Recently on the NewRetirement Facebook group, there was a lively discussion about the pros and cons of dividend investments as a source of retirement income. Let’s take a look at some of the pros and cons.
Are dividends like a golden goose or a big goose egg?
First, What is a Dividend Producing Investment and How Do People Use Them as Retirement Income?
A dividend-producing investment is a financial asset that generates regular income in the form of dividends. Dividends (a payout) are often given by established, profitable companies as a way to provide shareholders with a share of the company’s earnings. They serve as a means to distribute profits and return value to shareholders.
Some retirees rely on the dividend income generated by their investments to cover their day-to-day living expenses. Dividends can be used to fund ongoing costs such as housing, healthcare, utilities, groceries, and other essentials. The regular income stream provided by dividends helps retirees meet their financial needs without selling off their investments.
However, it is important to note that many people reinvest their dividends.
Pros and Cons of Dividend Producing Investments as Retirement Income
Using dividends to produce retirement income might seem like a brilliant idea. You get somewhat predictable income while preserving your original nest egg. However, not everyone sees it that way.
The Facebook poster who started the dividend conversation wrote that selling investments for income is an equal if not better method of generating a retirement income stream. He said:
“Living off your dividends only is not equivalent to some golden goose that lays the golden egg and selling shares is killing the golden goose.”
He is arguing that there is no magic to dividends. They are not inherently superior to other kinds of investments that you might need to sell in order to generate desired income. This is an argument shared by many financial gurus including Warren Buffet and Rob Berger. Watch Berger’s video on why dividends don’t increase wealth.
Downsides to Dividends as Retirement Income
NOTE: You have options for what to do with a dividend that is paid to you. Basically, you can reinvest the money or you can cash out and use the dividend as income. The pros and cons below refer specifically to using dividends as income. (Learn more about reinvesting in this discussion: Drip or draw, what to do with stock dividends in retirement.)
Dividends aren’t magic, the money comes from somewhere
Look, nothing in life is free. Dividends do come at a cost. The original Facebook poster argues, “If a stock is valued at $100 a share and pays a $3 dollar dividend the price drops to $97. There is no magic money making machine or golden goose.”
Nothing in life is free, including dividends. Dividends reduce the value of the investment. Learn more in this article, The Free Dividend Fallacy, from the Chicago Booth Review or read the Dividend Disconnect, a paper from researchers from the Boston College’s Carroll School of Management.
Dividend investments sometimes offer more limited capital appreciation
Dividend-focused investments may prioritize income generation over capital appreciation. Companies that pay high dividends may allocate less capital towards growth opportunities, potentially limiting stock price appreciation. This focus on income may result in lower overall portfolio growth potential.
A dividend is a choice the company is making to pay their shareholder instead of using the money to invest in the growth of the business.
Income dependence on dividend payments can be risky
Relying heavily on dividend income for retirement may expose retirees to the risk of dividend reductions or eliminations. Companies can reduce or eliminate dividends due to various factors, such as economic downturns, changes in business conditions, or management decisions. This can significantly impact retirement income and require adjustments to meet financial needs.
A balanced asset allocation to meet your overall financial goals is critical to investment success.
Dividend income is not guaranteed
Companies that pay dividends are not obligated to continue doing so in the future. Whether or not a company pays dividends, and the amount of those dividends, is determined by the company’s board of directors and is influenced by various factors, including the company’s financial performance, cash flow, profitability, growth opportunities, debt levels, and management decisions.
There is a strong argument that retirement income that you “need” should be guaranteed.
Sector concentration risk
Dividend-producing investments often concentrate in specific sectors, such as utilities, consumer staples, or real estate. Overly concentrating a retirement portfolio in one sector can increase vulnerability to sector-specific risks and economic downturns affecting that sector. Diversification across sectors is important to manage risk effectively.
Interest rate sensitivity
Dividend-paying stocks can be sensitive to changes in interest rates. When interest rates rise, fixed-income investments may become more attractive relative to dividend-paying stocks, potentially impacting their share prices. Retirees need to be aware of this interest rate risk and consider its potential impact on the value of their dividend-focused investments.
Market volatility
While dividend stocks are typically more stable than average, they are still subject to market volatility. Retirees relying on dividend income should be prepared for short-term fluctuations in the value of their investments. This requires careful portfolio management, considering diversification, and maintaining an appropriate asset allocation to balance risk and income needs.
Pros of Using Dividends for Retirement Income
Choice and flexibility
Retirees can choose to reinvest dividends to purchase additional shares, utilizing a dividend reinvestment plan (DRIP). Reinvesting dividends can help compound investment returns over time, potentially increasing the income generated from the investment.
Joe wrote in favor of dividends saying, “As an owner of the company, receiving a share of income allows me to decide what to do with it: reinvest it in the same stock, reinvest it in another company, set it aside for liquidity purposes or spend it because I have a need that requires money.”
