Dividend Cut? Don't Panic!

For years, dividends have provided income investors with a huge portion of the regular cash flow they need. Yet in this era of diminishing dividends, many investors who once relied on quarterly payouts from their stocks may now wonder how they can make ends meet.

The past year and a half has seen a huge drop in the dividend-paying power of the stock market as a whole. As of late March, 46 members of the S&P 500 had cut more than $42 billion in dividends just in 2009 alone, eclipsing 2008's record $40.6 billion in cuts over the entire year. Total dividends could fall another 25% or more from 2008 levels.

Fleeing financials
The primary contribution to dividend fears has come from financials. Consider the dividend cuts that these major banks and other financial firms have made in recent years:

Source: Yahoo! Finance.

Unfortunately, the list goes well beyond the financials. Companies like Pfizer (NYSE:PFE) have cut dividends to help finance acquisitions, while other companies, including Precision Drilling (NYSE:PDS), have reduced payouts as a preemptive measure to preserve cash.

Given this rash of dividend cuts, it's no wonder that investors are spooked by dividend stocks. If you decide that you no longer want the risk of seeing those payouts disappear, what can you do instead to raise the cash you need?

Build a short-term reserve
The bear market has proven the importance of not relying solely on long-term investments like stocks. If you don't have any short-term investments in your portfolio to tap during hard times, you'll have no choice but to sell your stocks, even when they're trading at multiyear lows.

Building an income cushion can solve that problem, and help you weather the sort of storms we've seen lately. Here's how it works:

• Figure out how much money you need to cover your annual expenses.
• As you near retirement, aim to build a reserve of three to five years' worth of expenses. Rather than holding stocks with that reserve, keep it relatively liquid, in bonds, CDs, or other safe investments.
• Once you retire, you'll start drawing down cash from your reserve. Most of the time, you can replenish that reserve by selling stocks and other long-term investments. But if the market has fallen sharply, you'll at least have the option of delaying those sales until your investments rebound.

Whether or not you include dividend stocks among your long-term investments is up to you. If you do own them, the dividends they pay will mean you won't have to sell as many shares of your stocks to replenish your income cushion -- you'll already have the cash from those payouts.

Have it done for you
In fact, some mutual fund companies now offer payout funds that are designed to target a certain amount of income every year. With these funds, the fund manager decides how much of the needed income will come from dividends, then sells securities to make up the difference. That reduces the amount of effort on your part.

Even with these automatic payouts, you still need to pay attention to your investments. Unlike an immediate annuity, payout funds don't guarantee that your money will last for any fixed minimum length of time, and the amount of income you receive can fall over time as you use up your principal.

Go for total return
But payout funds do remind investors of one important thing: In the long run, it doesn't matter whether you make money from dividends or capital appreciation. All you care about is your total return.

Don't let dividend cuts spook you. With the right strategy, you can still get all the money you need from your portfolio.

For more on dividend stocks, read about:

• The riskiest dividend payers right now.
• These companies have safe dividends.
• 7 stocks that are swimming in cash.