Paychecks that Keep on Going

Transcription

1 Paychecks that Keep on Going Jonathon D. McAdams 1400 Post Oak Boulevard, Suite 1000 Houston, TX

2 Jonathon D. McAdams Jon McAdams holds a BS from Texas A&M University and an MBA from the University of Houston. He is active in the alumni associations of both institutions. Jon has held memberships in the Financial Planning Association (FPA), the International Association of Registered Financial Consultants, and the Greater Houston Business Ethics Roundtable (GHBER). Jon is a member of the American Economic Association (AEA) and recently served on the Finance Committee of the Houston chapter of the Alzheimer s Association. He is also a member of the National Committee on U.S.-China Relations and was recently elected to the Board of Directors of Target Hunger, a local Houston charity.

3 Paychecks that Keep on Going A frequent topic of conversation at meetings of the Linscomb & Williams Investment Committee: The change we have seen during our 45 years in how clients plan for the transition in giving up a regular paycheck at retirement. The biggest change? Today, very few people can count on a company pension to help replace their paycheck when they retire. Data from the Pension Benefit Guaranty Corp (PBGC) confirms this. When we founded L&W in 1971, these were the statistics for private sector workers: 4 workers out of 10 started their retirement entitled to a monthly pension from their company. This was an attractive addition to their Social Security income. Hardly anyone had a 401k-type account. As late as 1980, less than 1 in 10 workers had a 401k account. Today, only 1 worker in 7 has a pension from their company when they retire. 401k-type plans or other Defined Contribution plans, such as 403(b)s, are clearly predominant, covering 1 of every 2 workers in the private sector. Retirement cash flow planning for today s retirees is clearly different. They are not living their parent s retirement. What today s retirees need is a retirement paycheck. Imagine having a predictable cash flow throughout retirement to supplement Social Security. And imagine a retirement paycheck that, like your working-years paycheck, could keep pace with or even out-pace inflation. That starts to paint a retirement picture with much more security and peace of mind. Is it realistic to create a retirement paycheck like this? the basics a few things are obvious A retirement paycheck like this is possible in our view. It requires investing available funds in a way that can confidently provide monthly cash withdrawals for many years. That confidence is based on two concepts already well-explored in the financial press. We will not write here about withdrawal rates, as this subject has already been so thoroughly covered in our papers and others papers. The hard number crunching from researchers indicates a realistic withdrawal rate for investors retiring in their 60 s is somewhere between 3% and 5%. This means if you invest your retirement assets in a reasonably balanced way, and initially withdraw the appropriate percentage (let s assume 4% per year), you can probably continue withdrawing this amount and adjust it each year for inflation. You probably will not outlive your assets. So for a retiree with a $1 million portfolio, this means a paycheck starting at $40,000 per year. We also will not write a lengthy reminder that common stocks have produced the best returns for retirees over the long-run. A short review of any market history table or chart showing long-term cumulative returns by asset class will demonstrate the historic advantage of stocks compared to more conservative investments like bonds and cash.

