In retirement, there are two ways to use your assets to cover your expenses. You can either draw down your money or you can live off the income that the investments provide. Living off the income that your assets produce allows you to hold onto and even grow your nest egg for longer, which helps ensure that you can make it all the way through retirement without running out of money.
Investing in stocks that pay out dividends can be a smart way to establish a reliable income stream in retirement.
Here are some of the best dividend exchange-traded funds (ETFs), which allow you to invest in a bucket of dividend stocks somewhat more easily than if you were to research and choose individual stocks on your own. In choosing these funds, we looked for stability, low fees, enough assets under management to ensure they would be around for a while and a good yield. (For more, see the tutorial: Introduction to Dividends.)
The Vanguard dividend appreciation ETF (VIG) has a low expense ratio of only 0.09%, so very little of the income and growth you get will go to management. The yield is 2.15% — while ideally you want this a bit higher, it is a touch better than what the S&P 500 yields. Where it is different is its stability during down years. The fund managers filter to find high-quality companies, which means they look for firms that have raised their dividends over the past 10 years. They also have minimum liquidity requirements so you won't be exposed to small stocks that can be hard to get out of.
The fund also features real estate investment trusts (REITs) and limited partnerships. Finally, it uses some other proprietary filters to narrow it down to about 150 to 190 stocks; it currently holds 185 stocks.
The Vanguard High Dividend Yield (VYM) also has a low expense ratio of only 0.09%, but its yield is much higher at 3.24%. That's because the fund takes on less high quality stocks and instead focuses on yield. This can mean that the dividend may be at risk if it is too high for the company to sustain. One way the fund mitigates this risk is by making the fund larger; it has more than 400 stocks in its portfolio.
Fund managers determine what stocks get in by sorting all dividend paying stocks by yield, highest to lowest. They then proceed to add stocks until the cumulative market capitalization is 50% of the total market capitalization of all dividend paying stocks. The stocks are then market cap weighted. This process tends to produce a large cap value lean. (For related reading, see: 2 Vanguard Dividend ETFs Poised for More Growth.)
The SPDR S&P Dividend Yield (SDY) uses dividend yield weighting instead of market cap. It does have a higher expense ratio at 0.35%. The yield is 2.46% and it has 107 stocks.
You might consider this ETF if you are looking for more exposure to small and mid-cap stocks (it has 48% of its assets in small- and mid-cap equities). This occurs because of the yield weighting. The fund managers determine the stocks by taking the dividend aristocrats — stocks that have raised dividends for 20 consecutive years. It then filters out low liquidity and low market cap stocks. Then it weights the remaining stocks by annual dividend yield; it caps the yield at 4%.
The Schwab US Dividend Equity ETF (SCHD) has the lowest expense ratio of the bunch at 0.07% and has a yield of 3.15%. It only holds 100 stocks and it selects them by looking at more than just yield and size. (For more, see: How to Reinvest Dividends from ETFs.)
The fund excludes REITs, master limited partnerships, preferred stock and convertibles. It has stocks that have been paying dividends for 10 consecutive years and that meet minimum liquidity and market cap minimums. Stocks are listed in descending order of annual yield. The managers take it a step further than most and select four fundamentals that they use to gauge the quality of the underlying businesses, looking at items such as return on equity. They then take the 100 top rated stocks from this filter and market cap weight them. This process tends to produce high quality mega cap companies for the ETF.
Dividend investing can be a good way to create income to make your retirement portfolio go further. ETFs, with their relatively low fees and exposure to a wide swath of stocks, make the investing process even easier. (For related reading, see: Why Monthly Dividend ETFs Are Good for Everyone.)