I recently read this post on The Retirement Café. It’s a fine blog for sure penned by Dick Cotton. Here’s The Mystery of The Dividend Preference and the ‘Spend Only’ Strategy.
First, let’s set the stage, from that article.
A good many retirees seem to be enamored with the “Spend Interest and Dividends Only” strategy for spending down their retirement savings. The foundation of this strategy is a preference for the value of a dollar generated from dividends over the value of a dollar generated from the sale of stock, or capital gains.
Let’s move on to the statement that for my money, is largely false and based on unproven or ‘unprovable’ assumptions.
Hartzmark thinks dividends fall under the category of mental accounting. He describes a “free dividend fallacy”, in which investors view dividends as a source of return that is independent of the price of the stock when in reality the price of the stock is immediately reduced by the value of the dividend when it is paid. This fosters the mistaken belief that dividends are the same as bond interest.
I’ve been around investors for many decades. I’ve been writing on Seeking Alpha for quite some time. I was an advisor at Tangerine Investments for over 5 years. In all of those years I never came across an investor who described their dividends as ‘free money.’ I was never given the impression that an investor did not know where ‘the money came from’ to create that dividend. Read my many, many dividend-focused articles that will at times generate hundreds of comments and you’d have to search long and hard to find a comment or ‘commenter’ that is suggesting that the money just appeared out of thin air. They know that stocks are not bonds, even when they write about using some juicy dividends as bond replacements.
These investors know the risks. They know a dividend might not be forever. From my experience – they are not stupid.
Please show us the studies that demonstrate that dividend investors, and retirees, think that the dividends are from heaven. While one could find a few comments that lean in the direction of ‘free monies’ that is largely and mostly not how retirees view the dividend payments.
Dividends come from free cash flow from business operations
When a company generates revenues and they pay all of their business expenses, they then have options in how they will conduct their business and reward their shareholders. Certainly, they can reinvest in the business to drive future revenue and cash flow and earnings. They can buy back shares and they can pay and increase those dividends. And certainly it’s true that if a company has $100 million and they choose to buy back shares instead of using those monies to pay $100 million in additional dividends, it produces the same result with respect to the shareholder’s ownership of company profits. That fact will have absolutely nothing to do with argument. The retiree that has that dividend payment in hand has that retirement income in hand. They have that income in hand irrespective of the stock price movement. They do not have to sell shares. Their income level in this case is determined by the company management and dividend policy, not the stock market makers who can knock down the stock price in a hurry forcing and requiring the selling of additional shares to create that same level of income.
The risk is from the dividend policy and over the longer term the risk has its roots in that free cash flow tied to business success or failure.
Where the dividend doubters get it right
In fact, there are tax advantages to generating income with capital gains in a taxable account, despite the fact that qualified dividends and capital gains are currently taxed at the same rate. The investor can postpone capital gains tax until the funds are actually needed whereas a cash dividend (the most common type) will be immediately taxable when the company decides to issue it. An added bonus of capital gains is the ability to minimize taxes by selling specific lots.
Yup. Know your tax situation. More options can be ‘more better.’ With capital gains you will have greater control of when you create that income. In Canada we have the dividend tax credit, and that can certainly add another layer of consideration, mostly for those in modest income brackets. As was observed in Retirement Income For Life, most retirees will have a dynamic spending plan and spending needs, that means having enough control of income beyond dividend payments.
Greater diversification and growth prospects
Swedroe further notes that concentrating on dividend-producing stocks reduces diversification benefits. Concentrating is a key word here because adding some dividend-producing stocks to a portfolio can increase diversification. Said differently, there is nothing wrong with dividend-producing stocks but investing in only those stocks can be hazardous to your portfolio’s health. As is often the case, too much of a good thing is too much.
I will often write on this subject. If we have an exclusive ‘live off of the dividends policy’ we may be closing many doors to many types of stocks and perhaps to many important sectors. We may even close the door to geographic and currency diversification. That can be especially true when we exclusively look for more generous dividends as we stretch to cover every penny of our spending needs with income. It’s certainly not optimal on many fronts.
That said, in real life I play that concentration card with my Canadian Wide Moat Dividend Portfolio. But I go that route with full understanding of my concentration ‘risks.’ Like my dividend growth counterparts I am not suffering from any mental accounting. I know who makes my dividends and how they make my dividends. I am also not averse to any future share harvesting for these Canadian companies. It’s just by chance that these companies pay out an extraordinarily large percentage of their free cash flows to shareholders.
I understand that route to the greatest retirement income for me is by way of some nice juicy dividends and some share harvesting. For our US dividend portfolio component there is no yield focus, we hold a number of Dividend Achievers (VIG) and a few picks by way of Apple (NASDAQ:AAPL), BlackRock (BLK) and Berkshire Hathaway (BRK.B) (BRK.A). If a group of lower-yielding stocks has greater growth and greater longer term business success compared to a higher yielding slower growth basket, it will outperform that lesser performing high yield group. Yes, we’d have to sell some shares of the lower-yielding group to unlock that value. And yes, we’d have to manage that sequence of returns risk. Many retirees who embrace dividends and dividend growth investing try to find that balance between the comfort of those larger dividend payments and that portfolio growth kicker.
But again, in the end, we/they are not blinded by the dividend light. We know what we are getting into. In this recent article, I referenced The Dividend Guy who is one of the most popular writers on Seeking Alpha for dividend coverage. Mike did a very solid and measured refute of ‘every point’ of a dividends don’t matter podcast.
Mike says he’ll keep his 4-5% annual market beat of the market.
Author’s note: Thanks for reading. Please always know and invest within your risk tolerance level. Always know all tax implications and consequences. If you liked this article, please hit that “Like” button. Hit “Follow” to receive notices of future articles.
Disclosure: I am/we are long BNS, TD, RY, AAPL, BCE, TU, ENB, TRP, CVS, WBA, MSFT, MMM, CL, JNJ, QCOM, MDT, BRK.B, ABT, BLK, WMT, UTX, LOW, NKE, TXN, PEP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.