Income in retirement? I look at utilities

Stocks of power companies can produce a steady stream of cash in your golden years.

By Roy W. Huntsman

Boring old utility stocks recently got a lot more interesting. Thanks largely to tax code changes, their prices have surged in 2003, after struggling the previous two years. The Dow Jones Utility Average, an index of 15 utility stocks, is up more than 10 percent this year.

Before President Bush signed his tax bill into law this spring, the dividends that utility stocks threw off were taxed at regular income rates—as much as 38.6 percent for high-earners. Now, they're taxed at just 15 percent. Better still, the new rules apply to all dividends received in 2003, not just amounts received after Bush whipped out his pen.

That's great news for people who own these stocks. But I was a big fan of income-producing stocks, especially those of utility companies, long before the new tax law came along. Utilities are much easier to analyze than growth stocks, I believe, and a lot safer.

True, many people would rather brag that they've found the next Microsoft than discuss an electric utility that pays a consistent dividend. But slow and steady wins the race, I've found.

Live off the income, not the principal

Take, for example, a doctor's widow I'll call Mary Smith. In August 1997, four months after her husband died, she came to my office unsure of what to do with her finances.

"I have no money worries," Mary began. "The house is paid for. The children are on their own and happy with their lives. I know I should be satisfied, but I'm not. I want cash to spend, without having to worry about which of my assets I should sell. I don't want to have to consult a broker every time I need money."

Mary said that to live comfortably she would need at least $800 a month in addition to what she received from Social Security. I suggested she take most of the proceeds from a $150,000 life insurance policy and invest it in utility company stocks. The dividends from an investment that large should give her the income she would need.

Because I'd been following utility companies closely for about 23 years, it was easy for me to suggest half a dozen good ones: Dominion Resources, Florida Progress, Houston Industries, PPL, Puget Energy, and United Illuminating. She then went to her broker to purchase them. When Mary bought these companies, they were yielding 7.3 percent on average. That provided her with a first-year income of $10,296, or $858 a month.

The brokerage firm allows Mary to write checks against the account, up to half of its value. If she needs an amount that exceeds her monthly dividends, the brokerage floats her the difference in the form of a margin loan. She doesn't have to sell any shares to repay the loan; the dividends will eventually cover it. She pays a $150 annual maintenance fee on her account and a little bit of interest on the amounts she borrows, but these expenses are less than what she'd be paying in ongoing fees had she invested her insurance proceeds in mutual funds.

Fees aren't Mary's main concern, however. For her, the beauty of this is the fact that she doesn't have to consult anyone. She just writes herself a check each month and the money's there for her.

Naturally, the value of Mary's portfolio has fluctuated over the years. Yet despite a three-year-plus bear market, she has never had a month where her account balance was less than her initial investment of $142,000. The high-water mark was $256,062, on April 30, 2001. The account was at $197,040 on May 30 of this year. Despite the swings that her stocks have experienced, Mary's total return has been exceptional—78 percent. Her average annualized return of 9.7 percent includes roughly $55,000 in capital appreciation and another $55,000 in dividend income.

Her portfolio has remained the same, although a few of the names have changed: Florida Progress is now Progress Energy, Houston Industries is CenterPoint Energy, and United Illuminating trades as UIL Holdings. And Dominion Resources is now simply Dominion.

Choose your companies carefully

Before you run out and try to duplicate Mary's returns, let me offer some advice. First, not all utility companies are worth owning. Certainly Enron taught us that. Moreover, business models can vary widely. Depending on the company, it may invest in oil, natural gas, electric, nuclear power, telecommunications, or some combination of these. And all utilities are sensitive to the current regulatory climate and to interest-rate fluctuations. For instance, I've found that local and state governments in the Southeast are the most favorable to utilities, so I try to stick with companies that do most of their business in that region.

Avoid companies that are deemed poor choices by an independent service like Morningstar ( www.morningstar.com) or Quicken ( www.quicken.com). A weak company may slash its dividend, while a strong utility will maintain it—and often increase it when times are good. (Morningstar and Quicken both provide detailed information on dividends.) That's why I recommend utilities for steady income instead of bonds and certificates of deposit, which lock you into a rate that may not keep pace with inflation. Not to mention that income from bonds and CDs continues to be taxed at ordinary rates.

Many utilities allow you to buy shares directly from the company, without a commission. For example, Southern, an Atlanta-based utility, has a direct-purchase plan. It's an excellent company, with interests in electric, gas, nuclear energy, and wireless communications.

Note that unless you have a large portfolio that can generate gobs of dividends, you'll probably tap into or borrow against your principal on occasion. That's fine, so long as you know the maximum amount you can safely withdraw each year. And if your brokerage allows you to take margin loans, don't abuse them. If you run up too much debt, the brokerage may sell some of your shares to pay off the loan.

But if you do a good job of picking utility stocks, you can sit back and watch the dividends roll in, and wake up each morning knowing that money will be available when you need it. Who wouldn't want peace of mind like that?

Stocks mentioned in this article

The author, a Certified Healthcare Business Consultant, is a principal with Medical & Dental Management of Gainesville, FL, and is an editorial consultant for this magazine.

 

Roy Huntsman. Income in retirement? Medical Economics Aug. 22, 2003;80:30.