Hot topic: What are the best sources of yield for retirees entering the drawdown phase?

Few would argue that the vast majority of Canadians are struggling to build a nest egg for their retirement. Millions of them are nearing, or going into, retirement fearful of the prospect of outliving their savings. This presents a challenge to many financial advisors who must help this demographic make investment choices that will generate a predictable retirement income. We asked two advisors to share their thoughts on the best sources of yield for retirees entering the drawdown phase, and on investment choices that best mitigate longevity risk.

Don G Levy, BA, CFP, CIM, FCSI, TEP Managing Director, Confido Wealth Management Group Senior Financial Advisor, Certified Financial Planner & Branch Manager, Manulife Securities Incorporated

The information garnered from many investment courses for financial advisors emphasizes retirees in the drawdown phase should look to fixed income – GICs and bonds – as the best source of yield. If a client’s investment objective is income, the advisor is expected to recommend fixed income securities.

This conventional wisdom’s rationale is based on retired clients being more risk averse. There is insufficient time for them to maneuver a recovery from equity investments. Such a sentiment is common in Canada’s investment advisor community.

Given their longevity risk, retired clients need attractive yields combined with growth and augmented with a tax-efficient strategy. Advisors are now rethinking the strategy of fixed income as a source of yield during retirement in favour of portfolio dividend-paying security.

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If you are an advisor still stuck on the antiquated notion of fixed income investments as the best source of yield, consider the following: Today’s low interest rate environment renders impotent any reliance on government bonds as a source of yield. A ten-year government bond yield is approximately 2% versus the TSX composite dividend yield of 3.2%.

With retirees living much longer and their ever-increasing cost of living, reliance on bonds and GICs as sources of yield increases the risk that they may outlive their capital. In addition, if bonds and GICs are held outside a registered plan they will be taxed as income, which further reduces the paltry interest yield they may generate.

Yields on corporate debt instruments with stellar credit quality are slightly higher than those on government bonds. In fact, several 10-year corporate debt instruments with an AA rating yield approximately 3% with hardly any prospect for capital appreciation given today’s yield curve.

In fact, most debt instruments will likely face headwinds and downward volatility pressure as interest rates are unlikely to go anywhere but higher in the medium term.

Many advisors have turned to high-yield corporate bonds, or junk bonds, for the answer. High yield is synonymous with lower credit quality and higher risk of default. But the notion that such higher risk debt instruments are more immune to rising interest rate pressure is simply ludicrous.

During the financial crisis, high-yield corporate bonds saw severe price declines as tightening credit created serious liquidity issues. Therefore, a yield strategy based on dividend-paying securities that have a strong history of increasing their dividend may be the best path for advisors to guide their clients along.

Dividends generally have little or low correlation to interest rates. A portfolio of dividend-paying securities provides attractive returns in four ways.

The portfolio provides a good yield, which in many cases can be 50% to 100% higher than current yields on government bonds and 25% higher than corporate bonds yields. A good portfolio of 20 to 25 solid companies can produce dividend yields of approximately 4%.

Dividend stocks provide meaningful capital appreciation over time. Historically, such appreciation has generally exceeded non-dividend paying securities.

Dividend stocks categorized as the “aristocrats” have generally grown their dividend payouts. This increases the income paid to clients and as such provides a hedge against inflation. The chart below illustrates the growth of dividend yields for the S&P 500 versus the decline in bond interest over the last 32 years.

Dividend Growth Outpaces Bond Income (1980-2012)

Source: Fayez Sarofim & Co. Data as of 12/31/2012.

Dividends receive very favorable tax treatment resulting in higher after-tax yield where they’re held outside of registered plans.

Studies have shown that dividend-paying securities generally experience less volatility as such companies are generally more stable. From a risk management perspective, dividend payers can mean less risk as these companies tend to have higher amounts of cash and often low debt-to-equity ratio.

Moreover, dividends can eliminate the need to sell shares to meet income needs during a market downturn. As a result, the number of shares isn’t being reduced, which provides considerable benefit when the market rebounds.

