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November 14, 2005

A Return to Stock Dividends

During the bull market of the 1990s, dividends fell out of favor. With stock prices rising so dramatically, dividends didn’t seem to matter. Historically, however, dividends have been a significant component of stocks’ total return. For instance, from 1926 to 1985, dividends equaled approximately 49% of the total return of the Standard & Poor’s 500 (S&P 500), with an average dividend yield of 4.8%. In contrast, from 1998 to 2004, the average dividend yield was 1.5%.*

A major reason for this dramatic shift was investors’ preference for growth rather than income stocks. Growth companies tend to retain earnings to generate future growth, while more mature companies tend to pay out dividends.

But two factors may cause investors to shift their preferences back to dividends. First, the market volatility over the past few years has made the assured returns of dividends seem more attractive. After several years of decreasing or fluctuating stock prices, it can be comforting to count on dividend income. Second, since long-term capital gains and dividend income are now taxed at the same rates (5% for taxpayers in the 10% and 15% tax brackets and 15% for all other taxpayers), capital gains no longer enjoy a tax advantage over dividend income.

If you’re thinking about adding dividend-paying stocks to your portfolio, consider these tips:

  • Look for reasonable dividend yields. Don’t just search for stocks with the highest dividend yields. Like all stock investments, you want to purchase a dividend-paying stock with good future prospects. Dividend yield is calculated by dividing the dividends per share by the market price. A company with an exceptionally high dividend yield may be experiencing problems that caused a significant decline in price and may be forced to reduce dividends in the future.

  • Make sure the payout ratio is reasonable. The payout ratio equals dividends per share divided by earnings per share, indicating how much of a company’s profits are used to pay dividends. A general rule of thumb is to consider companies with a payout ratio under 50%. A company needs to retain some of its profits to reinvest in the business and to smooth out business cycles to ensure sufficient cash for future dividends.

  • Review dividend growth. A review of past dividend payments will indicate whether the company has consistently raised dividends in the past. Companies with consistent dividend growth tend to have consistent earnings accompanied by strong balance sheets and good cash flow.

* Source: Stocks, Bonds, Bills, and Inflation 2005 Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results.

Handling the Family’s Finances

In many families, one spouse takes primary responsibility for the family’s finances, doing everything from paying bills to making investment decisions to reviewing insurance policies. If that spouse dies first, the surviving spouse may have difficulty taking over these tasks. Therefore, if you take care of money matters in your marriage, one of your most important financial duties is to prepare your spouse to handle the family’s finances. Some strategies to consider include:

  • Maintain good records. Financial records should be well organized, located in one central place, and contain only pertinent information. Old or outdated information may confuse your spouse.

  • Prepare written instructions. These instructions should cover everything from insurance policies to investments to company benefits to monthly bills, so nothing is overlooked. Also list all your assets, why you own them, and where important documents are kept. Update these instructions at least annually. You may want to store these documents "digitally" which will give you safety against loss, 24/7 access from anywhere in the world, and the ability to share these documents with all of the appropriate people, such as your spouse, children, accountant and/or attorney. ManagingMoney.com offers Secure Online Storage in our Documents Center.

  • Discuss your finances with your spouse. Go over your written instructions, explaining your rationale for major financial decisions. Your death could likely necessitate changes in investment allocations, insurance policies, and other financial matters, so encourage your spouse to explore all options before making decisions.

  • Involve your spouse in the family’s finances now. Your spouse can start by paying monthly bills, balancing the checkbook, or reviewing credit card charges. Increase his/her involvement as confidence builds.

  • Line up professionals for your spouse. Even if your spouse assumes some financial duties, there may be areas he/she will never feel comfortable handling. Identify those areas, find knowledgeable professionals who can help, and introduce your spouse to them now.

These strategies can help smooth the transition if your spouse needs to take over the family’s finances.

How Affordable Is Housing?

