When thinking about income in retirement, many investors embrace the adage “never tap growth or touch the principal.” However, generating an acceptable income solely from interest and dividends requires a sizeable portfolio, and isn’t practical, realistic or necessary for many investors.

• Interest and dividends only: In this approach, you rely on investment income only, without touching growth or the original investment.
• Total-return approach: This strategy aims to generate a targeted annual return from all sources (interest, dividends and growth), and may or may not involve touching the original investment. It could make sense to think of this as interest and dividends “first.” If interest and dividends alone are enough to support you, great—if not, you can tap growth and/or the original investment.

Investors should be aware of the potential trade-offs that accompany a focus on interest and dividends only. A total-return approach can lead to a more balanced portfolio and can mitigate some of the risks of only an income-oriented portfolio, provide more flexibility and can help create sustainable growth for a longer retirement.
For stockholders who own dividend-paying shares, those payments arrive on a schedule (quarterly, in many cases). The cash to fund a dividend must come from somewhere, however. We know the price of a stock is potentially influenced by all expected future cash flows to shareholders. If cash is paid today in the form of a dividend, the stock price—and total market capitalization—of the issuing company may therefore fall, as the hypothetical Portfolio A in Exhibit 1 shows. That means, all else being equal, an investor who receives a dividend may also be left with a less valuable equity holding.

CASH CONSIDERATIONS

An alternative method of raising cash is to simply sell shares. Exhibit 1 compares the two methods of generating income by contrasting Portfolio A with the similarly valued hypothetical Portfolio B. While Portfolio A receives income through a dividend payout, Portfolio B generates it through a stock sale.

The investor in Portfolio A, in which a dividend is issued, ends up holding the same number of shares as were held prior to the dividend payout, but we assume that those shares have declined in value. The investor in Portfolio B holds a reduced number of shares that haven’t seen their value decrease as a result of a dividend payout. The two approaches arrive at the same place—both investors end up with $100 in cash and $1,900 in stock, notwithstanding potential trading costs or tax implications. But there are potential considerations to the dividend approach when contrasted with the stock-sale approach.

First, the average proportion of firms paying dividends in the US was about 52% from 1963 through 2019,[1] meaning an investor focusing only on those stocks is missing out on nearly half of investible US companies. Dividend and income strategies may have concentrated sector positions and may be unnecessarily risky due to a lack of diversification.

A second consideration is that a dividend’s value, while not subject to the same degree of fluctuation as a stock price, isn’t guaranteed. Just 10 years ago, more than half of dividend-paying firms cut or eliminated those payouts following the financial crisis.[2] More recently, a company that had consistently paid dividends for more than a century, General Electric, slashed its payout to just one cent a share,[3] and the UK’s Vodafone Group cut its full-year dividend for the first time in two decades.[4]

Thirdly, investors may give up flexibility in terms of the timing and the size of the payout when they rely on company-issued dividends. With stock sales, an investor determines the amount and schedule of the income.

Lastly, dividends may not be as tax efficient as selling securities at long-term capital gains rates. Non-qualified dividends are taxed at your regular income tax bracket whereas long-term gains are generally taxed at 15% or 20%[5]. Additionally, investors can control when sells are placed (and thus when taxable gains occur), whereas they can’t control when dividend payouts occur.

TOTAL RETURN

A total return strategy attempts to grow the overall portfolio by maintaining a diversified basket of investments – some income producing, some for growth and some that do both. Since growth is a part of the total return strategy, there is potentially higher volatility and greater risk of capital loss. But growth is just one aspect of the strategy. Blended with more stable income producing securities, the overall portfolio can be potentially more diversified and tax efficient.

High dividend yields alone may not lead to high total returns. Exhibit 2 plots the trailing 12-month returns of S&P 500 Index constituents as of December 31, 2019, with each dot representing a company. It’s clear that companies with greater dividend yield, (the dots located higher up the vertical axis) didn’t have higher total return over that period.

Income generation may be a priority for some investors, but other important investment considerations, such as diversification, flexibility and taxes, needn’t fall victim to that aim. While the use of stock sales instead of dividends to create cash flow may involve trading costs and tax considerations, those concerns may be offset by the benefits of investing in companies that don’t currently pay dividends. An approach focused on income derived through dividends may not be the most desirable choice when weighing broader investment goals.

1. Source: Dimensional, using data from CRSP. Stocks are sorted at the end of each June based on whether a dividend was issued in the preceding 12 months.
2. Stanley Black, “Global Dividend-Paying Stocks: A Recent History” (white paper, Dimensional Fund Advisors, March 2013).
3. Janet Babin, “GE cuts dividend to a penny per share. Why bother keeping it at all?” Marketplace, American Public Media, October 30, 2018.
4. Adrià Calatayud, “Vodafone cuts dividend after swinging to 2019 loss.” MarketWatch, May 14, 2019.
5. Some dividends are tax at qualified dividend rates. For 2020, Long-Term Capital Gains and Qualified Dividends are taxed at 0% for married filers with taxable income below $80,000, 15% for married filers with taxable income between $80,000 and $496,600 and 20% for single filers with taxable income above $496,600.

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any particular strategy or investment will prove profitable. As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

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INDEX DEFINITIONS

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.