4 We are not re-writing about these because they are two things most people already know, or have at least heard. Some may have even proved it to themselves with some form of Monte Carlo analysis or Stress Testing analysis of their own numbers. It would not be so difficult to create this retirement paycheck but for one simple fact which stands in the way of success for most retirees. Fact: Stocks can be hard to live with since they bounce around in value. This is a plan that many people will not stick to. Is there any solution for this dilemma? Our answer is a qualified YES. (Just in case you are about to discontinue reading at this point, we will fast forward just enough to tell you what is NOT the answer. Do not put your money into some sort of guaranteed variable annuity contract. We ll save the details on that discussion for another time by simply saying that 99% of the time, variable annuities with so-called guaranteed withdrawals are a death wish for the longevity of your portfolio assets.) the qualified yes creating your retirement paycheck with a dividend stock portfolio Why is the stock market so difficult to live with as an investment strategy? Perhaps the best explanation we have seen comes from Ralph Wanger, a founder of the famous Acorn Funds mutual fund family. We can paraphrase his explanation of the stock market this way: The market is like a man walking a very excitable dog on a long leash in New York City. The man is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. The dog is darting randomly in every direction as the man walks. At any one moment there is no predicting which way the pooch will lurch. But in the long run, you know he s heading northeast at an average speed of about three miles per hour. You know where he s started and where he ll end up. What is amazing is that almost of all the market players, both big and small, seem to constantly keep their eye on the dog, and not on the owner. No wonder they cannot make any sense of it. To stick with common stocks as part of this retirement paycheck strategy, we need to keep our eye on the man rather than the dog. Said another way, we need to keep our eye on the dividends we are receiving on our stocks and away from the fluctuation of their market prices. As long as those dividends are consistently moving ahead, then we are on the right track, regardless of the price movements. Our qualified Yes answer then is to build your own retirement paycheck using a sensibly balanced portfolio of stocks and bonds, but build your stock portfolio on a foundation of stocks with above-average dividend payments that are rising over time. We believe this can work for retirees for three reasons -- Focus, Fundamentals, and Facts. FOCUS. When you focus on dividend payments and dividend growth, you are paying attention to the man instead of the dog. This counteracts our natural human tendency to panic just because the dog (the stock prices) darts in the wrong direction. On a short-term basis, the return you will receive from your stock dividends is dull and boring, like watching paint dry. (Do not expect to see Jim Cramer get emotional on television discussing dividend numbers.) However, a 2010 paper published by James Montier of GMO (who incidentally describes

5 himself as the Amish for his shunning of the modern world ) provides an insightful analysis of the U.S. stock market since 1871, using more than 100 years of data. Montier admits that when you examine the stock market for any single year, dividends are indeed boring. They typically account for less than 30% of the performance of your portfolio. However, extend your time frame to five years, and now, the dividends and their growth in dollar amount will account (on average) for more than 75% of your stock returns. So in reality, Dividends Matter and are precisely what you should be watching. With this focus, you do not need to panic in a bear market. Rather, you simply continue what you should be doing every year adding up your cash dividend payments (your retirement paychecks) to see if they are equal to or greater than the previous year. FUNDAMENTALS. Dividend payments speak loudly about the quality and maturity of a business. Start-up or young-stage companies are hungry to retain their earnings in order to reinvest for the growth of their business. For this reason, it is likely they will not pay a dividend. Mature companies with more stable cash flows often decide that one important use of that cash is to repurchase shares or pay dividends. Therefore, dividend payments are the hallmark of a quality company, because paying regular dividends reflects management s confidence that it will be able to support payments via expected future earnings. In fact, some investment analysts argue there is no stronger message about the confidence in the future of the earnings stream than management s declaration of a dividend. Therefore, a stock portfolio built on a fundamental foundation of the stocks of mature business with these characteristics is almost, by definition, a portfolio of some of the highest quality companies. Dividends are not guaranteed, of course, but for that matter, neither was your paycheck when you were working. For some people, these retirement paychecks might be more secure than their working paychecks ever were. FACTS. Has the dividend portfolio stood the test of time as a retirement paycheck strategy? In fact, there is a wealth of academic study that supports this thesis: Investment capital will hold up best to periodic paycheck withdrawals if the portfolio includes stocks which are paying above-average dividends. If time permitted, we could write a 20-page white paper detailing these studies. Instead, we took a poll among our Investment Committee members to determine the single best example to share here which illustrates this widely-studied but under-recognized truth. Our nod went to a 2014 article in Financial Advisor by Jan Holman of Thornburg Asset Management detailing a study conducted by Thornburg in conjunction with William Bengen. The study was simple. They created two hypothetical investors, both starting retirement with a traditional portfolio that was 60% stocks and 40% bonds. There was a single difference between the two. Investor A owned the S&P 500 Stock Index for his 60%, while Investor B owned solely the top 100 dividend-yielding stocks within the S&P 500 Index. Each investor had $1 million at the start of retirement and withdrew 5% or $50,000 for spending in year one, increasing the withdrawal each year by the inflation rate. Both investors therefore

