Walk Softly, and Carry a Big Dividend

Dividends boost the return on your savings, but also increase the risk.

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Those of us who are retired need to squeeze some income out of our investments to pay our monthly bills. That's been like wringing water from a stone during the last few years, with interest rates at rock-bottom levels.

How are you supposed to live on the 1 percent interest you get from a bank CD? You deposit $100,000 of your hard-earned money and, if you're lucky, you get $85 a month. If you buy a U.S. Treasury bill, you do no better.

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Retired folks who have put their money into bonds, or bond mutual funds, have done a little better. They haven't seen much in the way of interest payments, but at least those bonds have gone up in value as the Fed has relentlessly pushed down interest rates.

What about buying a bond today? A good intermediate investment grade bond fund yields barely 3 percent. So your $100,000 produces $250 a month. It still doesn't buy many groceries, and you risk losing money if and when interest rates go back up.

In pursuit of more income, it's tempting to mine the universe of high-yielding stocks. Last year, according to Birinyi Associates, the 100 stocks in the S&P 500 Index with the highest dividend yields were up an average of 4 percent, plus the dividend payouts. By contrast, the 100 lowest yielding stocks actually lost money. According to Standard & Poor's, over the long term dividends contribute almost half of the total return from the stock market.

Dividends are nice. But they do not offer guarantees. Not long ago, major banks paid fat dividends. But we all know what happened during the debacle of 2008. The dividend disappointment didn't end at the banks, either. Many so-called blue chip companies, from General Electric to Pfizer, cut their dividends mercilessly.

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Today's dividend champions are the two big telephone companies, AT&T (T) and Verizon (VZ). They both pay stockholders over 5 percent—five times what you get from a bank CD. The phone companies are doing well. They enjoy a near monopoly, and both companies have been ringing in higher revenues as more people use cellphones and smart phones. Both these companies have raised their dividends in the past year.

What can go wrong? Verizon actually lost $2 billion in the last quarter, largely because of a huge pension charge. And AT&T lost $6.7 billion because of pension costs and termination charges for its failed attempt to take over T Mobile. The dividends of these two companies are probably safe. But these losses illustrate that even the phone companies can have problems. If you want to dial up those dividends, you must assume some risk.

Chevron (CVX) is one of the world's largest oil companies. It pays a 3 percent dividend, and should be a good hedge against inflation if the price of oil increases. But remember British Petroleum? And Chevron faces its own environmental costs, most recently with an $18 billion judgment for pollution cleanup in Ecuador.

Johnson & Johnson (JNJ) is the country's largest health care company. It offers a yield of 3.5 percent. But the stock has gone nowhere for two years, in part because of manufacturing problems in its over-the-counter drug business. Procter & Gamble (PG) pays 3.2 percent. But the consumer products company is bucking headwinds trying to sell name-brand products in a bad economy. PG just reported lower earnings.

These stocks provide a lot more income than a boring old savings account. But to reap those rewards, you must be prepared to take some risk. One way to mitigate risk is to diversify by investing in exchange-traded funds or stock mutual funds. S&P offers the SPDR S&P Dividend ETF (SDY), which holds a basket of highly rated, high-yielding stocks and pays out 3.1 percent.

[See top-rated funds by category ranked by U.S. News Mutual Fund Score.]

Wisdom Tree has several high dividend exchange-traded funds, including the High Yielding Equity Fund (DHS), which offers a 3.3 percent yield. Vanguard boasts several high-yielding mutual funds, including Vanguard High Dividend Yield Index Fund (VHDYX) at 3.2 percent. Vanguard also has balanced funds, such as the Wellington fund (VWELX) or Wellesley Income Fund (VWINX). Both of these hold a mix of stocks and bonds and yield north of 3 percent.

Dividend-paying stocks can provide opportunities for people who need income from their investments. But before you venture in, do a little homework, and make sure you've got some other savings locked away in a safe place.

Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement, and other concerns of baby boomers who realize that somehow they have grown up.