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How are you really going to fund your day-to-day expenses in retirement?
A recent Wall Street Journal report pointed out something that has been on my mind lately, as my parents prepare to retire. They're in pretty good shape, financially speaking, and one key source of their income will be the pension that my dad is set to receive from a former employer.
Many people who are now in or close to retirement have a pension that will fund part (in some cases, a big part) of their retirement income needs. Often, these folks are able to get by quite comfortably on (mostly) pension income while taking only the minimum distributions from their 401(k) plans and IRAs.
But pension plans began to fall out of favor a couple of decades ago, and lots of employers have long since done away with them entirely. As the Journal pointed out, that means that there are an awful lot of people approaching retirement who don't have a pension, and who will need to rely on their retirement savings to pay the expenses that their meager Social Security payments won't stretch to cover.
That can be a challenge. But investing in dividend stocks -- before and during retirement -- and letting the dividends contribute to your income once you're retired can be a great way to meet that challenge.
The power of dividend stocks
The best dividend stocks -- those of steady, blue-chip companies with long histories of increasing dividends -- have advantages for folks near or in retirement that few investments can match. Those advantages start with the dividends themselves, of course, which can be reinvested for extra growth until you need to start taking them as added income.
That added growth can be significant. Electricity giant Consolidated Edison (NYSE: ED ) is a slow-moving stock, like most utilities, but it also has a dividend yield of over 4%. If you had reinvested it, your return over the past decade would have been about 150%. And this is a utility stock that's far from perfect -- hardly a stock you'd pick for growth on its own. But with stocks like Con Ed or pharmaceutical giant Eli Lilly (NYSE: LLY ) , which has ahigh but sustainable dividend yield of about 5%, that fat dividend can be reinvested to drive solid portfolio growth before you retire -- and then turned into the income stream you need once you need it.
One of my favorite illustrations of the power of dividend reinvestment is what Procter & Gamble (NYSE: PG ) has done over the past 10 years. If you look just at the stock price, Procter & Gamble rose about 75% -- but factor in dividend reinvestment, and that turns into an even nicer 125% gain. This consumer-products giant has increased its dividend for 55 years running, and it's a great stock to hold in tough economic times like these.
Solid growth, without "growth stock" volatility
Consider: The Dow Jones Industrial Average (INDEX: ^DJI) has risen about 27% over the past 10 years. That's not bad, though it's arguably a little misleading if you think about where the stock market was in October 2001, after the dot-com crash and the 9/11 attacks. Still, it's a better return than some funds have seen.
But compare that with a great stock like McDonald's (NYSE: MCD ) , which has tripled in value over that period thanks to strong global growth -- even before we factor in its dividend. (With the dividend, it would have quadrupled.) That's a superb rate of return. And the best part, for folks in or near retirement, is that unlike the latest "hot growth stock," growth at McDonald's is likely to come with less volatility during market turbulence, and less risk of a big implosion should something go wrong. And it keeps coming even after you start using the dividends as income.
The power of rising dividends
What's more, many companies that regularly increase their dividends tend to see their stock prices rice over time. ExxonMobil (NYSE: XOM ) hasn't had quite the run that McDonalds has, but it has still roughly doubled in value over the last 10 years, thanks to earnings-per-share growth that averaged 13% a year and funded those rising dividends. Likewise, Air Products & Chemicals (NYSE: APD ) , a big supplier of industrial and medical gases that has raised dividends every year for the past 29 years, has more than doubled over that same time. And in both cases, that growth doesn't count the dividends, so it's growth you would have seen even if you had been taking the dividends as income.
And those long histories of rising dividends? Every one of the stocks I've mentioned is on the Standard & Poor's list of "Dividend Aristocrats" -- companies that have raised their dividend payments every year for at least the past 25 years. Most of the Dividend Aristocrats should make great investments for years to come. That's not just because of the rising dividend payments themselves, but also because those rising dividends will tend to attract more investors over time -- and that, in turn, should help drive the stock's price as well.
Getting growth even when the market has stalled
Finally, even in times like these when the market's not cooperating, dividends can still power growth. As Foolish retirement guru Robert Brokamp recently pointed out to me, even if you assume that stock prices will stay absolutely flat -- unchanged -- a portfolio of dividend stocks with an average yield of 3% can generate annual returns of 8% or more over time, if you pick the right stocks (those with reliable, rising dividends) and reinvest the proceeds.
If you're not feeling ready to buy individual stocks, or just want to skip the research now that you're retired, a well-constructed dividend ETF like Vanguard High Yield Dividend (NYSE: VYM ) can give you some of the same advantages these great stocks offer, including a solid yield and lower-volatility exposure to the stock market -- along with some diversification. Don't hesitate to check out that option if it feels right for you. And for more on exchange-traded funds, grab your free copy of The Motley Fool's special report on ETFs. You'll find the names of three ETFs that Motley Fool analysts have identified as solid bets for the long haul.