is the Nasdaq US Dividend Achievers Select Index—whose members have raised their dividends for at least 10 straight years.

The fund has placed in the top 20% of its Morningstar peer group based on one-, three-, five-, and 15-year returns. Its 10-year annual return of 12.8% is in the top 30%.

That’s the kind of performance retirees can live with.

Whatever approach is used for retirement income, dividends should play a key role—but it’s important to understand where and how they fit in.

Corrections & Amplifications

An earlier version of this story was accompanied by a table that showed the 12-month yields, including capital-gains distributions, of 10 mutual funds. The table has been updated and now excludes those distributions.

Write to Lawrence C. Strauss at lawrence.strauss@barrons.com