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Earn a Cool 4% - Without a Ton of Risk

By Carolyn Bigda, staff writer (MONEY Magazine) --

Whether you want income to help you cover your expenses in retirement or to help protect your portfolio from losses as you save for the day you quit working for good, you're not getting any help from the usual places these days.

Pessimism about the economy and a headlong flight to safety by investors have pushed down yields on traditional savings vehicles to barely-there levels. Cash is a joke: Rates on bank money-market accounts and short-term CDs average less than 0.5%, and money funds yield a microscopic 0.04%.

Meanwhile, rates on Treasuries are close to the record lows hit during the worst of the financial crisis; even 10-year notes will nab you only 2.5%. And the dividend yield on the typical stock is just 2%, nearly half its historical average.

So how would you like to earn a cool 4% -- or more -- on your money? And how would you like to do it without taking on tons of risk or tying your savings up forever?

Yes, you really can get there from here, as long as you're willing to follow a less traditional investment path, combining high-quality dividend-paying stocks, corporate and foreign debt, and perhaps even an annuity to reach your goal.

"You have to be more creative today to get to 4% than you used to be," says Richard Whitney, director of T. Rowe Price's asset-allocation group. "But while a 4% yield is challenging in this environment, it's definitely not impossible."

Why make 4% your target?

Because 4% is a magic number of sorts in the annals of retirement investing. When you're still in the building phase, 4% is the number you need to beat inflation over the long term (average rise in the cost of living since 1914: 3.4%).

And once you're ready to retire, it's the number that financial advisers recommend should guide your portfolio withdrawals. If you start retirement by pulling out a modest 4%, and then adjust those withdrawals annually for inflation, you'll have a very good shot at making your money last your lifetime.

Mind you, getting to 4% these days isn't risk-free. Corporate and foreign bond prices have risen sharply over the past year, posing the possibility that the run-up could run out of steam. And if stock prices tumble, returns on high-dividend payers could be squashed as well.

Here are three strategies to help you minimize the danger of losses by building on a foundation of safe investments, then simply juicing up yields around the edges of your portfolio. Retirement paradise ought to be worth a few calculated risks.

Dividend-paying stocks have traditionally been the plain Janes of the market -- dependable but nothing to get excited about. Lately, though, they've gained a new allure, with many blue chips yielding more than top-rated corporate bonds, providing investors with the opportunity to earn payouts up to 4% or more.

Adding to their appeal: Dividend stocks typically have a better shot at capital gains than bonds and enjoy more favorable tax treatment, at least for now. (Dividends today are taxed at a top 15% rate, vs. 35% for bond interest; that limit is set to expire in January but Congress is debating a new cap of 20%.)

What's behind the fat payouts? They are largely a function of falling stock values. As prices have declined over the past decade (and fallen 5.9% so far this year), many high-quality companies have continued to pay, even increase, their dividend.

As a result, their yields -- calculated by dividing the annual cash dividend that a company pays out per share by its stock price -- have been rising. Lately many of these same companies have built up record amounts of cash reserves, providing even more of a cushion with which to pay and raise dividends.

But if the economy worsens, corporate profits might come under pressure again, squeezing dividends, warns Lewis Altfest, a wealth manager in New York City.

Just remember 2009, when a record number of firms cut or suspended their dividend. Or earlier this year, when BP halted its payout after the gulf oil spill. To make sure your 4% target is safe, follow these steps:

1. Aim for the sweet spot. Focus on high-quality companies with a dividend yield between 4% and 6%. That's a lot higher than the 2% average yield on the S&P 500 but not so lofty that the company may be hard-pressed to keep up payments.

One way to spot a sustainable dividend: Look for companies that use no more than 50% of their earnings to pay shareholders (known as the payout ratio). That leaves ample funds to plow back into the business.

Also key: dividend payments that will grow over time. Ideally you want to zero in on companies that have in creased payouts for five straight years or longer. "They give your portfolio the juice it needs to keep up with inflation," says Cliff Remily, co-manager of Thornburg Investment Income Builder.

2. Build on a strong core. You can assemble a diversified portfolio that meets these criteria with a half-dozen or so well-chosen individual stocks and funds.

For your foundation, put half the money you're allocating to dividend payers in the SPDR S&P Dividend (SDY), an exchange-traded fund that tracks the 50 highest-yielding stocks in the S&P 1500 index of large, medium, and small companies that have paid a dividend for 25 consecutive years or more. Recent yield: 3.6%. Among its holdings: household products maker Kimberly-Clark (KMB), yielding 4.1%, and components manufacturer Leggett & Platt (LEG), yielding 5.6%.

Then, to get to a 4% yield overall, put the rest of the money in a handful of stocks that together will pay an average of 5%. Start with picks from the traditionally high-yielding telecommunications and utilities sectors.

David Katz, chief investment officer of Matrix Asset Advisors in New York City, likes wireless giant AT&T (T), which has more than doubled its cash reserves since 2006 and was recently yielding 6.2%.

MONEY columnist Pat Dorsey, director of equity research at Morningstar, is keen on Exelon (EXC), the country's largest nuclear plant operator, which has raised its dividend 5.6% annually over the past five years and now yields about 5.2%.

Then spread the rest among different industries and regions. Laton Spahr, co-manager of Columbia Dividend Opportunity, likes drug giant Merck (MRK), which yields 4.3% and uses about 40% of its cash to pay the dividend, and Intel (INTC), yielding 3.6%, which has boosted its dividend 17% annually over the past five years. Another smart bet: European telecom Vodafone (VOD), which has a 48% payout ratio and currently yields 7.%.

