Dividend-paying stocks are enjoying a renaissance in the face of sluggish economic growth and extremely low interest rates. But pension plan executives should pay close attention to valuations and diversify across a broad mix of sectors — not just traditional defensive ones — in order to tap dividends' full potential and meet funding requirements.
Since the financial crisis, steady income options for retirees and pre-retirees have become scarce at the same time that many pension managers are facing shortfalls and heightened risk aversion. These conditions have fueled renewed interest in companies that reward shareholders with a regular slice of their profits. And for good reason: Dividend payers have a decided performance edge over non-dividend payers, historically. S&P 500 dividend payers, on average, have returned 8.66% annually since 1972 vs. 1.48% annually for non-dividend payers, through June 30, 2012. Dividends have also accounted for 40% of total return during this period.
Moreover, companies that pay a dividend — and display an ability to grow that dividend over time — are generally viewed as healthier and more stable. Plus, their consistent income streams help cushion volatility and offset inflation. These steady payouts also help pension funds meet liabilities and mandated return targets at a time when the threat of a shortfall looms large. Indeed, two nasty bear markets — in 2000 and 2008 — have created wider funding gaps as millions of Americans near retirement. Some consultants are now projecting as much as a 2% shortfall per year for the next decade.
What's more, pension managers looking to offset risk through exposure to fixed income assets are being punished by an aggressive monetary policy. The Fed is essentially forcing them to take risk by pegging its target rate near zero until mid-2015. Meanwhile, the recovery has slowed and capital markets are in flux. With income and growth so scarce, stretching for yield without regard for price/earnings multiples puts pension return targets in jeopardy.