WASHINGTON — U.S. lawmakers will scrutinize the Pension Benefit Guaranty Corp.’s ability to continue paying monthly annuities to retirees amid news that the agency’s deficit has tripled to roughly $33.5 billion in the last six months.

The financial update comes at the request of Congress as lawmakers plan to discuss PBGC’s solvency and concern of mismanagement at a Wednesday afternoon hearing held by the Senate Special Committee on Aging.

The $33.5 billion shortfall, up from $11 billion shortfall reported at the close of fiscal year 2008, is a record high for the agency and comes on the backdrop of controversy surrounding former PBGC director Charles Millard, who may have crossed the line with communication he had with potential investment partners.

According to testimony submitted to the committee, PBGC’s Acting Director Vincent Snowbarger attributed the lose to additional pension plans terminations, investment losses, administrative fees and a decrease in the agency’s interest factor — which is a method PBGC uses to value liabilities.

“Economic turmoil poses issues we have never before confronted and that do not lead to easy solutions,” Snowbarger said in written testimony. Snowbarger is expected to reassure committee members that despite the inflating deficit, “PBGC has sufficient funds to meet its benefit obligations for many years’ because the monthly annuity payments are not lump sums.

Still, the agency makes more than $350 million in annuity payments monthly to workers or retirees who are eligible.

The agency receives its funding primarily from insurance premiums that companies pay and from returns on its investment portfolio, which has been scrutinized as well.

The agency’s investment portfolio, as of April 30, had 30% allocation for equities, 68% bonds and less than 2% with alternative investments, such as private equity and real estate. All of PBGC’s alternative investments have been inherited from failed pension plans.

Snowbarger is scheduled to testify alongside PBGC’s inspector general, a representative from the Government Accountability Office, and possibly Millard, the former PBGC head.

The committee hearing will address to some extent Millard’s improper contact with financial firms and the structure of PBGC’s board of directors, which hasn’t met in roughly 15 months, according to written testimony submitted by GAO Associate Director Barbara Bovbjerg.

Apprehension about PBGC’s operational structure and which industries and sectors agency officials believe could pose great fiscal risk are among the other topics expected to be discussed at the hearing.

The agency is closely monitoring financially distressed businesses related to automotive, retail, financial services and health-care industries. Of particular concern is the automotive industry; PBGC estimates that pension underfunding in the entire auto sector is $77 billion, of which $42 billion would be guaranteed.

By Darrell A. Hughes
Of DOW JONES NEWSWIRES

President Obama’s budget proposes to hike the marginal tax rates of the wealthy to 36% and 39.6% beginning in fiscal 2011, and to increase by 5% the capital gains and dividends tax rate for the wealthy - tax changes that market participants say could lead to higher demand for tax-exempt bonds.

“The Obama tax hike [on the marginal rates] would mean that muni investors could buy bonds about 40 basis points richer in yield to achieve the same after-tax yield,” said Matt Fabian, a managing director at Municipal Market Advisors.

Wealthy would be defined as married couples earning over $250,000 and individuals earning $200,000 or more.

However, the administration has abandoned a proposal aired in a budget outline released in February that would have capped the amount of deductions taxpayers could take at 28%, another move that may have pushed wealthier investors into the muni market.

The most recent budget document also shows an even smaller estimate for how much the federal government will pay for the new Build America Bonds program than a document released Thursday.

However, market participants said the discrepancy does not really matter since the higher numbers were already underestimating the amount of payments that will be made under the program.

In an appendix to the budget released last week, the administration estimated that the Treasury Department would spend $91 million in fiscal 2009 and $340 million in fiscal 2010 on BABs, which it said included Recovery Zone Economic Development Bonds

But the Analytical Perspectives document released yesterday estimated just $50 million and $192 million for BABs during those years. Neither administration officials nor market participants could explain the differences in the estimates.

Treasury officials say roughly $9 billion of BABs have been issued during the past two months since the program started. Clifford Gannett, the director of the Internal Revenue Service’s tax-exempt bond office, which is charged with processing the direct payments for those bonds, said Friday that doing “very conservative” math on those numbers indicates $90 million of payments on just those issuances.

It is possible that the budget numbers stem from revenue estimates put together when the BAB legislation was being drafted, well before anyone knew how popular they would become, sources said.

