Create Your Pension With Dividend Stocks

Co-produced with Philip Mause.

Today we have an article co-produced with Philip Mause discussing the demise of the “defined benefit” pension and how retirees can create their own simulated defined benefit pension with their portfolios.

As life expectancy increases, retirement can be a very long time. It is essential that you have a plan in place that can provide the income you need today but also provide the income you need in the future after inflation has taken its toll.

Some Definitions

First, we should introduce a few basic definitions. A “defined benefit” pension plan is a plan which provides the retiree with guaranteed periodic (usually, monthly) payments for the remainder of the retiree’s lifetime. Some of these plans include survivor benefits for the spouse of the retiree. Some plans include annual adjustments to compensate for inflation, completely or in some cases partially. Social Security is a kind of defined benefit pension plan.

In contrast, a “defined contribution” plan is a plan which specifies the amount an employer will periodically contribute to the worker’s retirement fund. At the time of the employee’s retirement, those contributions (plus in some cases contributions of the employee) and earnings or income on the contributed funds are available to the retired employee as a source of retirement income.

A Little Bit of History

As recently as the 1970s, a large percentage of private-sector employees had defined benefit pension plans. This percentage was estimated by one source to be 50% in 1960. The percentage of private sector workers with these plans has declined precipitously. It is estimated that as of 2019, the percentage of workers with such plans is only 16% and that only 5% of new hires obtain those plans. The difference in these percentages is due to the fact that in some companies incumbent workers are in “frozen” plans which are not available to new workers. It should be noted that a very large percentage of public sector workers still have defined benefit plans.

There are a number of reasons for the decline in defined-benefit pension plans in the private sector. In the 1970s, there were some plan failures and the federal government imposed a combination of plan insurance to protect workers as well as plan regulation to be sure that employers were setting aside enough funds to cover their obligations. This made the obligation to set aside sufficient funds binding. It also increased the “regulatory expense” of hiring consultants and lawyers to be sure that a plan was in compliance.

Another factor leading to the abandonment of defined benefit pension plans was increasing longevity which had the effect of making a given stream of benefits much more expensive. Additionally, the steady reduction in the unionized percentage of the workforce also freed up management to move away from these plans. Finally, in the late 1970s, the amendment of the Internal Revenue Code to enable 401(k) plans opened up the opportunity to substitute defined contribution plans for defined benefit plans.

We can argue whether these developments were good or bad, but they did occur on a very large scale. The shift has had a number of effects. Corporations in general – and especially new corporations started since 1980 – have reduced obligations under defined benefit plans. As a result, their balance sheets are easier to understand and evaluate. It is possible that the demise of these plans is a small factor in the increased multiples seen in the stock market over that period of time.

Everyone Has a Second Job

Another important effect of the change is that employees and retirees now have to be engaged in a degree of investment activity whether they like it or not. Some 401(k) plans limit investment choices before retirement, but many allow considerable flexibility. Many employees and retirees have IRAs as well as 401(k)s, and there are a variety of ways for a retiree to modify or transition a 401(k) to permit considerable flexibility in investments.

This means that the funds at the point of retirement and during retirement are very much affected by the investment actions of the fund participant. An adroit investor can take the same initial contributions and generate a much larger corpus than an unsuccessful or overly conservative investor. Upon retirement, a given amount can be invested to generate more or less income depending upon investment decisions.

Replicating a Defined Benefit Pension

With careful planning and security selection, a retiree can develop a strategy to generate a stream of payments that can be similar to what he would receive in a defined benefit pension. This can be done by the careful selection of income-producing securities including dividend stocks and fixed-income securities such as preferred stocks and baby bonds. Under current market conditions, there are a number of strategies for achieving a return of 7% or more in the form of periodic payments. Careful planning and the selection of monthly dividend payers can produce a stream of payments that is roughly equal from month to month. It is probably better to maximize the expected total return rather than making a fetish about having precisely equal payments each month, but there are a variety of ways to produce a reasonably consistent level of income flow.

Inflation – an Important Issue

As stated above, some defined benefit pension plans (including social security) provide payments that are annually adjusted upward for inflation. This feature is important for all retirees, but it is especially important for young retirees. Our recent article on inflation noted that prices rose roughly sevenfold in the past 50 years. While very few retirees will spend a full 50 years in retirement, 30 and even 40-year retirements may become more and more common as longevity increases. Thus, there may be people retiring right now who could experience 3 or 4-fold inflation during the duration of their retirements.

Coping with this issue requires a more aggressive investment strategy. Fixed-income investments will generally create a stream of payments that will be vulnerable to an erosion in purchasing power over a prolonged period of inflation. Even if the Federal Reserve tames the current inflationary surge, the reality is that the Fed actually targets a level of positive inflation of 2%. Assuming that it will miss that target from time to time and inflation over a long period of time will average – say – 3%, prices will double every 24 years or so. If inflation follows the pattern of the past 50 years, the average will be much higher than 3%.

Inflation is not – at least in the short run – good for the stock market because it leads to higher interest rates and, consequently, multiple compression. However, it is undeniable that over a very long period of time, inflation will, by definition, increase prices and the nominal GDP. Corporate revenues will tend to increase in nominal terms, and over the long term, earnings will as well. This should result in higher dividends. One of the reasons that we have stocks that have consistently raised their dividends for a long number of years is that the time periods over which this has happened have included considerable inflation and a steady increase in nominal GDP.

Young retirees should therefore try to create a portfolio containing some securities with at least some promise of paying out higher income over time. The HDO portfolio contains several securities of this type. Enterprise Products Partners (EPD), for example, has a long history of increasing distributions. All of the equity real estate investment trusts (“REITs”) (as opposed to mortgage REITs) own actual real estate, which has tended to appreciate over long periods of time because – as Will Rogers put it – “they stopped making land a long time ago.” REITs like W. P. Carey (WPC) have a modest yield today but provide consistent growth that has historically outpaced inflation.

A Possible Strategy

It may make sense for retirees to structure their portfolios based on the expected number of years the portfolio will need to deliver income. Estimating this number can be a morbid endeavor, but unfortunately, it is necessary to confront this issue. Many young retirees may be surprised at the large number of years of retirement that they may potentially experience, with a surprisingly high probability. Calculating purchasing power toward the end of this period of time using various assumptions about average future inflation can be a very sobering experience. This analysis should underline the importance – for young retirees at least – of building a growth factor into the portfolio.

This analysis should also make retirees – especially young retirees – very skeptical about investments like life insurance and fixed annuities. Using current dollars to generate payments in the future is less valuable. This is a strategy that creates considerable vulnerability to inflation.

HDO gives both young and old retirees the tools necessary to design portfolios tailored to take account of these considerations through investing in high-dividend stocks. The Income Method seeks to ensure that your income keeps growing, even when you are withdrawing an income to live on. It does this primarily in three ways:

1. Some exposure to stocks that are likely to increase dividends.
2. Reinvestment is included in the plan. With yields of 8-10%, you have enough excess to reinvest and increase your income by owning progressively more dividend-paying shares.
3. Actively managing your portfolio. Dividend yields change as prices rise and fall. By realizing gains in investments that have increased in price and no longer have a high yield, you can reinvest where the dividend is safe but the prices are low. As a result, your income grows by selling at a low yield and investing at a higher one.

Unfortunately, the days when a retiree with many potential years ahead of him could simply buy an annuity or a bond fund and put things on “automatic pilot” are probably gone forever. A degree of careful active management with the kind of guidance we provide is increasingly necessary for good long-term results. Investing in high dividends stocks can give you the peace of mind you need for a long and wealthy retirement.