It's natural to want income in retirement. You've spent your whole adult life living below your means and building your portfolio, and the thought of spending it down is terrifying. It is to me, too.
At the same time, it's important not to chase high yields, as tempting as it may be in today's low-interest-rate environment. High yields can mean low returns and, sometimes, massive losses. I've seen people have to return to work or drastically cut their expenses because they built portfolios to produce high income and ended up losing much or all of their principal.
Total return (appreciation plus income) is far more important than income alone. Let's take a look at mistakes that people make when chasing income, and what you should do instead.
High-yield dividend stocks
This strategy involves buying stock in large companies that pay above-average dividends, preferably those with long track records of paying dividends. ExxonMobil (XOM), for one, has grown its dividend by an average 6.2 percent annually the past 37 years. The stock now yields 7.82 percent. And Verizon Communications (VZ) stock yields 4.17 percent. It feels so good cashing these dividend checks, and these companies aren't going anywhere, right?
The problem is that companies generally don't have a high-dividend yield because they love to give out money. A stock's yield is its annual dividend payout divided by its current share price. The yield rises if the company increases its dividend, but more commonly, a high yield is a result of a falling stock price.
Sometimes, a high yield signals something far worse. General Electric (GE), for example, was once one of the most valuable companies on the planet. Three years ago, GE stock paid a quarterly dividend of 24 cents a share, and its yield reached 4 percent in September 2017. Today it yields a penny a share each quarter, and that dividend may not be sustained. The stock has lost more than 75 percent of its value.
General Motors (GE) is another sad story of once-reliable dividend payers. I remember the saying “As goes General Motors so goes America.” I'm awfully glad that wasn't true. Though GM exists today, the shareholders were wiped out in 2009 and got nothing.
If you think this can't happen to today's blue chips, think again. When the economy suffers, businesses cut dividends, particularly those that pay high dividends. S&P Dow Jones reports that 50 S&P 500 issuers decreased or suspended their forward dividend rate by $29.0 billion in Q2 2020, pointing to a lower Q3 2020 payment.
Sometimes, too, sector-specific woes can hurt dividend investors. ExxonMobil had losses during the first half of this year as oil futures briefly traded at negative values. Who would have imagined having to pay someone to take delivery of oil? One key reason the yield at ExxonMobil is so high is that the price of the stock has fallen so much. Over the past five years, ExxonMobil has lost over 5 percent a year, including dividends, while the U.S. stock market as a whole gained nearly 12 percent annually, according to Morningstar.
You may think you're getting more protection in a basket of stocks within the same sector, but that's not always true, either. Take Master Limited Partnerships (MLPs), which are pipeline networks that make money as companies pay to have oil and gas transported. They have high yields. “It's like owning a toll road and every bit as safe as a bond” — or so I've heard countless times. But according to Morningstar, a fund that owns these MLPs (Alerian AMLP) has lost an average of 11.71 percent annually over the past five years, as of Aug. 10, despite its current 13.3 percent dividend yield.
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With a five-year Treasury bond yielding a paltry 0.29 percent annually, and even a broader investment-grade bond fund such as the iShares Core US Aggregate Bond ETF (AGG) yielding 1.20 percent annually, we want more income.
So we buy riskier bonds and reach for yield. We buy something like the iShares iBoxx $ High Yield Corp Bd ETF (HYG), providing an attractive 4.54 percent yield. “High yield” is Wall Street's genteel way of saying “low credit quality."
The problem is that when the economy goes south, many of these companies with low credit scores default on their bonds. When GM filed for bankruptcy, bond holders got back very little. A more recent example is Hertz Global Holdings (HTZ), which filed for bankruptcy this year. Of course, no one saw the auto-rental business crashing as a victim of COVID-19.
High-yield HYG crashed with stocks, though it recovered and is down 0.11 percent for the year as of Aug. 10. On the other hand, the higher-quality AGG fund stood its ground during the COVID-19 crash and is up 7.66 percent for the year. Another name for high-yield bonds is junk bonds; I like that description.
A better strategy
The purpose of money is to give you choices in life. You worked really hard for your dollars. Losing principal in the name of maximizing income is foolish and may have you cutting back on your lifestyle unnecessarily.
Build your stock portfolio with the broadest index funds owning the entire U.S. and the rest of the world. Total return (appreciation plus income) is far more important than income alone. For example, the SPDR S&P Dividend ETF (SDY), a diversified fund that invests only in companies that pay dividends, earned 8.90 percent annually as of Aug. 10. That's a combination of the dividends and appreciation of the stocks within the fund, and it earned a decent return. Yet even that trailed the iShares Core S&P Total US Stock Mkt ETF (ITOT), which tracks the entire stock market. It earned 11.59 percent annually over the same period.
Since stocks are risky, make sure your bond portfolio is of the highest quality, mostly backed by the U.S. Government. A fund like the iShares Core US Aggregate Bond ETF (AGG) fits the bill. You won't get as much income as you would from a high-yield bond portfolio, but you will get protection if the stock market craters. But whatever you do, don't take unnecessary risks with your money by chasing yields.
Allan Roth is the founder of Wealth Logic, an hourly-based financial planning firm in Colorado Springs, Colorado. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.