Pay Yourself What Social Security Won't

Monday, November 2, 2009 - 10:30am

by Tom Hutchinson

They came every year like clockwork. They were so usual that most recipients took them for granted. But next year will mark the first time in decades that Social Security payments will see no cost of living adjustment (COLA).

You see, the adjustment is tied to increases in the Consumer Price Index (CPI), which measures inflation. Typically inflation rises a few percentage points a year, in turn leading to an annual increase in Social Security benefits. But with the recession in full force, the CPI has actually decreased about -1% this past year.

The issue is that the CPI is calculated using a basket of goods bought by the "average" consumer. Of course, people who receive Social Security are usually retirees -- and their expenditures are different than many consumers. For example, medical expenses and prescription drugs usually make up a large share of a retiree's budget.

So while the CPI is down, many expenses for seniors continue to rise. According to a Price Waterhouse study, overall medical costs have increased +3.5% for the last year. Hospital costs have increased +6.6%. Even some everyday items like water and trash collection have risen about +6.0%.

Yet, many income sources Social Security recipients depend on have been flat or declining during the past year. In addition to no bump in payments, a one-year CD averaged close to 4% in 2008; it is paying 1.6% today. Ten-year Treasury notes paid above 5% in 2007 and pay only 3.5% today.

But you can fight back. We've found a way that you can battle higher expenses and lower income... and in effect create your own cost of living adjustment.

Social Security Cost of Living Adjustments
2005 +4.1%
2006 +3.3%
2007 +2.3%
2008 +5.8%
2009 0.0%

The Key to Increasing Income
The key to boosting your monthly income lies in a security most investors are familiar with: Closed-end funds.

Right now, more than 650 of these funds trade on U.S. exchanges. They invest in every sector of the market (stocks, bonds, REITs, MLPs, etc.) and even every niche of every sector (tax-free bonds, high-yield bonds, international equity, preferred stocks, etc.). But what they're best known for is their income.

Unlike traditional open-ended mutual funds, closed-end funds don't have cash going in and out of the fund -- only a set number of shares trade. If you want to buy in, you purchase your shares from another investor, just like a stock.

The structure lends itself to paying out high income because the funds don't have to keep money available for redemptions and can invest all its assets.

It shouldn't be a surprise then that it's no problem finding closed-end funds that pay income. My screening software shows 290 CEFs currently yielding over 7%. More than 130 are yielding 10% or higher. The overwhelming majority of evs pay distributions on a monthly basis -- 460 of the 654 to be exact.

Adding one of these high-yielding gems to your portfolio should give your monthly income a quick boost. However, the last thing any investor should do is buy into a fund simply because it pays an enticing yield.

Just like any other investment, you need to do your homework. But since funds are different than a normal stock, there are a three unique metrics you should keep an eye on:

Performance During the Downturn
Past performance is a fund's resume. While nothing is certain, you can generally increase your chances of choosing a solid-performing fund by selecting one that has proven itself already. In particular, you want to ask:

  • How has the fund performed in good markets and bad?
  • How has the fund performed relative to its sector?
  • Does the fund perform well in the long term and/or the short term?

If you're most worried about safety, a good place to start your search is with funds that were able to hold up in the last downturn. These may not offer sky-high gains in a rising market, but they've proven their mettle in one of the worst downturns in recent memory.

Discounts and Premiums
Sometimes closed-end funds trade out of line with their net asset value, meaning the share price may be higher or lower than the per-share value of the assets held by the fund.

Some funds may trade out of line with their net asset value for years. Therefore, it's important to look at the discount or premium in relation to its historical average. The key is to find funds trading for less than their average historical discount or premium.

Avoid Return of Capital Distributions
Before buying into any fund, you'll want to know where the dividend payments are coming from. You can usually find this by look at the last year's tax breakdown on the fund's website.

Many funds have "managed distribution policies." This is a fancy way of saying they plan to make the same payment each month, no matter how much income the fund earns from investments.

Usually the fund sets payments at a sustainable level. But in some cases, a fund may earn less income than it pays out -- forcing it to dip into its assets to maintain the payment.

These distributions are classified as return of capital. Such payments are simply a return of your principal and erode the value of the fund. In short, it's usually best to avoid funds making return of capital payments.

Tom Hutchinson does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.