Enhanced Dividend for Income

“FOLLOW THE COURSE OPPOSITE TO CUSTOM AND YOU WILL ALMOST ALWAYS DO WELL.”

JEAN-JACQUES ROUSSEAU

It is axiomatic in the financial planning canon that investors searching for a steady source of income should rely heavily on bonds. Stocks are for capital appreciation and bonds for income. The practice is so ingrained, that I have not heard of many investors who would make the case for using an equity portfolio to generate income. Bonds also appeal to advisors because of their inherent principal protection advantage. As a bond owner, you are a creditor, not an owner. If you buy relatively riskless securities like 10-year Treasury notes from the U.S. Government, you face an almost 100 percent chance that your principal will be returned to you in ten years. Of course, riskier bonds with lower ratings (“junk” bonds) are available with much higher yields, but with these instruments, you face a much greater risk that you could lose a good portion of your principal if the bond defaults.

For me, the problem with fixed income investments is that they arefixed. Once you lock in a yield—if you hold the bond to maturity—you will receive the same coupon payment for the remainder of the bond’s life. While that might work fine in a stable economic environment with low inflation, it becomes a big problem if inflation is consistently reducing thepurchasing power of your annual earnings. Since the early 1970s, the inflation rate in the United States has been 4.41 percent. That means that something that cost one dollar in 1970 now costs $5.36! Someone who put their entire savings in U.S. Treasury bonds hoping to live off the income would find themselves unable to do so because of the savage effects of inflation over the period. Since, if you consume the income generated by the bonds, you always get back just what you invested, with no principal growth in the value of your portfolio, you have no way to make up for what is being lost to inflation. With current government deficits and debt running amok, expecting inflation rates toremain low is wishful thinking—indeed, given current trends, it is morelikely that inflation will be significantly higher over the next ten to 20 years than it was from 1970 until now.

I believe that investors and financial advisors should shift their focus from bonds to finding an investment that could continually grow income over time. That is why I decided to turn orthodoxy on its head and look primarily at the income benefits of our Enhanced Dividend strategy. Rather than focus on what happens to the total value of a portfolio from year toyear, I decided to look at what happensto just the income portion to see if we could see a pattern.And oh boy, did we find a nice pattern! Starting on December 31,1969 (where our ability to backtest monthly data begins), what would happen to an investor’s annual income if they simply invested in the strategy and consumed all of the dividend?Before we look at the results in Table 1,let me enumerate some simple assumptions:

I assume a lump-sum investment similar to what you have by rolling over a 401(k) into an IRA;
I assume the vehicle we are using to invest is similar to a Roth IRA for individuals or a charitable or similar tax-free institution for institutional investors;
I assume that the investor receives a payout which equals the realized dividend yield of the portfolio as of December 31. Dividends can go up or be cut, and in the real world we would take actions around the dividend cut, but for our illustration here, we assume we get the realized dividend yield and consume it entirely over the course of the year. I also present the results on a gross basis that ignores transaction costs and fees.

As you can see in Table 1, by implementing the Enhanced Dividend strategy and simply looking atwhat is happening to your annual income, you see that, on average, the strategy generates a 10.6 percent pay raise year after year. Between 1970 and 2012, there were 11 occasions (highlighted in red) when your income declined from the previous year. What’s more, this consistent increase occurred despite the fact that the principal value of your portfolio declined in nine of the 42 years covered (shaded blue/gray in the table). Interestingly, income declined onlyonce when the value of the portfolio also declined! Look at what happened over the entire period—income generated by the portfolio starts at a modest $13,957 in 1970, butsoars to $627,741 by 2012! There are ten years where income increases by more than 20 percent, yet the average decline in income was 9.1 percent.

If you look at the rollingten-year increase in annual income, you see that thelowest ten-year increasewas 98 percent for the ten years ending 1980. On average, ten-year annual income increased 187 percent over all rolling ten-year periods.