A word of caution: While dividend-paying securities have many attractive attributes sought in yield-producing investments for retirees, financial advisors should ensure these dividend-paying portfolios are well-diversified. A portfolio with adequate diversification can increase the level of yield predictability and generate a stable income stream.

Be wary of companies that use cheap financing to fund dividends. This is often a ploy to boost stock prices. Focus on companies that have a healthy, free cash flow and historically stable earnings. Such companies are less likely to cut their dividend.

Healthy sources of yield serve as vehicles that deliver a stable income. If such a vehicle is structured with careful selection and adequate diversification, it can increase the level of predictability of income.

The capital growth element of portfolios boosts retirees’ purchasing power. And when undergirded with a strategy to reduce risk, they can address the needs arising from longer life expectancy. A proper strategy using dividend-paying securities can accomplish both.

Allan Small, FMA, FCSI Senior Investment Advisor of Allan Small Financial Group with HollisWealth

Retirees have reached the drawdown stage of life, when they are likely no longer working and accumulating capital. For that reason, most retirees shouldn’t take the same risks as those who have age on their side and are earning an income. Generally speaking, the older you get the less risky you should be with your investments. It is advisable that a retiree’s portfolio should consist of a large component of lower-risk investments such as preferred shares or bonds.

Bond yields will fluctuate with interest rates, but eventually if investors hold the bond to maturity, they will be able to receive their money back with interest. Investment-grade bonds present little risk of loss over the longer term unless the issuer defaults on the payment.

Corporate bond yields tend to be higher, which is why I’d pick them over government bonds; however, those looking to maximize returns while still operating in a low-risk investment should likely opt for investment-grade bonds (BBB+ or higher) that mature in six to 10 years, which today can pay in the 3% to 4% range. With investment-grade bonds, the risk of default is minimal.

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Another good option is preferred shares, which today can pay investors 4% to 5% dividends annually, depending on the type. They tend to offer relatively higher yields than government or investment-grade corporate bonds, and offer the same favourable tax treatment as common shares. But preferred shares have no voting rights and do not participate in a company’s growth.

Investors must understand that the type of preferred share they own – perpetual or reset, for example – will dictate the amount of volatility within this asset class. It’s important, therefore, to know how a specific type of preferred share will work within the context of their overall portfolio.

On the equity side, I would consider dividend-paying stocks in the utilities, banking, telecom and pipelines industries. There are companies in these sectors that tend to be a little less volatile than the market as a whole, yet they have yields that are higher than investment-grade corporate or government bonds.

It’s important to note that, in many cases, the best source of yield is not the highest yield. In fact, the second-tier of dividend payers – not the highest dividend payers – outperform the first-tier on a regular basis. The reason? The highest dividend payers often have trouble maintaining the higher rate and, therefore, are periodically forced to reduce their payouts. That can spell disaster for the share price of those companies. By contrast, the second-tier dividend payers are able to maintain their dividend payouts relatively easily and, as a result, are less volatile.

When it comes to deciding on a specific asset allocation in a retiree’s portfolio, it’s the level of risk the retiree is willing to take that should dictate the percentage of her portfolio to be invested in dividend-paying equities relative to fixed-income bonds or preferred shares. The other deciding factor is the desired yield or income the retiree needs. If a retiree requires a yield of 5%, for example, she won’t be able to attain that objective with government bonds or GICs.

Many equities, at least in the current environment, are paying out higher dividends than the interest rates on bonds. Therefore, incorporating income-generating stocks into a retiree’s portfolio will not only provide a higher yield in many instances, but will also help protect the portfolio against the negative effects of rising interest rates on bond yields. As interest rates tick higher, the price of investments – such as bonds and preferred shares – tend to drop.

As a rule of thumb, clients should invest the equivalent of their age into fixed income. In other words, an 80-year-old investor should have 80% in bonds and 20% in equity.

All things considered, a balanced portfolio made up of both equities and fixed-income products can provide the best source of yield during the drawdown phase of retirement. A portfolio of mixed investments constructed with careful thought serves as a shield against market and interest-rate risks, while generating a higher average yield for the retiree investor. This is the best way to make money, and mitigate or minimize risk in the current investment environment.