The BAB program, created by the stimulus law, allows governmental issuers to sell an unlimited amount of taxable debt and either receive a cash payment from the federal government or provide investors with a tax credit equal to 35% of the interest rate.

The Recovery Zone Bonds, $10 billion of which were authorized under the stimulus law, also would provide issuers with a cash subsidy, but that payment is equal to 45% of the interest rate, and there is no option to provide a tax credit to investors. The bonds are to be allocated to areas hit hard by unemployment in 2008.

The budget documents also provide some fresh details for the administration’s estimated savings of phasing out the Federal Family Education Loan student loan program and moving to a system in which all federally guaranteed student loans are originated directly by the Department of Education. Many state-level FFEL lenders, who are opposed to the switch, issue municipal bonds backed by their student loans.

By ending “subsidies” paid to FFEL lenders, the budget documents estimate savings of $24 billion over five years and $48 billion over 10 years.

But an appendix to the budget proposal shows that the federal government has historically overestimated the costs of subsidies for FFEL while underestimating the costs of the direct loan program.

For the roughly $811.7 billion of FFEL loans originated since 1992, the cost of each loan averaged about 8.2 cents per dollar, compared to original estimates of about 10 cents. Issuance costs for the roughly $249.8 billion of direct loans were about 4.5 cents for each dollar loaned, compared to estimates of about 0.6 cents.

Almost three quarters of the budget’s proposed $100.5 billion of grants to state and local governments would be used for transportation infrastructure, mostly highways.

The budget proposed some modest changes to transportation and infrastructure funding, including a new user fee that would fund the air traffic control system beginning in 2011.

The administration argued that the current excise tax that is levied on users based mostly on airline ticket prices should be replaced by a tax related to the cost of services provided by the Federal Aviation Administration. If such a measure is taken, it will generate $9.6 billion in 2011 and existing aviation excise taxes could be reduced, according to the budget.

The administration also confirmed in its budget that it hopes Congress will create a national infrastructure bank and fund it at $5 billion in fiscal 2010. However, only a portion of that would be spent in 2010, the budget said.

The budget estimated that the federal government will provide $73.4 billion of transportation in grants to state and local governments in fiscal 2010, up about $11 billion from this fiscal year. Federal transportation grants would reach $102.3 billion in fiscal 2019 under current policy, according to budget documents.

The administration also proposes a five-year, $5 billion high-speed rail state grant program that would add on to the stimulus funding provided for high-speed rail development.

In addition, the budget includes $3.9 billion for the clean and drinking water state revolving funds.

By Peter Schroeder, Audrey Dutton and Andrew Ackerman, Bond Buyer
May 12, 2009

Variable annuities are in the midst of a major overhaul. In recent months, VA providers have been busy raising fees, decreasing benefits and, in some cases, suspending guaranteed income and withdrawal riders all together. As asset values in VA portfolios plummet along side of the market, and interest rates sink, many insurance companies are struggling to fund guaranteed payments on the products. More fee hikes and benefits cuts are expected in May, when new product prospectuses collectively hit the shelves.

It’s a big disappointment for advisors who sell a lot of variable annuities—and it means a lot more work. Frank Dragotta, managing principal of a LPL independent b/d branch office in Lyndhurst, NJ, says variable annuities (VAs) really caught his eye when insurance companies started offering guaranteed withdrawal benefits in 2001 and 2002. Dragotta, for whom VAs account for 40 percent of his $40 million book of business, says over the next ten years benefits quickly became more robust as insurance companies competed to create the most attractive offering.

But at the end of March, Dragotta began to notice insurance companies decreasing benefits and increasing fees, and in some cases discontinuing products all together. In response, Dragotta spent the last two weeks of March documenting these product changes, contacting wholesalers and doing due diligence on the financial health of the insurance companies—in many cases going back to meet with product providers in person. In all, Dragotta says he is spending 30 percent more time now doing due diligence on insurance providers than he used to.

“Of the companies I was doing business with six months ago, some I will continue to do business with, but I am also adding new carriers who are in a better [financial] position, but weren’t as big on the shelf,” Dragotta says.

Like Dragotta, many advisors who use VAs are trying to digest the massive changes in product design, while also spending added time assessing the financial stability of insurance companies. And in many cases, like Dragotta, advisors have decided to switch providers.

