How Dividend Stocks Can Help You Retire

By Markets Fool.com

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Dividend stocks can play an incredible role in helping you retire comfortably, but not necessarily the way you think. On the surface, they look tempting. In today's low-interest-rate environment, it takes a 10-year U.S. Treasury bond to even approach the yield you can get by owning a typical S&P 500 stock. If you make investments that focus on dividends, you can collect even more cash from your stocks than you would by investing in that market-tracking index.

On top of that, dividends have the potential to increase over time -- and if you choose wisely, that income will be accompanied by capital appreciation. Add yields comparable to, or even higher than, those of bonds, and the case for owning dividend-paying companies starts to look compelling.

These properties look particularly tempting for retirees, who tend to value steady income and avoid the risk of being forced to sell stocks in a down market to generate cash. If you can get enough income from dividends to cover your costs and enough income growth from dividend increases to beat inflation, then it looks like you can get what you need in a single package.

What could go wrong?
Unfortunately, that theory tends to hold true until a certain point -- and then fail catastrophically. The issue is that dividends aren't guaranteed payments. When it comes to corporate capital-allocation, they're about the lowest priority of them all. Debt, suppliers, salaries, and all the other operational and financial costs of doing business have to be covered first, and then if there's money left over, a company may pay dividends.

In good times, it's easy for companies to pay and increase their dividends. In tough times, the stronger companies out there may be able to continue the trend, but many others fall by the wayside. And when we have a financial crisis like the one we faced in the past decade, all bets are off.

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General Electric , for instance, was once considered to be among the top-tier dividend-paying companies around. In its heyday, it raised its dividend for decades and had a top-tier AAA debt rating. In the recent financial crisis, however, we found out that GE had been relying too heavily on its financial arm, rather than growth in its core industrial business, to juice profits.

When the financing spigot got turned off in the crisis, GE was forced to slash its dividend. Along with its dividend cut came a free fall in the stock price -- from more than $40 a share to less than $10. And as awful as that sounds, GE was actually one of the survivors and is well on the road to recovery.

Other companies, like Washington Mutual -- at one time one of the largest banks in the U.S. -- didn't make it. Still others, like Citigroup , survived only due to a government bailout, and that particular titan still hasn't restored its dividend.

So how should you use dividend stocks?
The secret to using dividend stocks as part of your retirement portfolio is to use those dividends for two purposes: as signals and as a source of capital to reinvest elsewhere in your portfolio. From a signaling perspective, dividends are at least as valuable for what they tell you about a company as they are for the cash they hand you. Here are things to look for from a signaling perspective:

  • Payout ratios: For ordinary companies, payout ratios above 70%-80% often suggest that a company is starting to struggle to fund its dividend from its operations. In the short term, a high payout ratio can be caused by legitimate "one time charges," but if it persists, it's a sign that further trouble may be brewing.
  • Growth rates: Over time, a company's dividend can only sustainably grow as fast as its ability to generate cash. If a company is saying optimistic things but only anemically increasing its dividend -- or even missing expected dividend increases altogether -- chances are that its dividend is telling the true story.
  • Yield: If a company's dividend yield is substantially higher than others in its industry, it's often a sign that the market is expecting a dividend cut due to significant operating struggles.

If you know what to look for, a dividend will often telegraph bad news that a company's leadership either won't -- or can't -- say publicly. Learn to listen to what they tell you, and use those signals to your advantage.

As a source of capital, dividends have more obvious benefits. They provide cash from your stock investments -- without your needing to sell -- that can be used to buy other investments. For a retiree, one such investment might be the next rung in a bond ladder that you use to preserve your near-term and midterm spending power.

By adding that interim step between your dividends and your spending cash, you can use those bonds to better protect yourself from those periods of time when dividends don't work as you'd ordinarily hope. If you manage to build enough of a bond buffer, you might get to the point where you can take your dividends as cash when they're working as expected and you have the bonds to spend when they aren't.

Dividend stocks can help you retire well
Learn to listen carefully to what your dividends tell you, and the companies that pay them can be a powerful tool to include in your retirement portfolio. Just be sure to recognize where dividends fall in the corporate capital structure so that you're not expecting more from them than they're capable of delivering.

The article How Dividend Stocks Can Help You Retire originally appeared on Fool.com.

Chuck Saletta owns shares of General Electric Company. The Motley Fool owns shares of Citigroup Inc and 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.