Can dividend stocks support your retirement?

Does investing in dividend-paying stocks generate a higher or lower retirement paycheck compared to other retirement income generators (RIGs)? A few readers suggested that I look at this question as a follow-up to my January post that analyzed the strategies that generated the highest retirement paycheck.

With most other RIGs, your retirement paycheck is funded by a combination of investment income and withdrawals of principal. Therefore, RIGs such as systematic withdrawals and annuities usually have a head start over dividend-paying stocks when considering just the total dollar amount of your retirement paycheck.

However, the flip side of this consideration is that using dividend stocks preserves your principal, whereas the other methods use up your principal. So, here's a key trade-off in making this decision: How important is the amount of your retirement paycheck compared to the goal of preserving your principal?

Preserving principal has the following significant advantages as a RIG strategy:

• You can tap principal for unanticipated emergencies, such as long-term care.
• It's flexible, so later in your life, you can change strategies for generating retirement income.
• Upon your death, unused funds can serve as a legacy for your descendants or selected charities.

How big is the difference in a retirement paycheck between dividend stocks and other RIGs? One way to systematically compare them is to calculate the payout ratio for each one. The payout ratio is the amount of annual retirement income you'll receive initially upon retirement, divided by the amount of savings used to generate that income.

For a 65-year-old couple, here are the payout ratios for a few common RIGs at the beginning of January 2015:

• 5.6 percent, using a fixed-dollar immediate annuity
• 4.5 percent, using a guaranteed lifetime withdrawal benefit (GLWB)
• 4 percent, using systematic withdrawals with the 4 percent rule
• 3.9 percent, using an immediate annuity with an inflation cost-of-living adjustment

To estimate the initial amount of your retirement paycheck, you'd multiply these ratios by the amount of your savings. For example, if you have $100,000 in retirement savings, a 1 percent difference in payout ratios would result in a difference of $1,000 in annual retirement income.

Now, let's use these yardsticks to compare a few different methods of using dividend stocks.

The easiest way for many investors to benefit from dividend stocks is simply to buy a mutual fund or exchange-traded fund (ETF) that have dividend stocks as the primary form of investment. Using recent information from Morningstar, here are a few annual yields on mutual funds that emphasize dividends:

• 2.7 percent from the Vanguard Equity Income Fund (VEIPX)
• 1.9 percent from the Vanguard Total Stock Market Index Fund (VTSAX)
• 3.4 percent from the Vanguard Total International Stock Index Fund (VTIAX)
• 3.4 percent from the Vanguard REIT Index Fund (VGSLX)

Here are recent payout ratios from some common ETFs:

• 3.2 percent from the iShares High Dividend Equity Fund (HDV)
• 3.2 percent from the Vanguard High Dividend Yield Fund (VYM)
• 5.7 percent from the iShares S&P US Preferred Stock Index Fund (PFF)

Note that with this last ETF, preferred stocks have significantly different characteristics compared to common stocks, with higher yields but much less potential for appreciation.

As you can see, by using mutual funds and EFTs, you can come close to the payout ratios of some other RIGS, but there are shortfalls ranging from 0.5 percentage points to 3.7 percentage points (except for the preferred stock ETF, which beat all the other RIGs).

If you're comfortable selecting stocks on your own, you can earn yields higher than the amounts shown above with mutual funds and ETFs. For example, using a recent screen from Morningstar, I identified 93 common stocks that Morningstar ranks three stars or higher with dividend yields of 4 percent or higher, including stocks from Allianz (AZSEY), AT&T (T), Blackstone (BX), BP (BP), ConocoPhillips (COP), Mattel (MAT), Shell (RDS.A) and Verizon (VZ). This level of yield compares favorably with payout ratios of other RIGs above.

The same Morningstar screen identified 158 common stocks ranked three stars or higher with dividend yields of 3 percent or higher, including stocks from Aegon (AEG), Chevron (CVX), Dow Chemical (DOW), GE (GE), McDonalds (MCD) and Occidental Petroleum (OXY).

You could also include individual preferred stocks to boost your yield. By choosing the right stocks, it's possible for individual investors to construct a portfolio of income-producing common or preferred stocks that compares favorably to the payout ratios of the other RIGs shown above.

Considering the goal of preserving principal:

• With dividend-paying stocks, at any point, your principal depends on the appreciation or depreciation of the underlying stocks.
• With systematic withdrawals, in addition to the appreciation/depreciation factor, your principal dwindles over the years due to your principal withdrawals. The higher your rate of principal withdrawals, the faster your principal declines.
• With most immediate annuities, you have no principal that's accessible or can be left behind as a legacy -- that's the price you pay for the guarantee of a lifetime retirement income.

As you can see, you'll need to make important trade-offs when considering a retirement income strategy. In addition to the amount of your retirement paycheck, other factors need considering: You'll want to evaluate your investing skills and the amount of time you can devote to managing your retirement portfolio. Spend time developing a thoughtful retirement income strategy, then go enjoy your life!