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For many, the definition of financial security is having a big enough savings nest egg to live off your income without ever having to sell off any of your investments. Unfortunately, it's exceedingly difficult to put that philosophy into practice, and trying to do so could make you take more risks with your money than you should.
Old-school retirement saving
It may seem like low interest rates have been around forever. But it really wasn't so long ago that conservative investors could expect to get a decent return on their money without putting a huge portion of their investments into the stock market. As recently as early 2010, 10-year Treasury bonds yielded almost 4%, with longer-dated Treasuries or higher-risk corporates offering substantial spreads above that level. Even bank savings accounts and CDs could get you 5% to 6% on your money if you were willing to lock it up for several years.
With rates in the mid- to upper-single digits, it wasn't that hard to put together a fixed-income portfolio that would meet a retiree's needs. If you needed an extra $2,000 per month (pre-tax) and could get a fixed-income investment yielding 6%, you'd need total savings of $400,000 to the income you needed.
That's obviously a lot of money. But it's a lot less than the $800,000 to $1.2 million that you'd need today, with prevailing interest rates closer to 2% to 3%. Put another way, if you've got $400,000 in savings today and still need that $2,000 per month, your income is going to end up more than $1,300 short. Nowadays, many retirees wish they'd accepted what seemed like typical rates and locked them in for the long haul.
Making ends meet
The insistence of retirees to try to preserve principal has helped boost the popularity of dividend-paying stocks. Like fixed-income investments, dividend stocks let you leave the "principal" of your share investment untouched, living instead on the dividend distributions your companies pay you.
The trade-off, though, is that the underlying price of dividend stocks moves around. As a result, the idea of preserving your principal isn't quite analogous. If you own individual bonds or other fixed-income securities, if you're willing to wait until maturity to get your money back, then you typically won't suffer a capital loss. Only if you sell early, or own a bond fund to invest, will you be faced with capital gains or losses. Even in that event, fluctuations in bond values tend to be less severe than what you'll see in the stock market.
It's easier than ever to get dividend yields that fit just about every budget. Want 4% to 5%? Blue chips Eli Lilly (NYSE: LLY ) and AT&T (NYSE: T ) can deliver the goods while having well-known names that elicit trust from the most conservative of investors. To get into the 6% to 8% range, diversifying into master limited partnerships can get you much of the way there. Pipeline companies Kinder Morgan Energy Partners (NYSE: KMP ) and Energy Transfer Partners (NYSE: ETP ) offer exposure to the booming energy sector in the U.S. and will prosper as more exploration and production companies need to bring their newly discovered products to market. Mortgage real estate investment trusts can even get you into the double-digit yields if you need them.
The wrong equation
But buying stocks based on dividends alone ignores another key component of smart investing: getting good valuations. Because of the premium for dividend stocks, those that don't pay dividends are actually cheaper right now.
One example is Western Digital (Nasdaq: WDC ) , which has largely recovered from natural disasters that hurt its business last year. Trading for less than seven times earnings, it doesn't pay a dividend, which has kept some investors away. Yet the shares have risen 60% in the past year, earning big profits for those willing to accept no current income.
The better way
To figure out a sustainable way to make your portfolio support you, the better strategy is to use what endowment funds and other long-term investors use: a withdrawal amount based on total assets. You can be just as careful, if not more so, by taking a fixed percentage of your total portfolio every year, selling off enough shares to generate the cash you need to live. Given the danger of expensive dividend stocks, the capital withdrawal strategy can even be safer.
You can't afford to take too big a percentage, though. The long-held 4% rule may not be perfect, but it's a reasonable starting point that you can then modify for your own particular needs.
In the end, the goal is making your retirement money last as long as it can. Low rates have been terrible for retirees. But by choosing investments based on total return rather than current income, you can stretch them as long as they'll go -- an important consideration in a tough economy.
Smart investing is a big part of the shift that retirees need to make. To learn more about retiring more securely, don't miss out on the Fool's special report on stocks that can help you retire rich. This free report is just a click away, so don't wait; read yours today.