As you grow older, the toughest thing you'll face in your investing life is the shift from trying to grow your investments as quickly as possible, to figuring out how to make them produce enough income to pay your living expenses. Even though there are many different methods for generating income, one remains the most effective by far in paying a healthy cash stream to investors year in and year out.

Income shortages
Unfortunately, it's really hard for those who need it to earn an income from their portfolios right now. If you look at money market funds in your brokerage or mutual fund accounts, you'll see that most of them pay only a pittance above zero. At an interest rate of 0.01%, for example, you'd earn less than a dime a month on $10,000.

Say you need to generate an annual income of $40,000 -- a quite comfortable sum as a supplement to Social Security and a pension, or just a way to cover basic needs, depending on your particular financial situation. To do so in a money market fund paying 0.01%, you'd need a staggering $400 million to come up with that $40,000 annually.

Short-term Treasury bills aren't much better. At current rates between 0.12% and 0.18% for three- and six-month bills, you're looking at $1 to $1.50 per month in income. It'd take between $23 million and $33 million invested in T-bills to generate the $40,000 in annual income you need.

Getting longer -- but not stronger
If you're willing to lock up your money for somewhat longer periods of time, you can at least get yourself out of the sub-1% rut. The average rate on five-year bank CDs is just less than 3% right now, reducing the size of your needed nest egg to just $1.3 million. On a 30-year long Treasury bond, you can get 4.5%. It'd take less than $900,000 worth of those bonds to generate $40,000 annually from now until 2040.

Going long with your fixed-income investments, though, is a problem in itself. After all, most people can't be satisfied with a fixed annual income throughout their retired years; they need their income to rise steadily in order to keep pace with overall inflation and higher prices in the particular things they want and need. Even high-yielding corporate bonds from issuers like Frontier Communications (NYSE: FTR) and AES (NYSE: AES), with yields in the 6.5% to 8% range, will slowly see the purchasing power of the fixed income they pay erode over time. And if something happens with those risky issuers, then you could see big unexpected hits to both interest and principal payments -- at exactly the time you're least able to handle them.

Not just income. Growth in income.
In order to pay you what you need to get by in retirement, you don't just need an income. You need an income that will grow with the costs you incur. With uncertainties about big items like energy, housing, and medical costs, nearly every major category of expenditures is something you can't completely control. To cope with that, you need income that will stretch over the years to match increases in the bills you pay.

Nothing does that job quite like dividend-paying stocks. You can match or beat the yields on even high-paying dividend stocks with other investments, but what's tougher is finding the growth those dividends have seen over the years. Take a look:

Stock

Current Yield

Growth Rate in Dividend Payments Over Past 5 Years

Total SA (NYSE: TOT)

5.7%

10%

Sanofi-Aventis (NYSE: SNY)

4.4%

25%

Exelon (NYSE: EXC)

4.7%

10%

Paychex (Nasdaq: PAYX)

4.1%

22%

Reynolds American (NYSE: RAI)

6.8%

15%

Sources: Yahoo! Finance, DividendInvestor.com.

With a portfolio of dividend stocks paying 4% to 5% in yield, you can produce $40,000 in income with between $800,000 and $1 million. More importantly, though, if that stock portfolio manages to continue its dividend growth at 10%, then next year, you'll get $44,000 in income -- exactly the kind of boost you need to keep up with rising costs.

The right mix
For most investors, dividend stocks shouldn't be the only thing you own in your retirement portfolio. But as a way to provide income, you should definitely consider owning some dividend stocks. As a smart way of meeting your income needs while also giving you the growth that's so essential to your long-term financial success, it's hard to beat the power of dividends.

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Fool contributor Dan Caplinger is a known cheapskate. He doesn't own shares of the companies mentioned in this article. Exelon and Paychex are Motley Fool Inside Value selections. Paychex and Total SA are Motley Fool Income Investor picks. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy pays the best dividends you could ever ask for.