What's Killing Your Retirement

For retirees and those approaching retirement, the state of the market must be terrifying.

Consider:

• 10-Year Treasury Notes are yielding a paltry 3.6%.
• The S&P 500 has dipped 8% since last March.
• Inflation currently stands at 4.3%.
• The average gallon of gas costs $3.23 nationwide.

In other words, everyone's buying power is diminished as common expenses like gas and food prices surge. But because retirees rely on withdrawals from principal and interest income to maintain their lifestyles, a declining stock market combined with low interest rates can end up being a retirement killer.

Dollar-lost averaging
Markets like these hit retirees particularly hard. If Joe Retiree sells stocks to supplement his income in a bear market, he'll have fewer shares left to appreciate when the market picks back up. To compound the problem, that also means he'll be left with less principal to invest in interest-bearing bonds later on.

In their book All About Dividend Investing, authors Don Schreiber Jr. and Gary E. Stroik call this phenomenon "dollar lost averaging":

As the stocks go down, you have to sell more of your position and begin liquidating more of your capital base in order to meet the given income need. ... When you have bear markets ... you eviscerate so much of your capital base you may never be able to recover.

So what is a retiree to do?
As the title of their book suggests, Schreiber and Stroik recommend dividend-paying stocks as an income-generating alternative to either buying bonds or selling stocks during retirement.

With dividend-paying stocks, the retiree hangs onto the shares and receives preferable tax treatment (qualified dividends are currently taxed at a maximum of 15%), while receiving better yields to bonds in some cases.

Consider these S&P 500 components with dividend yields greater than or equal to the current 10-year Treasury rate of 3.6%:

Not so fast ...
None of this means retirees should run out and buy stocks based on their dividend yield alone. Stable dividend payments, after all, are not guaranteed, as we've seen with Citigroup (NYSE: C) and MBIA (NYSE: MBI) recently.

That's why it's still important to find stocks that are undervalued, that have a proven dividend track record, and that have room to increase their dividend payments -- Johnson & Johnson (NYSE: JNJ), for instance, has increased its dividend for 45 consecutive years.

Of course, investors should remember that dividend-paying stocks are, after all, stocks -- they naturally come with a bit of volatility. Investing in stocks is never a short-term strategy, and investors have to be prepared to ride out swings in the market.

Over the long term, however, the opportunity to keep inflation at bay throughout retirement is a worthwhile tradeoff for the volatility of dividend-paying stocks. Don't forget, too, that bonds also fluctuate in value until maturity.  

The middle way is key
Used in combination with fixed-income products, dividend-paying stocks can not only maintain capital appreciation during retirement but can also support capital preservation, which becomes more important as retirement progresses.

The question of appropriate diversification -- how much of your portfolio to dedicate to stocks -- can be challenging, especially since your needs will change during the course of your retirement. That's where our Motley Fool Rule Your Retirement service can help.

Advisor Robert Brokamp will help you understand everything from what to hold in your Roth IRA to proper asset allocation. If you're ready to learn more about how to protect your assets in every market, we offer a free 30-day trial of Rule Your Retirement.

Fool contributor Todd Wenning is a firm believer that Apple Jacks are a part of a balanced breakfast. He does not own shares of any company mentioned. Pfizer is a Motley Fool Inside Value pick. Pfizer, Johnson & Johnson, and Duke Energy are Income Investor choices. The Fool's disclosure policy rules Fooldom.