One of the scariest parts of retiring is figuring out how to live on a fixed income. Most annuities or company pensions (if you have one) at best provide consistent payments for life, and while Social Security usually provides an inflation adjustment, in 2016, it won't. To add to that concern, there are serious questions as to whether Social Security's inflation increases sufficiently to cover the inflation felt by senior citizens.
In a very real sense, living on a fixed income means facing financial death by a thousand papercuts as inflation slices away at that income's ability to cover your costs. To break free of that trap, you need an investing strategy that gives you a legitimate chance of seeing your income grow over time -- even after you've retired. There are no real guarantees in investing, but there's one investing strategy that focuses on dividend growth that gives you a good chance of getting that raise, every year.
What to look for in growing dividends
Key to a strategy focused on an increasing income stream is to own shares of companies that pay, have increased, and look capable of continuing to increase their dividends over time. While past performance is no guarantee of future results, a track record of increasing dividends is worth looking for.
After all, dividends don't just happen. It takes action by a company's management to put the company in the position of having more cash available to pay a higher dividend, and it takes action by its board of directors to approve the higher payment. A decent track record of increasing dividends tells you that the company's management and its board are actively taking steps to make that happen.
Still, a track record of dividend growth isn't enough by itself; you also need to have a reason to believe the trend can continue. For that, you'll want to look at a few additional measures, key of which is the company's payout ratio. A company's payout ratio simply divides its dividend per share by its earnings per share to tell you what portion of its earnings it is paying out to its owners.
This is important because companies can use the money they're not paying in dividends to grow their business and provide the foundation for future years' potential dividend increase. Too much paid out means too little retained to invest for future growth, and less chance of an increase in the future. In general, you'll want to look for companies with payout ratios below about two-thirds of earnings, though companies with special structures like Real Estate Investment Trusts can handle higher payouts.
On top of the direct dividend measures, you'll want to make sure the company is capable of withstanding the inevitable bumps in the road that the economy hits from time to time. Because dividends aren't guaranteed payments, if times get tough, they can be cut. The stronger a company's balance sheet, the better its ability to maintain rather than cut its dividend during short-term bumps in the road.
While judicious use of some debt can help a company grow more quickly than it could simply by reinvesting its profits, too much debt can impede its ability to survive those bumps in the road. As a result, one key balance sheet metric to look at is the company's debt-to-equity ratio. If that ratio starts to creep above 2-to-1, you need to consider whether it will have the ability to keep its dividend intact if times get tough.
In addition to the financial metrics, you'll need to know enough about how the company makes its money to understand whether you have a true reason to believe it can continue to grow. A company that makes its money laying copper telephone wires would need to seriously reinvent itself to remain relevant in today's cellular world. On the flip side, one focused on building and operating nursing homes is playing into an aging demographic trend that's expected to continue for decades.
It's about more than just the dividends
While the core concept of dividend growth investing is simple, the challenge comes from the fact that dividends are not guaranteed payments, and companies can and do cut their dividends if times get tough. That makes it a bit more complicated than simply picking at random off of one of the available lists of dividend growth companies.
To protect against that risk, you need to add two key factors on top of the strong dividend characteristics into your portfolio management plans: valuation and diversification. Valuation matters because you want the company's stock to be supported by more than just its dividend payout. If a company's dividend does get cut, its share price will likely drop. If a company looks reasonably valued based on other fundamentals, even without its dividend, it can reduce the severity of that decline.
Diversification matters because investing is all about predicting the future, and nobody gets it right 100% of the time. Consider General Electric (NYSE:GE), one of the largest and most followed companies in the world. Before the recent financial crisis, GE sported a top-notch AAA debt rating and had over seven decades of a stable or growing dividend under its belt. During the crisis, however, even GE stumbled enough to both lose that debt rating and slash its dividend.
Of course, GE has largely righted its ship since then, has resumed increasing its dividend, and is actively divesting much of the financial arm of its business that got it in trouble during that crisis. Still, an investor overly concentrated in GE stock before the crisis would have seen a substantial income reduction during the crisis, along with a stock price that collapsed, making it difficult to recover that lost income elsewhere.
The portfolio that can give you raises
By focusing on just a handful of key factors:
- A history of growing dividends.
- Financial and operational reasons to believe that dividend growth can continue.
- A sufficiently strong balance sheet so those dividends aren't quickly jeopardized by unfavorable economic conditions.
- Valuation and diversification to protect yourself against those times when a company in your portfolio does falter.
...you can set yourself up to have a very good chance to get those raises every year, even after you've retired. There are still no guarantees in investing, but it's better to give yourself a fighting chance than to simply accept the financial death by a thousand cuts that you'd face on a truly fixed income.
Chuck Saletta owns shares of General Electric Company. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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