Enough with the cliché of the senior on a fixed income.
There's a fairly simple way to build an annual cost-of-living increase into at least part of your income in retirement. Just buy some blue-chip dividend growth stocks.
A quick illustration: BCE Inc. has raised its dividend by an average annual rate of 9.9 per cent over the past five years. Inflation over that period averaged 1.8 per cent annually.
There are dozens of Canadian companies that have raised their dividend by more than 1.8 per cent annually over the past five years. They're in a wide range of sectors, including financials, telecom, energy, materials and industrials. If you're on a fixed income, these stocks can help you absorb higher living costs.
Dividend stocks have been close to a sure thing for investors in the past five years and some people may have unrealistic expectations about how they will behave over the long term. Dividend stocks would be hammered along with everything else in a major market downturn, and sectors such as utilities and pipelines would do poorly in a fast-rising market fuelled by inflationary economic growth. Bottom line, dividend stocks can lose money, unlike guaranteed investment certificates and bonds held to maturity.
That's why dividend stocks should be a part of the typical senior's investments, not the whole thing. You can still beat inflation this way.
Let's use the example of a portfolio with 30 per cent in stocks and 70 per cent in bonds and GICs held for five years. If the stock weighting was invested in companies with a compound annual dividend growth of 5.6 per cent on average, the income flowing from your entire portfolio would rise by 2.5 per cent annually over the five-year period. Just to recap, that's based on a weighted blend of your dividend income rising at 5.6 per cent annually and your bonds paying out income that remains unchanged year by year. Bump up your weighting in those same dividend stocks and you've got even more inflation protection.
See the accompanying chart for a list of the blue chip Canadian stocks with five-year annualized dividend growth rates above 2.5 per cent, which is a reasonable expectation for future inflation in this age of slower economic growth. If you're building a portfolio, try to get exposure to as many stock market sectors as possible. U.S. dividend growers may help in your efforts to diversify.
BCE's ranking on this list is middling, but it's a stock I have first-hand experience with as a dividend grower because I put it in my wife's registered retirement savings plan and our sons' registered education savings plan. One block of 100 of BCE shares was purchased on Dec. 12, 2008, and the first quarterly dividend payment came in at $36.50. There have been 10 dividend increases since then, the most recent of which brought the quarterly cash dividend payment to $61.75.
If BCE's dividend had increase at the same rate as inflation over that period, the initial $36.50 payment would have risen to just under $40. The bonus growth rate over inflation is what you use to offset the flat rate of income from bonds and GICs.
Another example from my personal investing experience is Shaw Communications, which paid a monthly dividend of $6 on 100 shares when purchased back in early 2008 and most recently paid $8.38. Inflationary increases in that initial $6 payment would have increased the payout to just $6.65.
The investment industry has created hundreds of mutual funds and exchange-traded funds to satisfy demand for dividend stocks. If you don't see yourself researching individual stocks, give these funds a look to see whether they can meet your dividend growth needs.
The complication here is that dividend funds are usually run in a way that optimizes total return, or share price changes plus dividends. Stocks may be selected for the fund on the basis of potential share price gains, with dividend growth being a lesser priority. The net result is that you may end up with a satisfactory total return from a dividend fund, but not rising dividend income.
Consider the example of the $17.5-billion RBC Canadian Dividend Fund, the country's largest mutual fund. The total return over the five years to March 31 is an impressive 14.3 per cent, which beats the S&P/TSX composite total return index. However, dividends paid by the fund have been up and down in the past five years. The latest management report on fund performance for RBC Canadian Dividend shows dividend distributions of 60 cents last year, which is up from 55 cents in 2012 and 54 cents in 2011, but lower than the 66 cents paid in 2009 and 2010.
Exchange-traded funds based on indexes of dividend stocks appear to be a good alternative if your investing goal is rising income above all. The iShares Canadian Select Dividend Index ETF (XDV-TSX) has increased its payment of "eligible dividends" (those from big corporations) each year since 2010. The 2013 annualized dividend per share was 91.3 cents, up 8.8 per cent from 83.9 cents in 2012.
Dividend growth stocks are ideal holdings for tax-free savings accounts because you can withdraw your rising dividend payments without losing a cent to tax. In a non-registered account, your dividends would benefit from the dividend tax credit. A senior with taxable income of $50,000 would have a marginal tax rate on eligible dividends of between 9.6 per cent and 18.1 per cent, depending on the province.
You can certainly benefit from dividend growth in a registered retirement income fund, but the tax advantage is lost. All RRIF withdrawals are taxed at your usual rate.
Globe app users click here for table showing dividend stocks that fight inflation.