“Within two months this product has changed like night and day,” says Joe Spada, managing director of financial planning firm Summit Financial Resources, Inc., in Parsippany, New Jersey. Indeed, it seems the living benefit arms race is officially over, as insurance companies say they are withdrawing benefits to better align their products with the current economic environment.

VA Throwbacks
According to a recent Cerulli Associates insurance survey, insurers are using a number of strategies to manage the risks associated with paying guarantees on variable annuities. On a five-point scale where five indicates “most often used,” formal hedging programs came first, receiving a score of 4.4. Next in line was increased charges for benefits, with a ranking of 3.5, and reduced withdrawal rates on living benefits, at 3.1. Lisa Plotnick, associate director of Cerulli Associates, says many insurers are paring back living benefits of 7 percent to around 5.5 percent or 6 percent. (Fees on such riders range between 20 bps and 100 bps, on top of a base insurance charge of between 140 bps to 160 bps.)

For example, MetLife, a leader in the guaranteed minimum income benefit (GMIB) space, raised fees on its GMIB rider in February from 80 basis points to 100 bps, and hiked fees on its limited withdrawal guarantee rose from 65 bps to 125 bps—with additional changes to withdrawal guarantees scheduled for May. Other companies have also changed pricing; AXA cut its GMIB rate from 6.5 percent to 6 percent in November and then down to 5 percent in February. Effective in May, John Hancock discontinued all variable annuity share classes (“Bonus, C and L shares”) except its B-Share Venture product, which costs 50-60 bps less than other share classes. Meanwhile other companies are suspending benefit riders all together. In March, MassMutual suspended the sale of its GMIB riders, as well as the Guaranteed Minimum Withdrawal Benefit formerly available on its MassMutual Transitions Select and MassMutual Evolution variable annuity contracts.

In addition to these changes, many companies are simplifying products. “If you look at a VA prospectus right now, you need a hand truck to carry it,” says Mike Farrell, executive vice president of Retirement & Wealth Strategies at MetLife. “Part of that is the proliferation of funds that are in the product, and some of that will be simplified. I think the days of having 200 different investment portfolios is going to go by the wayside because it is very hard to hedge and maintain the correlation between the performance of those funds and their respective indices.”

Scott DeMonte, of FRC, an industry research group, says many insurers are also beginning to replace active managers with indexed portfolios. “We’re seeing companies make defensive moves and being proactive about the market decline—it’s not great for the investor but we’d rather see that then, heaven forbid, another AIG-type situation.”

In all, VA net assets dropped 24 percent in the fourth quarter of 2008 versus the year ago period, according to NAVA, which kept the acronym but changed its name recently to the Association for Insured Retirement Solutions. Meanwhile total variable annuity sales fell 15 percent in 2008 versus 2007, to $154.8 billion. Although insurance companies expect a continued downward trend in sales and 1035 exchanges (which allow an individual to replace one insurance product for another of a different brand without tax consequences), they hope to see an increased interest in VAs from baby boomers looking for equity growth and downside protection. “The client can see now what he is getting through one of these withdrawal benefits, that was something that may have been viewable only in the abstract five years ago, but we’re seeing it in practice today,” says Cerulli’s Plotnick.

But advisors who use VAs feel they have been blindsided by the polar change to benefits. To some advisors the new products may be good for the insurance companies but too complicated and risky to justify using and too expensive for their clients. As one advisor on our forum asked, “At what point do the VA companies price themselves out of business?”

 Evolution or Revolution?

The title of this Outlook, “The Future of Investing,” is a theme that will take the evolving years to resolve, let alone the next few days. Still, PIMCO is an organization that loves a challenge. All of us here today would agree that the answer to both questions will be highly dependent on the evolution of the global economy, and when it comes to those questions PIMCO has excelled because of its long-term secular outlook. It has paid dividends for our clients for over 30 years and it should do so now as well. The fact is, that the future of investing will depend on the long-term future of the global economy – its nominal growth rate and the distribution of that growth between public and private interests. And so we should start at the beginning, or perhaps at the top, of our top-down process – the future of the global economy.

