Although the finish line and the road leading up to it are unique for every American, practically everyone hopes to someday retire comfortably and on their own terms. And one incredibly important component of a successful retirement plan is dividend-paying stocks.
Dividends payments signify a number of positive attributes about a company. For example, a company that regularly pays a dividend sends a message to Wall Street and investors that it is profitable and its business model has staying power. It has also established that management values the interest of the company's shareholders.
And more than just implying that a company is healthy, dividend payments help investors hedge against the stock market's inevitable downturns, and the payments can be reinvested into the same stock, supercharging investors' gains by accelerating their compound returns over the long term. A 2% dividend yield might not seem like much, but reinvested over four decades, it could translate into big money!
The allure, and risk, of high dividend stocks
Of course, retirees and pre-retirees typically aren't on the lookout for dividend stocks yielding 1% or 2%. During retirement they'd much rather have high dividend stocks yielding 4% or more that give them the potential to outperform inflation and collect additional income.
High dividend stock yields -- especially high-single-digit or double-digit yields -- are certainly appealing, but they can also be extremely risky. If a business model isn't built to deliver on a dividend consistently over the long run, then Wall Street and investors may end up throttling that stock's share price, potentially costing you more than you'll ever make from dividend payments.
With that in mind, let's take a look at a couple of categories of risky high dividend stocks for retirement that you may want to avoid.
Pharmaceutical royalty dividend stocks
Big pharma and pharmaceutical companies in general tend to be a big attraction for income investors because of their high margins. Developing novel drugs isn't a cheap process, so branded drugs often have high price tags that cover the cost of research, development, and manufacturing, as well as the failure of other drugs in a company's pipeline that didn't succeed.
Some companies specifically seek out or benefit from royalty payments that are tied to drugs approved by the Food and Drug Administration, and this can often result in substantial dividend payments. PDL BioPharma (PDLI) is dishing out an 8.6% yield, while Theravance (NASDAQ: THRX) is yielding 6.6%. But, in my opinion, both stocks are a nightmare for retirees.
The downside to a royalty-based dividend is that pharmaceutical products only enjoy 20 years of patent protection. The clock starts ticking when a company begins human clinical trials, meaning they'll lose valuable patent years while studying a drug. What's left can be just a few years of patent protection to perhaps a little over a decade in some cases.
In December, PDL BioPharma witnessed the expiration of its Queen patents (which covered its humanized antibody technology). Queen patents are responsible for a vast majority of PDL's revenue, accounting for $487.5 million of its $581.2 million in revenue last year. When the last of the wholesale stock of PDL's Queen-backed products is sold (most likely in Q4 of this year), its revenue and profits could plummet, putting its dividend in jeopardy.
Similarly, Theravance could also be in big trouble. Having developed a number of COPD/asthma therapies in collaboration with GlaxoSmithKline (GSK -1.32%), Theravance wound up spinning off its earlier-stage pipeline into a separate company, planning to turn Theravance into a dividend powerhouse. Unfortunately, the launch of Breo Ellipta hasn't been that great thus far, which in turn has brought down estimates across the board for Theravance. Making matters worse, Theravance took out a $450 million loan last year to help pay its dividend, thinking its COPD drugs would fire like a rocket out of the gate. This debt carries a whopping 9% interest rate until 2018, when it's due. This dividend stock looks like pure danger for retirees.
Oil and natural gas royalty trusts
Another area of potential danger to retirees is oil and natural gas royalty trusts.
Asset-based royalty trusts are often highly sought-after because they avoid paying high corporate tax rates so long as they return a substantial portion of their income to unitholders. But the concern with oil and natural gas-based royalty trusts is that they're wholly at the mercy of commodity prices, often have a pre-set production limit that may not grow during the life of the recovery, and are often set up to produce dividends for only a limited time period, meaning the share price of the royalty trust will eventually hit $0!
Take BP Prudhoe Bay Royalty Trust (BPT 3.60%) as a good example. Its current yield of 18.4% is certainly bound to turn some heads, but its precipitous share price decline in the wake of falling oil prices, which also affect its dividends, has been turning heads, too!
BP Prudhoe Bay is also at the mercy of the infrastructure in the North Slope of Alaska. If a pipe breaks or drilling equipment needs repair, it can mean reduced dividends for the Trust.
Most importantly, BP Prudhoe Bay Royalty Trust is only forecast to pay dividends through 2027. With time winding down on this Trust, investors may be forced to balance dividend income with share price declines. Not to mention that royalty trust interest and income are an added burden to deal with come tax time, because they're treated as an asset and not a stock-like investment.
Individual stocks can be a menace, too
Lastly, it's important for retirees to realize that risky high dividend stocks for retirement don't have to come from these two subsectors to be dangerous.
Turning back to GlaxoSmithKline, it's a giant pharmaceutical company that pays out a 5.6% yield on a trailing 12-month basis. However, it also lost patent protection on COPD/asthma drug Advair/Seretide years ago. In 2014, Advair/Seretide delivered $6 billion in total sales. By 2016 a generic version is expected to hit the market in the U.S., causing a rapid erosion in Advair sales and significant declines in Glaxo's EPS. Based on its trailing dividend payout and Wall Street's projected EPS of sub-$2 in 2017, GlaxoSmithKline could be facing a sizable dividend cut.
This could be the type of individual stock that people will want to avoid during retirement.
One thing worth keeping in mind
It's important to remember that not all high dividend stocks are necessarily risky investments that you should avoid. However, when the dangling carrot is bigger at one company than at 95% of all other traded companies, you have to dig deeper and find out why. If that question can't be answered, it's probably a smart move to avoid that stock for retirement.