Financial advisors use a variety of investment strategies to replace retiree employment salaries or business income.
These include bond ladders, systematic withdrawal programs, guaranteed minimum withdrawal benefit products, and even strategies in the relatively new category of target payout funds. But one of the most common approaches is the dividend yield strategy.
Relying on dividends for income is a strategy that has served investors well in the past. Who hasn’t heard of the proverbial elderly widow living off the steady stream of General Electric (GE) dividend checks? And many investors believe that high-dividend-paying stocks are preferable to low- or non-dividend-paying stocks for portfolios intended to meet income needs.
Reason #1: There’s No Free Lunch
It’s not hard to see why investors are attracted to the idea of high-dividend-paying stocks. On the surface, these investments seem to offer the best of both worlds: the potential for long-term capital appreciation and a steady income stream. But this perception rests on a fundamental misunderstanding of how dividends work.
Dividends come from profits that a company distributes to shareholders. Faced with a choice between reinvesting this surplus into business projects, repurchasing their own stock, or paying it out to shareholders, dividend-paying companies emphasize the last option.
Paying out a dividend means a company has less capital to fund new or existing opportunities (assuming they don’t raise capital through issuing additional equity). Consequently, this is likely to dampen future business growth. All else being equal, when companies declare a dividend, their inherent value immediately declines by the amount of the distribution on the dividend record date. That’s a clear sign that dividends aren’t free.
Dividend Yield Versus Total Return
A different approach to framing the income replacement issue is through the lens of total return—the sum of both dividends and capital appreciation. According to this perspective, dividends aren’t necessary in order to receive money from a portfolio. If a shareholder needs income, they can manufacture their own “dividends” at any time by selling shares of stocks or mutual funds.
In 1958, Franco Modigliani and Merton Miller published a seminal paper on capital structure and dividend theory (“The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review, June 1958). Their assessment of optimal capital structures argues that companies should be indifferent to how they raise capital (whether through issuing more debt, selling stock, or issuing new stock) and that dividend policy doesn’t affect the value of a firm.
Most individual investors, however, don’t consider capital structure when evaluating high-dividend-paying stocks. Rather, they make their decisions according to more tangible criteria. And dividends are attractive because they create a mental accounting framework that is more psychologically tolerable. The rules of this game are simple: Spend the dividend check, and leave the rest alone.
Do Dividends Signal a Better Investment Opportunity?
Some might argue that dividend-paying stocks are more attractive investments and that when a company pays a dividend it signals something about its future prospects. For example, it could mean they’re more confident in their future earnings.
Research from Russell Investments hasn’t found a compelling investment case for this view that dividend-paying companies are better long-term investment opportunities. At best, there’s modest support for the view that some companies that increase their dividends over time may have better future prospects. Be careful of letting a convenient quarterly payment accidentally drive an active management strategy.
Reason #2: Dividends Have Been Declining
A few decades ago, it was reasonable to invest in a broadly diversified pool of stocks and still earn a healthy dividend. Since then, however, dividend yields have dropped significantly.
Relying on dividends to provide a level—and large enough—income isn’t as easy as it used to be. And while it’s difficult to predict the exact dividend policies companies will adopt in the coming years, it’s unlikely that they will be as high or as stable as they have been in previous decades.
Reason #3: Concentration Risk Is Common
In order to achieve a dividend yield level even close to what a broadly diversified investor would have received a few decades ago, an investor would need to concentrate their portfolio into the highest dividend-yielding stocks. However, these stocks tend to be concentrated in a few select sectors, such as financial services and utilities. Pursuing this strategy would allocate a large percentage of an investor’s stock portfolio to two narrow sectors. And as history has proven time and again, unexpected events can devastate narrow areas of the market and individual securities.
Lastly, don’t forget that dividend yield is defined as a company’s dividend payments divided by its share price. A high dividend yield might not equal a high dividend payment; it could result from the plummeting share price of a troubled company.
A Lesson Learned Too Well?
One of the more perplexing questions about the dividend yield approach is why dividends were so popular before the 2003 tax changes equalized their tax treatment. (Before the Tax Relief Act of 2003, dividends were taxed at ordinary income rates. After the act, their effective tax rate became the same as the capital gains rate, with a maximum of 15%.) It suggests that strong psychological or emotional factors are at work. If dividends can be considered a zero-sum game or a worse choice in historical tax environments, then why has dividend yield investing been so attractive in the past?
Much of the attraction undoubtedly stems from the classic wisdom voiced by experts, family and friends: Never invade principal. This tenet of responsible investing is ingrained so deeply and so effectively, it’s difficult to dispel. For many wealthy individuals, it’s a core belief that helped them create their wealth in the first place. Manufacturing dividends feels like robbing the nest egg; harvesting company profits a bit at a time does not. And so emotion trumps theoretical investment rationale.
In Defense of Total Return
As more investors enter retirement and need to replace substantial proportions of their income by using their investment portfolios, a dividend yield strategy is likely to fall short. There may simply be no alternative to adopting some form of total return investing. Even more worrisome for the never-invade-principal adherents: The time may come when prudently drawing down a portfolio becomes necessary to fund living expenses.
When we consider the risks of a dividend yield strategy discussed above, a total return approach that relies on a combination of dividends and capital gains to fund income-replacement needs is compelling.
This post was adapted from a July 2011 AAII Journal article by Rod Greenshields.