"It’s what we’ve been saying all along!"

Has history finally caught up with our long term approach?  Has the dash for market performance in volatile stocks slowed a bit?  You guessed it: Yes!  How, you ask? Consider common stock funds that pay dividends.

Of the 10% average annual total return produced by the S&P 500 Index from 1926 to March 2006, dividends accounted for 40% of that total return.  27% of the 11% of total return of the MSCI European, Australian, and Far East index was done with dividends, that’s from December 1969 through March 2006.

The list of dividend paying companies has grown from bank, telephone and utility companies (which have traditionally paid dividends to encourage more conservative investors to buy their stock) to companies now offering consumer goods, media, manufacturing and service companies.

"Why has this happened?"

There are several reasons.  First, remember that dividends work in all types of markets. In flat markets an investor doesn’t have to rely on market appreciation for profits. In down markets, the dividend paying mutual fund with reinvestment back into the fund, smoothes out the downside and adds to the compounding when the fund price increases (more shares coming off the bottom).

When a company’s stock price starts to fade, the resulting rise in dividend yield often attracts more buyers, usually long term investors.  While dividend paying stocks did not participate in the dramatic spike in the 90’s, they noticeably smoothed out and have given steady returns during all markets.

Another “added attraction” is that the individual tax rate on dividends went from 35% to 15% in 2003. Since then, 587 dividend increases were made and more than 30 companies in the S&P 500 have initiated dividend payments.

"Check its pulse, please!"

Paying dividends is a sign of a company’s health. Various studies have shown that companies paying dividends have out performed non-dividend paying stocks, and dividend growth has been even better for stock returns.

We’ll not cover here how dividends have pleased shareholders who are more cautious in trusting management with surplus cash. Stock buy-backs and how they favor company management is another problem, since stock options have recently come under close scrutiny.

Because dividends are a good indicator of a company’s balance sheet and management’s confidence in the company, they are a factor in how investors value a company. This is especially true as it applies to Institutional Investors such as mutual funds. We believe that dividends are a more powerful force than share repurchase when it comes to valuing a company.

To sum up the dividend idea we see that four factors have supported this trend.

1. A desire to earn a more stable return from equities, especially since expectations are for single digit stock returns over the next several years.
2. More favorable taxation of dividend income in the US.
3. Shareholders have become much more cautious in trusting management with surplus cash.
4. Boomers have started to retire and are now focused on the distribution phase of their investment cycle.

"So what does this mean to me?"

We have long advocated having dividend paying funds in our client’s portfolios. Equity income funds make up a high percentage of every recommendation that we make.

"Looking back…. Thinking forward..."

Oftentimes we publish articles in Opinions and Facts from past issues. This is one of those times.

Although it’s been more than a decade since we penned these lines, most of our clients will realize they’re as true in the 21st century as they were in the 20th.

“Seems I’ve heard this song before.

We’ve covered in these pages many times the fact that over the last three decades financial companies and the government are turning more and more to the transfer of retirement and investing onto the shoulders of the people who will benefit by it.

 We’ve seen the fixed pension plan movement slow almost to a crawl, with major fortune 500 companies freezing or terminating their defined benefit pension plans.  These plans provide a guaranteed income for a retired employee’s lifetime, but in order to do that, the company must make large contributions to the plan to build up the fund to provide this long term income. And the older an employee is the more costly it is to fund his/her pension. 

“Finally, a sensible law…maybe!”

Legislation recently signed by President Bush features a retirement savings system that will shift from what some people have called a worker’s “discretion” to participate in a 401(k), to automatic enrollment for companies and workers. 

Automatic 401(k) Enrollment

This portion of the law allows the employer to automatically enroll workers in 401(k) plans. An individual can decline to participate but he must formally opt out.

401(k)’s have become the investment vehicle de jour of corporations. It allows employees to set aside part of their wages, before paying taxes, and save the money for retirement. Savings can build tax free; however, taxes are due upon withdrawal of income.  This automatic enrollment can start in 2008 and employees who do not want automatic enrollment can withdraw during the first 90 days.

Another offshoot to the 401(k) is that now a corporation can offer a Roth IRA.  This account allows employees to set aside income in his 401(k) after paying taxes on it. The money can grow and be withdrawn later tax free.

College savings

And here is some great news. Federal income tax benefits that give contributors a tax break on income from money saved and invested in Section 529 plans for college expenses have been made permanent. Many people had been concerned that if the law was not permanent that they would not be able to utilize this benefit for their children’s college education.

 “…Then there’s a questionable clause…”

The new legislation includes a provision that we’re not that excited about.  It allows employers to hire outside financial advisors who must be utilizing a computer model to provide advice for the employees on how to allocate their 401(k)’s.

We believe that there could be a liability issue if an advisor advises certain investments in particular funds which are proven unsuitable offerings chosen for the plan by the employer.

We do not plan to enter into this market.  We would only advise employees if investments we recommended were available.

More money put away
The new law gradually increases the amount individuals can contribute to their IRA account. Savers can now deposit $4000 annually into IRA accounts. The contribution limit will rise to $5000 in 2008 and continue to increase to keep pace with inflation. People aged 50 and over can make extra contributions to their retirement plans.  Contribution limits for work place 401(k) accounts will also rise. 
Underfunded pensions
In regard to defined benefit pension plans about which we spoke earlier in this report: tighter rules are in place to ensure that plans are fully funded. The employers will have seven years to set aside 100% of the amount needed to meet their obligation. It’s our belief that the guaranteed defined benefit pension plans for large companies will soon disappear. There are other additions to the law which we’ll not attempt to delve into here. One of those things is the “cash balance availability plan” where an employer can contribute a set percentage of a salary to a worker’s account each year.  It can later be rolled over into an IRA.
Our Opinion
As you can see, what is happening is just a continuation of placing the obligation of assuring retirement income over to the individual. The obvious next step by the government is to figure out some way to solve the Social Security problem. We’ve mentioned in these pages a number of ideas for that, but unfortunately, it is a political quagmire. As baby boomers age there will be more and more of a demand on the government to increase funding for Social Security. We’ve asked the question several times: “Where will the money come from?”

Although the Social Security “account” is funded with Treasury Securities, when it comes time to “cash them in” the money must either be borrowed or funded with increased taxes.
 
Don’t be surprised if you’ll be waiting later in life to get your Social Security benefits and that we will eventually see a plan which involves “means testing”. This means that an individual who has outside income of say $100,000 a year will not receive the same Social Security benefits a person with a lesser income would receive.  We believe that unless Congress makes some hard decisions, that the promises it has made to future retirees will go unfulfilled.  It’s a tough deal.  Educating our children, trying to keep our standard of living and preparing for retirement is not easy.

“Is this a possible answer?”

We have discovered after more than four decades in the financial service business that as long as the free market and a capitalistic society exists that Americans will find a way to solve these problems and still have a growing economy.

So we say “don’t wait, don’t be surprised,” begin saving as soon as possible.
 
The people we’ve observed in retirement who are the most comfortable are the ones who are able to utilize outside investments rather than depend strictly on Social Security and IRA income.