High-yield stocks for retirement

Market swings have created a buying opportunity for retirement investors.

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Michael Sivy, Money Magazine editor at large

Make your money last
High-yield stocks outlast the S&P...
If you retired before the 1973-74 bear market with $500,000 in high-yielding stocks and withdrew 4.5 percent initially, you wouldn't have depleted your nest egg - far from it.
...they give you room for error...
Even if you needed more income and withdrew 5 percent the first year, that portfolio of high yielders would still be worth more than $2 million today.
...and they eventually produce more income than bonds.
High-yielding stocks initially pay less than bonds, but the annual income they generate swells over time thanks to dividend growth.
Source:Ned Davis Research, T. Rowe Price.

(Money Magazine) -- Recent turmoil in the stock market may be frightening, but the sell-off could turn out to be a blessing in disguise, especially if you're in or nearing retirement and are worried about generating income from your portfolio.

That's because several key groups of equities, especially the blue-chip financials that have been taking a beating of late, are so depressed that they're offering yields not seen since the end of the bear market. At the same time, other stocks that have always paid rich dividends are becoming more attractively priced.

Over the next several months, therefore, you'll have the chance to construct a safe, diversified retirement portfolio of blue-chip stocks paying out 4 percent in dividends.

Why is this so important? If you've ever used a retirement calculator or gone to a financial planner to figure out how much you can safely withdraw from your nest egg, you know that 4 percent is a kind of magic number.

To avoid the risk of outliving your money, academic research says, you should tap only 4 percent of your portfolio in the first year of retirement, and then increase that amount to keep pace with inflation in subsequent years.

But is it really so difficult to hit that target? Don't blue-chip stocks return around 7 percent a year even after inflation?

Yes, they do. But that's just an average - sometimes the results are better and sometimes they're worse. So creating a portfolio that relies solely on capital appreciation comes with a built-in risk - the danger that if you suffer big stock losses early in your golden years, you'll have to worry about running out of money.

If potential stock market losses are the problem, why not stick with bonds? After all, many investment-grade corporate bonds are paying out more than 5 percent. And some government bond funds are yielding almost that much. You could spend 4 percent, reinvest the remainder and keep your money growing, right? It's not that simple.

There's a reason bonds are called fixed-income investments. Over time, the income a bond portfolio generates won't rise much, which means you won't keep up with inflation.

Today's opportunity for income

A better strategy is to rely on income stocks. With a prudent, high-yielding equity portfolio, you won't have to worry about falling behind inflation. Nor will you have to care how the market performs, since you won't have to sell stock each year to pay the bills. You can simply live on the income your portfolio throws off.

There are other reasons to include high-yield stocks in your mix. Some may be getting hammered now - which is why their yields are so high - but in general, stocks that pay ample dividends hold up better than those that don't.

"When it looks like there's a bear market ahead, investors stop thinking about growth and start caring about preserving capital, so they pile into dividend-paying stocks where part of the return comes from income you can count on," says analyst Will Geisdorf at Ned Davis Research.

Because they resist major setbacks, high-yielding retirement portfolios tend to last longer.

Ned Davis Research recently crunched the numbers for Money and found that a high-yielding portfolio launched at the worst time in the past 40 years - before the 1973-74 bear market - not only would have kept your income growing at the pace of inflation but would have increased in value eightfold (assuming an initial withdrawal rate of 4.5 percent).

An S&P 500 portfolio, on the other hand, would have been used up by now. Over time, high-paying stocks also generate more income than government bonds. That's because while bond income is fixed, dividends aren't.

Companies typically increase dividends over time so your retirement income can stay ahead of inflation. "That can bring a lot of comfort to retirees who understand that they need some growth but also want fairly predictable income," says Christine Fahlund, senior financial planner at T. Rowe Price.

Until recently, though, this strategy was a nonstarter. Reason: The S&P's yield has been less than 4 percent for more than 20 years. But the market sell-off is driving up yields in certain sectors that have traditionally paid big dividends to begin with. For example, after plunging 20 percent this year through Nov. 19, large financial stocks have seen their average yields climb to 3.2 percent.

With a few of the higher-yielding bank stocks, mixed with some utilities and a couple of long-troubled drug stocks that are still paying out handsomely, a 4 percent dividend-paying portfolio is now within sight.

Constructing your portfolio - safely

If you want to put together a portfolio of high yielders, you may be smart to build slowly. The market slump that has pushed share prices down (and yields up) may not be over.

What to do now: In uncertain times it's important to make sure your portfolio is well diversified. The simplest step to take now is to buy the S&P Dividend SPDR (Charts), an ETF that spreads its bets among 52 stocks.

What makes this fund so attractive is that it tracks the S&P High Yield Dividend Aristocrats index, an elite group of stocks that have steadily increased their payouts over the past quarter-century. These include blue chips like Consolidated Edison (Charts, Fortune 500) and Coca-Cola (Charts, Fortune 500).

If a company can boost dividends every year for a generation, it should certainly be strong enough to survive the current market storm.

Moreover, only a third of the portfolio is invested in financial stocks, so you can benefit from the sector's high payouts without exposing all your money to its current troubles.

Safety has a price, though. The fund yields 3.5 percent, which is below the key 4 percent target. Still, you can use it as your core holding and then pump up your portfolio with higher-yielding securities.

To do that, you might consider investing in one of the more conservative high-yield bond funds like Vanguard High-Yield Corporate, which offers an attractive 8 percent yield. Also look at classic utility stocks, which have some of the same characteristics as bonds. Utilities overall are yielding less than 3 percent, but some high-quality names pay a lot more.

Integrys Energy Group (Charts, Fortune 500), which runs electric utilities and distributes natural gas in the Midwest, is yielding 5.2 percent. And Vectren (Charts), an electric and gas utility in Indiana and Ohio, is offering 4.5 percent. What to watch for in the coming months: Some of the best long-term opportunities to nudge your yield above 4 percent will be in stocks and other investments that will require a bit more patience.

David Katz, president of Matrix Asset Advisors, says, "There are two types of high-yield stocks - those like utilities that historically pay large dividends and those that have sold off so much that they happen to have high yields at the moment."

Financial stocks fall into the latter category and could report more bad news. Plus, their historical pattern during credit crunches suggests prices could be choppy until February or March.

But keep in mind that battered stocks also offer the greatest opportunity for gains. As long-term values, Katz favors Pfizer (Charts, Fortune 500) among the depressed drug giants and Bank of America (Charts, Fortune 500) among the financials weighed down with shaky loans.

A more conservative way to cash in on financials is through PowerShares Financial Preferred Portfolio. This ETF holds preferred stock in domestic and foreign banks.

Preferreds are like bonds - they're safe and pay high yields. Other industrials, such as DuPont and Leggett & Platt, a mid-size maker of furniture parts, also look attractive once the economy shows signs of picking up.

There's one last group to watch. Real estate investment trusts not only offer growth and fairly high yields, their property holdings also offer long-term protection against inflation.

Only trouble is, property prices could be weak for another year. A diversified fund such as Vanguard REIT Index fund is the safest way to invest in the group, but given current uncertainties, it's smarter to wait and watch.

You're going to be depending on your retirement portfolio for decades. You should be willing to spend a little time fine-tuning your holdings.

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