How to Invest for Income When Rates Are Rising

September 19, 2013

One of the biggest challenges facing current and future retirees is shifting from investing for growth to investing for income. This is especially difficult in today’s environment of low and possibly rising interest rates. Let’s start by taking a look at some options for getting investment income in retirement:

CDs and Bonds: Living off interest has traditionally been one of the most common ways for conservative investors to get income. There are a couple of problems with this approach though. First, with interest rates still near historic lows, it’s a lot harder to live off interest than in the past. Even 30 year treasury bonds are still yielding under 4%. Second, the interest payments are unlikely to keep pace with inflation over time so even if it’s enough income now, it may not be in 20 years.

Withdrawing From a Balanced Portfolio: According to what’s know as the  “4% rule,” conventional wisdom is that you can safely withdraw up to 4% from a diversified portfolio of stocks and bonds and increase your withdrawals with inflation each year for 30 years. But the rule has been drawing fire recently for being based on studies using time periods with higher bond rates and better stock valuations. 30 years may also be too short a time frame for early retirees or anyone concerned about having a longer life expectancy.

Immediate Annuities: One solution that’s growing in popularity is to trade in part of your assets for a annuity payments guaranteed for the rest of you and possibly a beneficiary’s life. The advantage is that you can usually get a higher income from the annuity than from the previous two options. The downsides are that you typically lose access to the money, inflation protection dramatically reduces your payout, you don’t benefit from future growth, and you generally can’t pass on the remainder to your heirs. You’d also be locking in payments for the rest of your life based on relatively low current interest rates.

Dividend-Paying Stocks: Stock dividends have the virtues of historically growing higher than inflation and you don’t have to worry about depleting your capital if you can live off the dividends. High dividend stocks have also tended to outperform the overall market in the long run with less risk. The main downside is that dividend yields are fairly low with even dividend-focused funds and ETFs typically yielding less than 4%.

However, there are places you can find higher dividend paying stocks:

 

Preferred Stocks: Preferred stock can be one option. These are stocks that tend to act like a mix of common stocks and corporate bonds, with generally less volatility than the former and higher yields than both. For example, while the S&P has about a 2% dividend yield, an ETF of preferred stocks of the same companies is yielding almost 6%.

However, preferred stocks have their drawbacks too. They don’t benefit in the company’s growth as much as stocks and they’re less secure than bonds. They may also be callable if interest rates go down.

High Dividend “Motif”: If you prefer (no pun intended) to stick to common stocks, one way is through the Motif Investing site I wrote about last week. One of their motifs, the High Yield Dividends, is made up of high-dividend common stocks that have never cut their dividend in the last 10 years (including the financial crisis) and are currently yielding about 4.7%. (You can also put a portion of your money into another motif of MLPs yielding 7.5% to bring your total yield above 5%.)

There are a few ways it’s able to do this. First, there are only 20 stocks. Most ETFs and mutual funds have many more stocks, which force them to dilute their highest yielding stocks with lower yielding ones. But research shows that it only takes 12-18 stocks in different sectors to be diversified.

Second, purchasing the motif costs less than $10 and there are no ongoing fees. A 1% mutual fee doesn’t sound like much until you realize that it could be 33% of your income if the dividend yield is only 3%. Funds also have trading costs that come out of your returns.

Global Dividend ETFs: One of the downsides of the motif is a lack of international diversification, despite the fact that many of the highest paying dividend stocks are overseas. For example, two global ETFs (exchange traded funds), the Global X SuperDividend(TM) ETF (SDIV) and the Guggenheim S&P Global Dividend Opportunities Index ETF (LVL), each have about 100 stocks from around the world (the latter also includes master limited partnerships) and have been yielding over 7%. Of course, there’s no guarantee that they’ll be able to sustain those dividends yields but to the degree they can, they can be quite attractive to someone looking for income that can grow with inflation over time.

The big danger with all of these options is that your principle can still fluctuate quite a bit. They may be particularly hurt by rising interest rates, especially the preferred stocks. But keep in mind that when it comes to investing in retirement, it’s the income that matters most.