The reason this works so well is because of a similar phenomena we see with bonds—when bond yields go up, bond prices decline. With stocks, when stock prices decline, dividend yields go up. But since stock prices generally go up (approximately 70 percent of the time since the founding of the New York Stock Exchange in the late 1700s) you have the added advantage of growing your principal as well as your income over time. Indeed,we see that even with the worst decadefor stocks in 110 years, the value of the portfolio—with a starting value of$250,000 in 1970—grew to $10.7 millionat the end of 2012. And since we are consuming all of the income from the portfolio, nearly all of that $10.7 million was from capital appreciation alone.

Compare these results with those featured in Table 2 where an investor simply bought and held the Barclays Aggregate Bond Index over the same 1970 to 2012 time period. While it isunlikely that an individual investor would simply buy and hold a bond index for 43 years, other strategies tested yielded similar or lesser results over the total period. Bond total returns are heavily reliant on income reinvestment; therefore, no matter what bond strategy you choose, consuming the income erodes purchasing power and income growth over time.

Because your principal is returned toyou when the underlying bonds mature,your base $250,000 is relatively stable. Whatdoeschange is thevalue ofthat $250,000—for your $250,000 investment to have the same purchasing power in 2012 as it did in 1970, it would have to grow to $1,564,785! By simply using bonds to generate income, your nest egg is still worth just$389,736 and that generates a mere $7,820 annual income, hardly the typeof income that leads to a life of leisure.

Look at the differences in total income consumed and total cumulative increase in income since 1970: with the Enhanced Dividend strategy, you would have consumed $8,938,135 over the period and seen your total annual income increase by 4,398 percent since 1970. With the bond approach, you would have consumed $876,771 in total income and seen your annual income decrease by

62 percent since December 31,1969. What’s more, as inflation raged on you would have had to endureincome declines of 12 percent in 1993 and

21 percent in 2003 as rates on bonds dropped.

Now, many might argue that people investing in fixed income don’t invest

in a vacuum—what if, when the yield on long-term U.S. Treasury bonds increased to 15.32 percent in September 1981, our hypothetical investor locked in those much higher long- term rates? Not counting the loss of principal he would have to take by selling his existing bonds at below face value because rates had been skyrocketing, he would not be that much better off—his total consumed wealth would increase just $124,312 and his annual income from the investment would be astatic $38,300 for the next ten years while Enhanced Dividend’s income would grow by 185 percent. Clearly, despite the more volatile nature of stocks, theyoffer a much more consistent approachto growing both income and principal.

If you are an investment advisor, youmight be wondering how you could havestopped clients from panicking in 2008. Had you positioned an investment in the Enhanced Dividend strategy by focusing on the income it generates, and making that the primary objective, you probably wouldn’t have to be talking clients off the ledge. You could remind your clients that in one of the worst years for stocks since the 1930s, their income from that investment had actuallygone up.Rather than the $713,219 they got to spend in 2007, they could look forward to spending $814,839 in 2008. This is an increase of 14.25 percent. Anincreaseof anything in that horrible year would feel like a very good thing. And why

did income increase? Quite simply, income from Enhanced Dividend went up because dividend yields climbed as the market fell.

What if the client argues that the value of their portfolio plunged from $12.85 million to $7.58 million? You give the same answer—the principal value of the portfolio is not itsprimary objective—growing your annual incomeat a consistent rate is theobjective, and it achieved this primary objective in a horrible year for stocks.

By changing what your client is focusingon, you will have a much easier time keeping them in the program. And by that reasoning, this is a strategy that achieved its primary objective of increasing annual income in 32 of the 43 years of the study, and when it did fail to increase income, it was, on average, a decline of just 9.1 percent.