 I. Future of the Global Economy

The future of the global economy will likely be dominated by delevering, deglobalization, and reregulating, yet if so, it is important to state at the outset that we do not envision a mean reversion, cyclically oriented future, but instead a new world where players assume different roles, and models relying on bell-shaped/thin-tailed outcomes based on historical data are less relevant. Historical models look backward while modern-day finance is being fast forwarded and reconstituted almost as we speak.

 1) Delevering – The prior half-century of leveraging and the development of the amorphous shadow banking system was growth positive. Major G-10 economies became dominated by asset prices and asset-backed lending most clearly evidenced in housing markets. Excess consumption was promoted, and investment based on that consumption followed in turn. Savings rates in many countries including Japan, the U.K., and the U.S. fell towards zero as the reliance on rainy day thrift faded. Deleveraging of business and household balance sheets now means those trends must reverse, and as they do, growth itself will slow, bolstered primarily by government spending as opposed to the animal spirits of the private sector.

 This topic is one which literally could take hours to discuss, and at PIMCO forums and Investment Committee meetings, it does. There are those of us here as well as highly respected economists outside of PIMCO who would suggest destruction as opposed to slow growth, and they may have a minority, but not insignificant, case. Much depends on the effectiveness of policy responses and the simplistic answer to a simplistic question. Can global financial markets and the global economy heal by pouring lighter fluid on an already raging fire? Can too much debt be cured by the issuance of even more debt? Must the debt supercycle come to an end by crashing and burning or does the world keep breathing with a whimper instead of a bang? We shall see, but there is a near certain probability that the financially based global economy of the past half-century will not return, nor will we experience the steroid driven growth excesses that it facilitated.

 2) Deglobalization – Lost in the wondrous descriptions of finance-dominated, Bretton Woods-initiated, global growth has been the adrenaline push provided by global trade and indeed portfolio diversification into a multitude of markets – developed or developing. Yet historians point out that globalization is not an irreversible phenomenon – witness the aftermath of WWI and nearly three decades of implosion. Now the beginning signs of trade barriers – “Buy American” and “British jobs for British workers” among them – as well as government support of locally domiciled corporations (banks and autos) suggest an inward orientation that is less growth positive. Additionally, “financial mercantilism” is an added threat – a phenomenon that speaks to growing pressure on banks to retreat from international business and concentrate on domestic markets.

 3) Reregulation – Academics, politicians, investors, central bankers and everyday citizens are questioning the economic philosophy that idolized free markets and their ability to self-regulate. The belief in uncapped and unregulated incentives producing unlimited upside but nearly always cushioned downside losses is fading. While Sarbanes-Oxley was a well publicized but relatively toothless response to the dot-com bust of nearly a decade past, today’s politicians have gained the upper hand, driven by a citizenry that has recognized the unbalanced, disproportionate distribution of incomes. The efficient market thesis, so prevalent in academic theory and market modeling is now in retreat, and perhaps rightly so. In its place, we will experience less efficient but hopefully less volatile economies and markets – monitored and controlled by government regulation. Executive compensation, of course, is just the poster child. Government ownership and control of vital financial and manufacturing institutions will politely be described as “industrial based” policy and “burden sharing,” but we should have no doubt that we will move significantly away from the free market model that has dominated capitalistic countries for the past 25 years.

 With the top-down framework for future global economic growth in place, let’s take a look at PIMCO’s outlook for the future of investing – evolution or revolution.

 II. The Future of Investing

Whether evolution or revolution it is important to recognize that the aftermath of an economic and investment bubble transitioning from levering to delevering, globalization to deglobalization and lax regulation to reregulation leads to an across-the-board rise in risk premiums, higher volatility and therefore lower asset prices for a majority of asset classes. The journey to a new stasis is a destructive one insofar as it affects previously assumed wealth. Rough estimates suggest that as much as 40% of global wealth has been destroyed since the beginning of this delevering process. In essence, asset prices, which are really only the discounted future value of wealth creation, go down – not only because that wealth creation slows down but because it becomes more uncertain. In such an environment, equity interests in the form of stocks, real estate or even high yield bonds become re-rated. Those who believe that capitalism is and will remain a going concern and that risk taking – over the long run – will be rewarded, must recognize that those rewards spring from beginning prices and valuations that correctly anticipate the global economy’s future growth path and volatility. In terms of that old maxim “buy low – sell high,” this means at the minimum that an investor during this period of re-rating must “buy low.”