The National Association of Realtors publishes a monthly statistic called the Housing Affordability Index (HAI), which compares median household income to income needed to purchase a median priced home. The index provides a measure of how affordable housing is in the United States, and tracked over time, shows whether housing is becoming more or less affordable.

Despite significant appreciation in housing prices in recent years, housing has remained fairly affordable due to two key factors. First, mortgage rates have been near their lowest levels in decades, keeping the cost of servicing a mortgage low. Secondly, annual increases in family median income have tended to outpace increases in housing prices.

The HAI compares median family income to qualifying income, or income needed to purchase a median priced home at current mortgage rates with a 20% down payment. The HAI has a value of 100 when median family income is just sufficient to purchase a median priced home. Values over 100 indicate that housing is more affordable, while values under 100 indicate that median family income is insufficient to purchase a median priced home.

As of August 2005, the national HAI was 115.4, based on a median priced home of $219,400, a mortgage rate of 5.87%, median family income of $57,511, and qualifying income of $49,824. However, the index varies significantly when looking at different regions of the country - the Midwest's index was 152.7, the South's index was 121.6, the Northeast's index was 111.8, and the West's index was 78.6 (Source: National Association of Realtors, October 2005). The reason for the low index in the West is due to much higher housing prices. For instance, the California Association of Realtors reported that the median home price in California was $568,890 in August 2005, compared to $219,400 for the country. Thus, the qualifying income needed to purchase a median priced home in California was $133,800 compared to $49,824 nationally.

What Happened to Personal Saving?

For years, we’ve heard that our personal savings rate is dismally low. However, that knowledge has not led to an increase in savings. Instead, personal savings as a percentage of disposable income has continued to hover at historically low levels, 0.9% in 2004 (Source: The Regional Economist, July 2005). How concerned should we be by this trend?

The Importance of Savings

At first glance, it appears that savings hurt the economy. If consumers save rather than spend their income, current sales for stores, service establishments, and manufacturers will decline, putting a damper on jobs and income. However, this is only a short-term effect.

Over the long term, these savings are used to make investments, which finance modernized equipment, new construction of homes and factories, and research and development of new products. These investments, in turn, create more jobs and more income.

However, savings in our country come from three sources: individuals, businesses, and the government. While the individual savings rate has been declining, the savings rate of businesses has risen significantly. Business savings comprised 93% of total national savings in 2003 and 2004, compared to 65% in the early 1950s (Source: The Regional Economist, July 2005). Government savings has tended to be positive due to surpluses run by state and local governments, while substantial investment by foreigners has also helped our national savings.

The Impact on Individuals

There is some debate over how much significance should be placed on the decline in the personal savings rate, since it only measures what percentage of disposable income individuals are saving each year. It does not factor in changes in wealth attributable to gains in investments and real estate.

Yet, even when accumulated assets are considered, most studies generally conclude that the baby boomers are not saving enough for retirement. For instance, the Employee Benefit Research Institute’s 2005 Retirement Confidence Survey found that only 69% of Americans had saved any money for retirement. Of those who had started saving, 65% had less than $50,000 of savings.

One study found that baby boomers are only saving about one-third of the amount needed to retire comfortably (Source: Accounting Today, June 5, 2005).

This is alarming when you consider that the baby boomer generation may be the first generation to have to finance a significant portion of their own retirements. The baby boomer’s grandparents typically did not retire — most men worked until they died. The baby boomer’s parents started the retirement trend, but they retired on other people’s generosity. Generous pension benefits and Social Security benefits indexed for inflation allowed them to retire to a comfortable lifestyle, without saving much on their own.

While savings have always been important to this country, many see increased personal savings as the only way to ensure that the baby boomer generation will be able to enjoy their retirement years. Corporations are increasingly moving from defined-benefit pension plans, where they make contributions, to defined-contribution plans, where employees must make contributions. The financial cost of providing current Social Security benefits to the huge number of baby boomers may mean that the system will have to be changed. Thus, savings will be very important to the future standard of living of a significant portion of the population.

While the debate over the significance of the declining personal savings rate will continue, on an individual level, it should serve as a wake-up call to reassess how much progress we are making toward our personal retirement goals.