6 drew out exactly the same total of paychecks during retirement. To make the study interesting, Thornberg had both investors begin retirement on August 31, 1987, just prior to the 1987 Black Monday market crash (the worst one-day stock crash on record). Then, they tracked these two investors over approximately 25 years until December 31, This was a period which included 3 bear markets (1987, , and ). The good news was that neither investor exhausted their assets. Investor A had almost $2.5 million left at the end of Investor B, emphasizing the higher dividends, enjoyed almost 50% more appreciation in value and therefore had almost $3.7 million left at the end of 25 years. Are there pitfalls to this dividend approach? Of course there are. Two are worth mentioning here. 1. The first trap for investors with a dividend strategy is the potential of overweighting the portfolio with high-yielding stocks focused upon only one or two market segments, such as consumer staples and utilities. Utilities, for example, are vulnerable if interest rates begin to rise. This could lead to investors selling their utility shares and usher in significant negative price movement and resulting under-performance. If you intend to own a dividend portfolio, it must truly be a portfolio, which means that it is fully diversified. 2. A second trap for dividend investors is to be guided solely by looking in the rear view mirror. These investors limit their universe only to dividend payers that have long and uninterrupted records of paying increasing dividends. Who would not want to own these, right? While you should not eliminate these from consideration, neither should you set unrealistic criteria. After all, well-known companies like General Electric or AIG would have initially qualified under such a screen, but then interrupted their dividends during the financial crisis. And other companies that have perhaps only recently started paying dividends (Apple comes to mind) may have a lot of room to increase their dividend payouts in future years even though they do not yet have a long track record of having made payments. This simply means a thoughtful approach is called for. wrapping up the paycheck discussion Using dividend-paying stocks as a cornerstone for the growth portion of a retirement portfolio is a sensible way to compliment more conservative investments like bonds. Together, these can work to create the retirement paychecks that are needed to effectively plan for sustainable cash flow. Linscomb & Williams would like to claim some unique insight in sharing this advice, but the fact is that a dividend emphasis is a well-regarded and well-researched theme, making it quite mainstream. That is the very thing that can give retirees more confidence in the approach. For those who like to get deep into the weeds researching these topics, we can suggest Jim O Shaughnessy s book, What Works on Wall Street, now in its fourth edition and updated through He has three full chapters describing his research into this topic. In our view, the important summary advice for investors looking at this avenue to create their

7 paychecks can be boiled down to several points: Do your homework with the financial statements. Stick with strong businesses that have solid balance sheets and financial strength. These are companies that have staying power to maintain dividends during weak cycles in the economy. Spend some time looking at the Cash Flow Statements for these companies, not just the Income Statement. This will give insight into free cash flow the actual cash being generated by the business after all expenses and required reinvestment back into the business. Generally speaking, you should desire to see that free cash flow per share is exceeding the dividends being paid to shareholders. This means there is some cash cushion to rely on during periods of weaker economic activity. Look at the history. Companies that have shown a commitment to maintaining and increasing cash payments to shareholders should be favored. Your objective should be a portfolio that does not require a high turnover in terms of trading. Stay diversified in building your portfolio. As we mentioned above, do not let the search for yield drive you into a portfolio that becomes unbalanced or unduly concentrated in particular industries or sectors. Do not stretch for yield. If your overall dividend yield is 50% higher than the market as a whole (3% when the index is yielding 2%), you are likely in the right zone, particularly if the dividends are likely to grow in future years. This growth potential in the income stream is very important. If you worked at a dream job during your working career, you probably felt you were getting paid above average and that your pay was likely to increase over time by more than inflation. A wellconstructed dividend stock portfolio should make you feel the same way about your retirement paychecks. The difference is that in retirement, these paychecks might be coming from employer companies managed by some of the best business minds on the planet. Linscomb & Williams does not provide legal, tax or accounting advice. The information, analysis, and opinions expressed herein are for general and educational purposes only. This presentation may contain forward looking statements that may or may not occur. Nothing contained in this presentation is intended to constitute legal, tax, accounting, financial, or investment advice. Always consult with your independent attorney, tax advisor, and other professional advisors before changing or implementing any financial, tax or estate planning strategy. Information expressed herein is based upon opinions and views of Linscomb & Williams and information obtained from third-party sources that Linscomb & Williams believes to be reliable, but Linscomb & Williams makes no representation or warranty with respect to the accuracy or completeness of such information. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.