 In turn, investor preferences towards risk taking, even when correctly calculated and modeled must be considered. Peter Bernstein has for several years counseled that policy portfolios structured for the long run and based on historical return statistics should be reconsidered. The standard pension or foundation approaches to policy portfolios are being challenged, he asserts, and PIMCO agrees. Stocks for the long run? Home prices that cannot go down? The inevitable levering of asset structures to double or quadruple returns relative to risk-free assets? These historical axioms must now be questioned. In fact, as of March 2009, the superiority of risk-asset returns are not what many assume them to be. For the past 10, 25, and 40 years, for example, total returns from bonds have exceeded those for common stocks.1 Home prices have declined a staggering 30% since their peak in late 2006, and have barely kept up with inflation for the last century according to Case-Shiller statistics. Commercial real estate when ultimately mark-to-market over the next several years will likely show similar results. In short, our stereotyped conceptions of what makes money are being challenged. As Bernstein says, there is no predestined rate of return. And a PIMCO corollary would counsel that future rates of return will be dependent on the beginning price and future growth rates and risk preferences that cannot necessarily be derived from historical models. Government policies will also play an important role, especially insofar as they impact long-standing property rights and capital structures. What I have previously described as a CQ – a common sense quotient – may take precedence over IQ and quantitative analysis in future years. How much of a benefit, for instance, did the renowned risk modeling of some of our major competitors produce over the past several years in terms of their bond funds and derivative-related products as compared to PIMCO’s? We invite comparison, not only of our own risk models, but our collective common sense quotient.

 What then does common sense tell us about future asset returns? Let’s revisit our previous conclusions on the developing environment for some clues. They include: delevering, deglobalization, reregulation leading to slow global growth, a heightened risk aversion, a distrust of conventional investment model portfolios, and a greater emphasis on surviving as opposed to thriving. If valid, then an investor or an investment committee would likely stress the bird in the hand – as opposed to the one in the bush; stable and secure income – as opposed to uncertain capital gains; a government-regulated utility model – as opposed to innovative yet risky venture capital investments. At current price levels, to cite one example, the current income from corporate bonds is higher and certainly more secure than the dividend income from stocks.2 A return to an era reminiscent of the first half of the 20th century is not unimaginable where stocks were viewed as subordinated income producers with yields exceeding their senior bond companions on the liability ladder.

 But let me not go too far in suggesting that asset classes near the perimeter of risk have no future. They do if only because they eventually will be priced right. In fact, PIMCO intends to participate in the management of many of them, and as argued previously should be well and healthily positioned to do so. Our recent launch of a global multi-asset fund featuring tail-risk protection is just one example. The potential participation in TALF and other government-sponsored levered structures is another. Still, the tide seems to be going out and as Buffet suggests, all swimmers are being exposed, swimming suits or bare-bottomed naked.

 There are a host of investment implications that one can subjectively conclude from this outgoing tide, although they have not been officially endorsed by our upcoming secular forum. It seems to me, though, that one has only to ask what investments were positively affected by the previous long-term cycle of levering, deregulation, and globalization in order to imagine which ones will do poorly as the trends reverse. A short list might read as follows:

 (1) The Dollar – As the center of structured finance and the shadow banking system, the dollar was bolstered as it sold paper to the rest of the world. To date, its recent strength seems counterintuitive. Weakness may more accurately describe its future.

 (2) Credit – Lax regulation and increasing leverage squeezed risk premiums and spreads to historically overvalued levels. We are now moving in full reverse.

 (3) Equity – In addition to the previous conclusions, it is evident in retrospect that narrow risk premiums in credit markets facilitated narrow equity premiums in stocks if only because they seemed cheap by comparison and allowed corporations to borrow cheaply and buy back their own stock.

 (4) Emerging Market Globalization and lax lending standards re-rated emerging and developing country financial markets to unrealistic levels. Eastern Europe is likely the first to fall.