Of course, you might also argue that while it’s great to see how this strategy performed since 1970, your clients do not have the time advantage of 43 years of compounding. Say you have a 65-year-old client who needs to live off his income over the next ten years, how might things look for him? On the following page, Table 3 answersthat question by assuming that your client will have to live through another decade that was as bad as the last one. We start with the same $250,000 investment on December 31, 1999 and run it for the ten years ending December 31, 2009. Remembering that the last decade was the worst

for stocks in 110 years, this should provide a nice “worst-case scenario.” In this worst-case decade, total income earned by the portfolio increases, on average, by 14 percent a year, and only has two years where income declines. Even so, the cumulative increase in income from December 31, 1999 to December 31, 2009 is 194 percent! Thus, you would have successfully achieved your primary objective of increasing you client’s income in eight out of ten years during the worst decade for stocks in 110 years. Imagine what you might be able to achieve for your client if returns over the next ten years prove to be better than those in the previous ten.

Compare the Table 3 results with those of another hypothetical client who had elected to follow the bond strategy who would have invested $250,000 in the Barclays Aggregate on 12/31/99 yielding 7.41 percent. That unfortunate investor would have seen his annual income decline from the $18,525 a year he would have earnedin 2000 to just $11,882 in 2009 becauseof a decline in interest rates in that year. Adding insult to injury, his principal value would have risen just 13 percent in 10 years—whereas your Enhanced Dividend client’s

would have increased to $571,434.

All during the worst decade for stocks in 110 years!

A Great Strategy for Charitable Trusts and Foundations

Imagine how well this strategy would work for a wealthy client setting up

a Charitable Remainder Trust (CRT) or a Charitable Lead Trust. With a Charitable Remainder Trust the beneficiaries receive the income from the trust for a pre-specified period of time and then the principal value of the trust is claimed by the charity that received the donation. Table 4 looks at the effect of setting up a CRT with a $10 million gift. Your client gets to deduct the gift and yet the income that the beneficiaries of the trust receive over the next 24 years amounts to $57.3 million and the principal the charity gets to use is $74.3 million!

With a Charitable Lead Trust, it would be the charity that enjoyed the benefits of the $57.3 million in income and your heirs the $74.3 million in principal value at the end of the trust’s life. In each case, there are multiple benefitsto the donor, his or her charity of choice and the beneficiaries of the donor. Slicing out a portion of aFoundation’s investments and following this approach would have equally beneficial effects.

What AboutTaxable Investors?

We generally use the simplifying assumption (as stated above) that investments are being made in a tax-free vehicle, since everyone faces different tax rates. Yet I also think this strategy is appropriate for taxable accounts, so we also looked at returns for an investor in the top projected tax rate (please see Table 5, page 7).

(The maximum expected dividend tax rate for 2014 and after is 23.8 percent, with capital gains tax expected to also be 23.8 percent. We retroactively applied these rates to the portfolio starting on December 31, 1969 for Enhanced Dividend. For the bond strategy of buying the Barclays Aggregate, we assume a 43.4 percent tax on income and a 23.8% tax on capital gains.)

For the entire period December 31, 1969 through December 31, 2012,

an investor using the bond strategy and paying tax on the income wouldconsume—after tax—a total of $472,756in income. His after-tax income in 2012 would be a paltry $4,010. Because there was little capital appreciation, thevalue of his portfolio would be $351,296,a fraction of the $1,564,785 he wouldneed it to be to just break even with inflation. His 2012 total after-tax income was $7,720 lower than what he earned in 1970.

Once again, an investor using the Enhanced Dividend strategy for income found himself in a much better financial position. After paying capital gains taxes and 23.8 percent on his dividend income, he would have consumed $2,510,569 in total income and the principal value of his portfolio—again, after tax—would be $4,469,487. His annual after-tax income would have increased by 1,780 percent to $148,496 in 2012. The annual increase in after-tax income would have been 8.19 percent and the average ten-year increase would have been 127 percent. By adding taxes to the equation, thenumber of years where income declinedwent up by just one occurrence— to 12 years out of 43; thus, after-taxincome increased in 31 of the 43 years.The average drop in the 12 years that income declined was 9.1 percent. His total after-tax income of $148,496 in 2012 was $140,596 higher than the $7,900 he earned in 1970. An investor following this strategy would have paida total of $1,599,305 in capital gains taxes and $1,055,681 in dividend taxes, for a total of $2,654,986 in taxes to Uncle Sam.

