Monday, September 28, 2009

What should one invest in during retirement?

Investing during retirement entails different criteria than investing during ones productive years. There are three paramount criteria that retirees need to consider when considering their investments--current income from their investments, safety of their capital, and protection against inflation.

If a person retires at age 65, that person can reasonably expect to live another 20 years. If we assume historic rates of inflation, in 20 years prices will be somewhere between 2 times and 3.5 times greater than they are today. Those are the previous 20 year inflation rates during the past 50 years in the United States. If one does not take inflation into account during ones retirement, the consequences could be considerably unpleasant as one approaches the grave.

Many investment advisers suggest a rather conservative investment philosophy for retired persons. Let's review a couple just to get a flavor of what conventional wisdom suggests. Vanguard Retirement Income Fund VTINX allocates 65% bonds, 29% stocks, and 5% short term investments. Its average return since inception is 3.39%. Its current yield is 2%. Fidelity Freedom Income Fund FFFAX allocates 60% bonds, 21% stocks, and 19% short term investments. Its average return since inception is 4.82%. Its current yield is 2.95%.

When one considers the current yield of these retirement funds, their asset allocations, and their returns one must question the wisdom of their philosophy. With historic inflation rates running at a minimum of 3.5% annually and as high as 6.5% annually over a 20 year period this investment philosophy is not going to yield sufficient returns nor yield sufficient income to last a 20 year term for the average retiree who is dependent on his retirement income and social security.

One of the common rules of thumb for retirees is that they can withdraw 4% of their retirement capital annually and have it last about 25 years. There are web based retirement tools to show the user the amount that can be withdrawn monthly assuming an initial amount at retirement and an expected life span. Unfortunately, many of these tools make assumptions that may not be correct and they do not allow the user to adjust the assumptions.

A simple calculator can be found at this link. Too simple.

I believe a better strategy is to allocate more to quality equities that have a history of increasing their dividends. Generally speaking that will accomplish two goals. It will provide over time an increasing income and the increasing dividends generally will support an increasing value of ones assets. Investing in bonds accomplishes neither. That is not to say that bonds have no place in ones retirement portfolio. They do add some stability to ones assets during market turmoil, which they did during these previous two years. Some of them did anyway. Some did not. Only the very highest quality bonds actually added to stability. The rest did very poorly.

Let's look at several examples of high quality stocks that have a history of increasing their dividends.

McDonalds Corp--MCD--10 years ago paid a dividend of 0.20 a share. Today it pays 1.63 a share. Ten years ago its average price was 42.50 a share. Today its price is 57.00 a share.

Procter & Gamble--PG--10 years ago paid a dividend of 0.64 a share. Today it pays 1.64 a share. Ten years ago its average price was 45.00 a share. Today its price is 58.00 a share.

Coca Cola--KO--10 years ago paid a dividend of 0.64 a share. Today it pays 1.52 a share. Ten years ago its average price was 60.00 a share. Today its price is 53.00 a share. But recall that 10 years ago we were at the peak of the bull market. KO has indeed during the last 10 years depreciated somewhat in value.

Chevron--CVX--10 years ago paid a dividend of 1.24 a share. Today it pays 2.53. Ten years ago its average price was 44.00 a share. Today its price is 71.00 a share.

Each of these companies pays a dividend of more than 3% annually, more than either of the two mentioned retirement income funds pay. They also each has a long history of raising their dividends annually.

This is not a full proof investment strategy. There are risks involved. One is that one of these companies that has had a history of raising its dividend might fall on hard times and not be able to do so. One might even have to cut its dividend. Bank of America recently was among companies that annually raised its dividend. But it recently had to drastically cut its dividend. A strategy to mitigate the impact of such an action is for one to invest in a diverse holding of stocks. It is generally suggested among asset allocation strategists that one should invest in no fewer than 20 different companies in a variety of industries.

One might ask why it would not be an appropriate alternative to invest in a blue chip mutual fund as such a fund should be composed of such stocks. One reason is that the term blue chip has been mis-applied by the investment communities in recent decades to include companies that have no claim to such a title. Another reason is that mutual funds feel themselves obligated to invest in a wide variety of companies. There are not that many companies that actually meet the qualification of quality companies that increase their dividends, maybe 50 to 100. Most mutual funds own many more than that number so they have to reduce their investment standard.

There are mutual funds that have a strategy of investing in dividend paying stocks. Several index funds come to mind. One is Wisdom Tree Large Cap Dividend--DLN. Its current yield is 3.3%. Unfortunately, the quality of some of its holdings leaves a great deal to be desired. One of its largest holdings is Bank of America, not a stock that one might choose to invest in. It currently holds stock in about 288 different companies. Considering there are only about 315 large cap companies, they are not all that selective in which ones they choose.

It would be a mistake to invest all of ones assets in only this type of companies. Indeed one should choose some bonds and also some other types of equities also. A diversified portfolio has a greater chance of limiting risk than one that is not. But I believe that for someone in retirement it is a better strategy to allocate a larger portion of ones assets to these types of stocks than to invest a large portion in bonds or in other types of equities.

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