It’s never too late, or too early, to start planning for your retirement. You may want to take a look at some of the High-Interest Bank Savings Accounts being offered in the Banking Center of ManagingMoney.com.

Are Federal Deficits a Cause for Concern?

A federal deficit occurs when the government’s expenditures for the year exceed its income. The government then pays for those excess expenditures by borrowing money, adding to the national debt. After a brief period of budget surpluses, the federal government is again running up substantial budget deficits. Are these deficits a cause for concern? It’s tough to decide, since opinions range from they don’t matter at all to they will ultimately result in federal bankruptcy. It might help to put the federal deficits in perspective.

In 1998, for the first time in 28 years, the federal government ran a budget surplus. Those surpluses lasted for four years. During that time, concerns about the viability of the Social Security system seemed less urgent, and there was talk about what would happen to the bond market if the federal government paid off all its debt. These concerns were short lived. Following two tax cuts, the September 11 terrorist attacks, the Afghanistan and Iraqi wars, and a recession, the federal deficits were back.

The fiscal year 2004 (the government’s year-end is September 30) budget deficit was $412 billion, while fiscal year 2005 is expected to be in the $325 to $350 billion range (Source: Associated Press, July 8, 2005). A recent Congressional Budget Office report projects federal deficits over the next 10 years to total $3.5 trillion.

Of course, a federal deficit results in an increase in the national debt. As of July 18, 2005, the national debt was $7.855 trillion. A significant portion of that debt is owed to the Federal Reserve and other government accounts. As of March 2005, the public held 59% of the national debt (Source: U.S. Treasury Bulletin, June 2005).

While the dollar amounts of the current and projected deficits and national debt are enormous, these numbers are often presented as a percentage of gross domestic product (GDP) to show that they really aren’t out of line with past deficits and debt levels. For instance, in 2004, the deficit as a percent of GDP was 4.5%, which was not dramatically out of line with past figures. But does that mean that we don’t need to be concerned about the deficits or the level of the national debt? Some of the more significant concerns include the following:

  • Higher interest rates: Deficits are generally believed to increase interest rates, due to their impact on the supply and demand for loanable funds. Deficits reduce national saving, causing interest rates to rise and investment to fall. A 2003 study by a Federal Reserve economist found that a one percentage point increase in the projected deficit-to-GDP ratio was estimated to increase long-term interest rates by .25% (Source: Federal Reserve Bank of San Francisco, 2004).

  • Interest payments on the debt: During periods of budget deficits, the national debt increases every year. Thus, even if interest rates remain constant, interest costs will increase. But interest rates do not remain constant and are now increasing. Thus, interest costs will increase due to a general increase in interest rates and an increase in the total amount of debt.

    For fiscal year 2004, interest was the sixth largest expenditure by the federal government, accounting for 6.7% of total expenditures (Source: Council of Economic Advisors, 2004). And that was during a period of very low interest rates. One study looked at what would happen to interest costs if the effective interest rate on the national debt rose from 3.54% in mid-2004 to the average level of 6.36% for the period 1992-2001. That increase would cause interest expenditures to rise to the fourth largest government expenditure and would likely move to third place, behind Social Security and national defense, if debt levels increased as well (Source: Business Economics, January 2005).



  • The government’s ability to contain spending: While projected budget deficits of $3.5 trillion over the next 10 years seem overwhelming, there are concerns that the deficit could exceed even those figures. For instance, the projections do not include the costs of additional Medicare benefits that were recently enacted. Also, these estimates are based on an assumed GDP growth rate of 4.62% per year for the entire 10-year period, an event that has never occurred before in U.S. history.

What impact on our economy will deficits of this size have if they continue into the future? No one knows for sure. For years, we have heard dire predictions about how difficult it will be for future generations to fund Social Security and Medicare benefits for the baby boomer generation. It may be even more difficult if, leading up to this time, we have years of budget deficits rather than budget surpluses.

 

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