Many individuals are facing the need for income in retirement while simultaneously searching for yield in a more challenging fixed income environment. High dividend stocks, when structured appropriately within a portfolio, can offer a very solid, predictable income source for retirees.

High-Dividend Stocks and Retirement

Clients nearing retirement are usually told the same thing: lean heavily on fixed income securities, and leverage equities only for selective exposure to certain sectors and markets. This guidance is rooted in good intention, as capital preservation is justifiably first and foremost for anybody in their golden years. However, current interest rates present a significant obstacle for fixed income investors. Many retirees have a need for more income than their bond-heavy portfolios can generate, and may be willing to tolerate the risk of volatility in exchange for greater equities exposure.

High dividend stocks can serve as a valuable tool for clients nearing or in retirement. These stocks can generate steady yield, provide potential for capital gains, and – when diversified appropriately – weather adverse market conditions more capably than equities that focus primarily on short term gains.

The Approach for Dividend Investors

Portfolios invested in high dividend stocks must be assessed on a company-by-company basis. While many firms may perform well operationally, others require the diligent investor to dig behind the numbers to discover hidden risks. Retirees, in particular, should have little tolerance for underperforming securities. An individualized approach to company selection will often be more successful than simply selecting clusters based on sector or other external attributes.

By many measures, the economy is stable with potential for a “gaining altitude” inclination, but the economy is still tight in some sectors – especially those laden with traditional cash-cow companies. Even in this positive economic environment, companies and industries can run into headwinds or competitive troubles.  Therefore, rigorous “bottom up” financial analysis of both companies and industries is very important in the dividend investing space.

Some prospective investors view the valuation of the market as a challenge.  It’s difficult to bargain-shop with many indexes at or near all-time highs. However, many market analysts believe high valuations are justified given favorable macroeconomic signals and the steady recovery from post-recession valuations. Even with prices that many consider on the high side, there are many opportunities to invest in companies that not only provide a healthy yield, but steadily grow their dividends year over year.

What If Rates Rise?

Many investors shy away from high dividend stocks because they fear what will happen during a time of rising rates.  Rate fears can drive some short-term performance jitters, there’s no question about it. Those clients who are at or near retirement are more sensitive to these fluctuations, so it’s important to fully disclose this potential volatility.

The good news is that the concern of rising rates is already priced into the market to some degree, though it’s difficult to say to what extent. There’s a big difference in the market when something is expected to happen versus when it comes as a complete surprise. By most sentiment, there is now acclimation to the idea of rates eventually rising, but this issue could also grow as the economy gets closer to a true rising rate environment.

During a time of rising rates, certain sectors may fare better than others. For example, utilities may be especially rate sensitive. This risk needs to be weighed carefully against the value that utilities typically bring as a core component of an income investor’s portfolio. Individual companies within the sector can be selected, provided they are operationally well-run and provide stable cash flow.

Overvaluation – Will High Dividend Stocks Continue to Deliver Income?

To a degree, valuations are on the high side, but this assessment lives within the context of where the market has been. The economy is now roughly five years into recovery and the market is six solid years off the bottom. Companies have been able to increase productivity, driving margins and profits – all of which feeds into the current market level. One would not expect to see record low, or even low, valuations at this stage of the economic cycle. When valuations are high, positions can be sold for gains – even high dividend stocks that otherwise generate steady yield. Retirement-age investors may balk at selling positions that are generating predictable income, but in some cases the gains can be too lucrative to bypass.

That said, in every sector – whether it is utilities, REITs, or MLPs – there are some stocks that have performed well and can still be considered good value.  Having weathered the recession, many companies are leaner and better positioned for growth, with improving prospects for future earnings or free cash flow.  Such stocks may still be inexpensive relative to their growth, and provide the opportunity for continued dividend increases, maintaining or even growing the portfolio yield despite price appreciation.

A Steady Approach for Retirement-Aged Investors

As with any strategy, it’s important to diversify and protect against risk. High dividend stocks can play an important role for those nearing retirement, but should not entirely replace core fixed income. However, with the right mix, high dividend stocks can provide significant potential for capital gain, and generate yield that otherwise may be lagging in a fixed income portfolio. In today’s rate environment, high dividend stocks certainly deserve a look.

City National Bank, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person of any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.

Non-deposit investment products are not FDIC insured, are not deposits or other obligations of City National Bank, its subsidiaries and affiliates, and are not guaranteed by City National Bank and involve investment risks, including the possible loss of principal.