 Many of these trends, of course, have now reversed course, direction, and magnitude, and there will come a point where those low and lower prices, as well as the potential for successful policy healing, will favor what is now in disfavor. For now, however, let it be simplistically said that the trend is your friend and that the ad hoc, disjointed and anemic policy responses of government appear to be too little, too late. Investors should therefore favor stable income as opposed to speculative growth or the subordinate liability structures of most private market balance sheets. Shake hands with the government is and has been our motto although the contractual certainty of a government handshake may now be questioned in an increasingly number of marginal areas.

 Another way to summarize our caution would be to quote a recent comment by Barton Biggs. “I am a child of the bull market,” he said which upon further elaboration meant that he bought on cyclical dips with the expectation of riding mean reversion to an upward sloping trend line of prosperity and ultimately higher peaks. In a sense, we are all children of the bull market, although some of us are more mature than others – a bull market of free-enterprise productivity and innovation, yes, but one fostered by a bull market in leverage, deregulation and globalization that proved unsustainable in its excesses. We now must view ourselves as chastened adults, forced into acknowledging a new reality that is dependent upon bear-market delevering and debt liquidation to deliver us to our new and ultimate restructured destination – wherever it lies. Thus, while historians might describe these years as an evolution, for those of us living it day-by-day it most assuredly has the feel of a revolution. Much like Irving Fisher’s “permanently higher plateau” of prosperity that was quickly turned on its head in 1929, those who would forecast a “permanently lower valley” of despair might similarly be off the mark. Yet there should be no doubt that the bull markets as we’ve known them are over and that the revolution is on. Investing is no longer child’s play.

Bill Gross, CIO PIMCO
 

As the population ages, wealth advisers increasingly will be called upon to stretch retirement savings over more years — sometimes a lot more years.

Take the case of an adviser in Portland, Maine, who was retained by a 97-year-old man with a big problem. “His wife had just died,” says Tom Rogers, a certified financial planner and a principal in the Portland Financial Planning Group. “I guess because his wife was younger, his lawyer had put together an estate plan that assumed he would pre-decease her. It said that in the event of her death, their assets would go to her children from a first marriage.”

Surprise, surprise: She died first, leaving him with no money.

“The estate wasn’t huge,” says Rogers, who is on the board of the Maine Estate Planning Council. It was about $600,000 including real estate and investments, but it was all he had besides Social Security and a small pension.

In many states, a surviving spouse who is disinherited can petition the court for what’s called a forced share, typically 30% of the estate including beneficiary accounts. “His stepchildren weren’t thrilled, but he was able to do that, and he got $200,000,” Rogers says.

The question became how to invest that money for someone 97 years old.

“He was in good health, completely lucid, actually a bit of a curmudgeon,” says Rogers. “He didn’t know how long he was going to live, but he wasn’t willing to assume he was going to die in two years. Obviously the stock market would not be a good choice, but we wanted better returns than a money market or CD.”

During discussions with the client, says Rogers, “it turned out that he was very loyal to his prep school and college. So my solution was to set up charitable gift annuities with those schools.”

Many charities offer these annuities where, basically, in return for handing over assets to the charity, the donor is guaranteed a lifetime income stream. And because of his advanced age, the client was eligible for a 12.5% annual return no matter how long he lived. No other conservative investment would have offered that kind of return, and he also received a major income tax deduction because it was part gift and part investment. “And it made him feel good that he was giving to his schools,” Rogers says.

As it turned out, the deal wasn’t so great for the schools. He died last year, at the age of 107.

“They probably were not expecting to pay out on that annuity for 10 years,” says Rogers. “But it goes to show you that you just never know.”

Clients don’t have to be centenarians to take advantage of charitable annuities. Rogers says an 80-year-old currently gets a return of around 7%. Rates have declined a bit recently due to increased longevity and lower expected returns on invested assets.

One catch for wealth advisers is that once the donation is made, the money is no longer under management, which means no ongoing fee income — though that wouldn’t stop an adviser like Rogers, who says the satisfaction of helping out his client far outweighed any lost fees.

By Max Alexander
A DOW JONES NEWSWIRES COLUMN

 Corporate dividends were once sacred, but no longer. As the economy declines, so have the regular cash payouts that both companies and stockholders considered untouchable. Some of the biggest names in U.S. business have cut or eliminated dividends — choosing not to share the wealth either because they need the money now or think they will later.

Last year was the worst ever for dividend reductions among Standard & Poor’s 500 stock-index companies. In the final three months of 2008 alone, $15.9 billion worth of S&P 500 dividend payouts were whisked off the table.