3. Use funds as an alternate approach. Not keen on making individual picks? You can also put together a well-diversified, high-yielding portfolio with a handful of mutual funds and ETFs. Once again, use the SPDR S&P Dividend ETF as a core holding, putting about 25% of the money you're allocating to dividend payers in it.

Add even more yield by putting another quarter each into the market's two highest-paying sectors with the Utilities Select Sector SPDR (XLU), yielding 4.1%, and iShares S&P Global Telecommunications (IXP), doling out 4.4%, suggests Scott Burns, director of ETF research at Morningstar.

Then, for international diversification, split the remainder between Vanguard European (VGK), yielding 4.2%, and Matthews Asia Dividend (MAPIX), with a payout of 3.3%. Average yield on the portfolio of five funds: about 4%.

Or if you'd prefer to leave the yield-hunting entirely to a portfolio manager, look at Columbia Dividend Opportunity (INUTX). The fund aims to pay out 1½ times the yield of the S&P 500 and counts AT&T, Intel, and Merck among its biggest holdings. Recent yield: 4%.

Boost Your Bond Yields

There's no getting around it: You have to take on some credit risk to wrest 4% from fixed-income assets these days. Treasuries, with yields ranging from 0.8% to 2.5% on intermediate-term issues, just won't cut it.

Even a diversified bond fund like Vanguard Total Bond Market Index (VBMFX), which revs up yields by blending a 30% stake in Treasuries with higher-rate mortgage-backed securities, corporate bonds, and foreign issues, gets you only to 3.5%.

Fortunately, you don't have to dive deep into the junk pile to earn a decent payout. Putting just a quarter of your fixed-income assets into high-grade corporates, when paired with the strong foundation that a total bond index fund provides, can get you to 4%. Willing to put 10% to 20% into somewhat riskier issues? You can do even better.

1. Add some higher-quality junk. Bonds rated BB+ or lower have surged 65% over the past 18 months, as default fears subsided and yield-starved investors grew too desperate to stay away. As a result, yields have plunged from as high as 23% to 8.5% today. (As bond prices rise, yields fall.)

But that's still seven points higher than the average Treasury bond for the debt of companies in much better shape than they were a year ago the default rate on high-yield issues is now 5.5%, vs. 11% in 2009. Notes Marilyn Cohen, founder of Envision Capital Management: "You're not getting stuck with businesses that have one leg on a banana peel, on their way to the grave."

Still, with talk of a double-dip growing, be cautious, putting no more than 10% of your assets in junk. And stick with the two top credit tiers in the junk universe (issues rated B or better) through a high-yield or diversified bond fund that focuses on these securities (for picks, see page 98).

2. Sprinkle in some foreign flavoring. Like junk, bonds issued by emerging-market countries such as Brazil and Russia have been on a tear lately. But their average 5.4% yield still looks rich compared with Treasuries and high-grade U.S. corporates.

Though the bonds had a higher default rate than European debt last year 3.5% vs. 1.4% -- they fared better than U.S. debt (average default rate: 5.6%). Minimize volatility with a proven fund such as Fidelity New Markets Income (FNMIX), which has beaten 94% of its peers over the past five years. Recent yield: 6.4%.

3. Ease the tax bite. If you're investing in a taxable account, the stiff bite on interest earnings from bonds will erode your real return. Solution: federally tax-exempt munis, recently yielding an average 2.9%, which is equivalent to 4% if you're in the 28% bracket.

While many states face steep revenue shortfalls due to the shaky economy, the historical default rate on munis is low -- under 1%. And you can minimize the risks by investing in munis from many different states through a fund such as Vanguard Intermediate-Term Tax-Exempt (VWITX), which was recently yielding 3.6% (equal to 5% in the 28% bracket).

If you're about to retire or have already quit the workforce for good, adding an immediate annuity to your investment mix can provide guaranteed income for the rest of your life and free a portion of your portfolio from the vagaries of the market.

'I'll work until I die'

Plus, the payouts on this insurance product are far higher than what you could earn on any other income investment without taking on huge risk, roughly 7% recently for a 65-year-old man, or nearly $600 a month on a $100,000 investment.

The drawbacks: You can't earn more than the guaranteed rate, no matter how high the market may rise. And you lose access to the money -- no tapping these funds to replace a broken-down car or spring for a vacation in Waikiki.

That's why you want to invest just enough money in immediate annuities (when combined with Social Security and pension benefits) to cover your basic living costs, and follow these guidelines:

1. Buy in gradually. Whatever amount you ultimately decide to put into annuities, invest in increments of, say, 20% a year over the next five years to achieve the best payout. How much income you receive is determined in part by your age and by prevailing interest rates. All else being equal, the older you are, the bigger your monthly checks will be. And if interest rates rise over the next several years a strong possibility given today's super-low rates -- your payouts will increase as well.

Another benefit to following this installment plan: "If something happens to your health, you won't have committed all your money," says Chris Cordaro, a wealth manager at Regent Atlantic in Morristown, N.J. You can use the leftover funds to help pay medical bills or leave a few more bucks to the grandkids.

2. Protect your investment. Stick with insurers rated A or better by A.M. Best or AA by Standard & Poor's, such as New York Life and Integrity Life. Then shop for the best rates among them at immediateannuities.com.

If you can afford it, spring for an annuity with monthly checks that rise along with inflation. Your payouts will initially be lower, but over 20 years, you should come out ahead (see the example below). In a sense, you'll be making a bet on how long you'll live. But with your retirement income covered, at least you can feel secure that your health won't suffer from worries about money.