Clearly, even taking taxes into account, the strategy still offers a tremendous return and consistent way to increase income year after year and a vastly better return on the principal of the portfolio.

The key element in letting a strategy like this work is getting your client to focus on the primary goal: increasing annual income from the investment.

If you can achieve that, clients will be far less likely to panic when the market declines in value, since for the most part, their income from the investment will not. Point to what happened after the 2008 collapse—income increased. Stress that you are working to endow their future with ample income to pursue the passions and avocations that they have developed over a lifetimeof successful work. Goethe said that “Many people take no care of their money till they come nearly to the end of it, and others do just the same with their time.” Convince your clients that using this strategy will help them with both.

General Legal Disclosure/Disclaimer andBacktested Results

The material contained herein is intended as a general market commentary. Opinions expressed herein are solely those of O’Shaughnessy Asset Management, LLC and may differ from those of your broker or investment firm.

Please remember that past performance is no guarantee of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this presentation, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for any portfolio. Gross of fee performance computations are reflected prior to OSAM’s investment advisory fee (as described in OSAM’s written disclosure statement), the application of which will have the effect of decreasing the composite performance results (for example: an advisory fee of 1% compounded over a 10-year period would reduce a 10% return to an 8.9% annual return). Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this presentation serves as the receipt of, or as a substitute for, individualized investment advice from OSAM. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that any account holdings would correspond directly to any comparative indices. Account information has been compiled solely by OSAM, has not been independently verified, and does not reflect the impact of taxes on non-qualified accounts. In preparing this presentation, OSAM has relied upon information provided by the account custodian and/or other third party service providers. OSAM is a Registered Investment Adviser with the SEC and a copy of our current written disclosure statement discussing our advisory services and fees remains available for your review upon request.

Hypothetical performance results shown on the preceding pages are backtested and do not represent the performance of any account managed by OSAM, but were achieved by means of the retroactive application of each of the previously referenced models, certain aspects of which may have been designed with the benefit of hindsight.

The hypotheticalbacktested performance does not represent the results of actual trading using client assets nor decision-making during the period and does not and is not intended to indicate the past performance or future performance of any account or investment strategy managed by OSAM. If actual accounts had been managed throughout the period, ongoing research might have resulted in changes to the strategy which might have altered returns. The performance of any account or investment strategy managed by OSAM will differ from the hypothetical backtested performance results for each factor shown herein for a number of reasons, including without limitation the following:

  • Although OSAM may consider from time to time one or more of the factors noted herein in managing any account, it may not consider all or any of such factors. OSAM may (and will) from time to time consider factors in addition to those noted herein in managing any account.
  • OSAM may rebalance an account more frequently or less frequently than annually and at times other than presented herein.
  • OSAM may from time to time manage an account by using non-quantitative, subjective investment management methodologies in conjunction with the application of factors.
  • The hypotheticalbacktestedperformance results assume full investment, whereas an account managed by OSAM may have a positive cash position upon rebalance. Had the hypothetical backtested performance results included a positive cash position, the results would have been different and generally would have been lower.
  • The hypotheticalbacktestedperformance results for each factor do not reflect any transaction costs of buying and selling securities, investment management fees (including without limitation management fees and performance fees), custody and other costs, or taxes – all of which would be incurred by an investor in any account managed by OSAM. If such costs and fees were reflected, the hypothetical backtested performance results would be lower.
  • The hypothetical performance does not reflect the reinvestment of dividends and distributionstherefrom, interest, capital gains and withholding taxes.
  • Accounts managed by OSAM are subject to additions and redemptions of assets under management, which may positively or negatively affect performance depending generally upon the timing of such events in relation to the market’s direction.
  • Simulated returns may be dependent on the market and economic conditions that existed during the period. Future market or economic conditions can adversely affect the returns.

Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise. High Yield bonds are speculative non-investment grade bonds that have higher risk of default or other adverse credit events which are appropriate for high risk investors only.

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