That quarterly record has already been eclipsed in the first two months of 2009 with more than $30 billion in dividends wiped out, most notably General Electric Co.’s (GE) move late last month to slash its quarterly distribution by more than two-thirds.

For investors who depend on dividend income, or who expected the cash would cushion the bear-market’s blows, the setback has been sobering. The cuts have been particularly unkind to shareholders of dividend-focused mutual-funds and exchange-traded funds who’ve suffered losses in both take-home yield and investment returns.

“Dividend investors have now joined the rest of investors in looking for safer harbors, and there are not many out there,” said Howard Silverblatt, senior index analyst at Standard & Poor’s Inc.

Big Payers Cutback

The comedown is especially hard for dividend cutters that not long ago were considered highly predictable payers — so-called dividend aristocrats — such as Bank of America Corp. (BAC), Pfizer Inc. (PFE) and GE.

Dividend investing itself also has been tarnished. Dividend growers historically have been defensive stalwarts, outperforming less-generous corporate rivals and the U.S. market as a whole through good times and bad, and with less risk.

S&P 500 companies that raised dividends gained 8.8% on average annually between January 1972 and last November, according to Ned Davis Research Inc. Index members that cut dividends or paid no dividends finished the period with essentially flat returns.

Still, shareholders who temper their expectations can find cash-rich companies that are increasing dividends. The battered financial-services sector is being necessarily frugal, but some commodity-related and consumer-staples companies have breathing room.

Recently, for example, agricultural bellwethers Archer-Daniels Midland Co. (ADM) and Monsanto Co. (MON), along with soft-drink giant Coca-Cola Co. (KO), retailer Wal-Mart Stores Inc. (WMT) and paper-goods supplier Kimberly-Clark Corp. (KMB) boosted payouts.

“Dividends are an endangered species, but nowhere near extinct,” Silverblatt said. “You’ve got to do a lot more homework. Pick the company first, the dividend second. A high yield won’t do you any good if the company can’t sustain it.”

Against this grim backdrop, managers of funds that focus on dividend-payers are facing the most challenging conditions many have ever experienced.

“Clearly this environment has created some stress,” said Don Taylor, lead manager of Franklin Rising Dividends Fund (FRDPX). He screens for companies that have raised dividends in at least eight of the last 10 years, and then chooses only those whose dividends have doubled over a decade.

“A lot of companies that previously met the rising-dividend screen no longer do,” he added.

Some managers are tightening the screws. Judith Saryan, who oversees the Eaton Vance Dividend Builder (EVTMX) and Dividend Income (EDIAX) funds, is analyzing corporate financials for signs of cash shortfalls.

“You want to avoid companies paying the highest yield because they’re the ones that are most at risk,” she said. “Even a very good company that needs to access the credit market might raise a red flag.”

Financial-services companies comprise the bulk of distressed dividend payers, and these high-yielding stocks often show up in the equity-income fund category, which has been broadsided as a result.

Roam The Market For Payers

“Equity-income is under a cloud because of the feeling that these companies are not secure, their finances are eroding, and they probably would cut the dividend,” said Mark Salzinger, editor of the No-Load Fund Investor newsletter.

Salzinger recommends vehicles that roam the broad market for dividend growers, such as the mostly large-cap Vanguard Dividend Growth Fund (VDIGX). An ETF sibling, Vanguard Dividend Appreciation (VIG), also highlights dividend standouts but sports a much different portfolio.

Other proven dividend-oriented stock funds, in addition to the Franklin and Eaton Vance portfolios, include T. Rowe Price Dividend Growth Fund (PRDGX) and Alpine Dynamic Dividend Fund (ADVDX).

Choices among ETFs include: PowerShares Dividend Achievers (PFM), WisdomTree Large Cap Dividend (DLN), SPDR S&P Dividend (SDY), and the largest of the group, iShares Dow Jones Select Dividend Index (DVY).

In the search for dividends, remember that high quality, not high yield, counts most in this market.

“You really need companies that have the most quality balance sheets you can possibly find,” Salzinger said. “A good dividend-growth fund would invest across industries in stocks that yield between 1% and 3% and have the capacity to increase those dividends over time.”

By Jonathan Burton