Regular income stream
Dividend-paying investments, such as dividend stocks or dividend-focused funds, can provide retirees with a steady and predictable income stream. Regular dividend payments can supplement other sources of retirement income, such as pensions or social security, helping to meet living expenses.
Sometimes the regularity of the income and not needing to worry about selling investments outweighs any loss in capital appreciation.
NOTE: While dividends may be somewhat predictable, they are not guaranteed.
Potential for dividend growth
Some companies increase their dividends over time. By investing in dividend growth stocks, retirees may benefit from increasing income, which can help protect against inflation and maintain purchasing power throughout retirement.
Portfolio stability
Dividend-producing investments are often associated with stable and mature companies. These companies tend to have a track record of consistent dividend payments, making them potentially less volatile than growth stocks. This stability can help provide a sense of security and reduce the impact of market fluctuations on retirement income.
Tax efficiency
Dividend income may be taxed at a lower rate compared to other forms of income, such as interest or capital gains. Retirees can take advantage of potentially favorable tax treatment on dividends, which can enhance after-tax income.
NOTE: Tax efficiencies on dividends usually only apply to taxable accounts. So, money invested from a Roth account won’t see the same tax advantages.
Psychologically easier than selling stocks
You think investing is a rational endeavor. However, our emotions play a big part in how we perceive different types of investments. And, so long as you are aware of the impact of your feelings on your money, there is nothing wrong with playing into those emotions.
Some people are simply more comfortable with cashing in dividends than they are selling off investments. As Joe (not the original poster) pointed out, “If you are living off your portfolio, spending the dividends is certainly easier psychologically than selling shares.”
Mark is enjoying this psychological comfort that dividends have given him. He wrote, “I retired into a bear market the fall of 2021 have been living off dividends ever since. Invested in broad range of CEFs, BDCs, REITs and individual dividend paying stocks. And although my overall portfolio is slightly down I have been able to grow my dividends “income” quite nicely and when the next bull market takes off I still have all of my eggs “shares” because I didn’t sell the golden geese! When the market recovers as it always does my portfolio will as well and all along the way I’m living fine off the dividends and distributions. I can’t imagine selling shares in a bear market to live on while locking in losses along the way! It might not be for everyone but it’s working well for me!”
There is Nothing Wrong or Right About Dividends: Use Will Depend on Your Goals, Tax Status, Overall Time Horizon and More…
Dividend producing investments are one of a nearly endless list of options for your retirement assets. Like any investment, you will want to assess the opportunity in terms of risk, returns, time horizons, your investment goals, your target asset allocations, taxes, and more.
Here are a couple of considerations to add to the discussion of dividends for income:
Investing can be complicated
Corey wrote, “There’s so much more to it than this. Qualified vs Unqualified dividends, monthly payout vs quarterly, how that compounds if automatically reinvested vs timed reinvestment or used as income. You have to look at all those situations before you determine which options are best for you or your situation.”
There are indeed many many factors to consider when evaluating any investment.
Focus on total returns
Total returns refers to the overall financial gain or loss an investor experiences from an investment over a specific period, taking into account both capital appreciation (or depreciation) and any income generated by the investment. It provides a comprehensive measure of the investment’s performance, including dividends, interest, and changes in the investment’s market value.
As one of the Facebook group’s resident genius’s, Glen, pointed out: “I would tend to agree that investing for dividends as a primary strategy is not as good as investing for “total returns” (where dividends are part of that total).”
Give every dollar a job
Glen continued, “I like the saying that every “dollar” should have a ‘job.'”
As part of developing your asset allocation strategy, you will want to assess your goals. If you are lucky enough to have sufficient assets, you may want to prioritize guaranteed income over growth of your overall portfolio. Or, maybe maximizing your inheritance is what is most important. Know your goals and put your money to work against those objectives.
Depending on your goals, you will want to put your dollars to work in different jobs: Some of your money may go to work in dividend producing investments, others in high risk stocks, with the majority in index funds or CDs and bonds.
As the original author, Joe, wrote, “each person should knowledgeably plan and apply an investing strategy that meets their requirements and allows that person to sleep at night, worry-free.”
However You Invest, Maintain a Plan and Seek Professional Advice When Needed
A comprehensive financial plan like what you can maintain with the NewRetirement Planner is critical to help you make informed decisions about how your money is invested and the implications for financial security.
NOTE: We are working on better asset allocation and dividend tracking functionality.
You may also wish to work with a financial advisor to help you determine your target asset allocation – the right mix of investments for your goals. NewRetirement Advisors enables you to collaborate with a CERTIFIED FINANCIAL PLANNER™ professional. Get a personalized asset allocation strategy from a flat fee planner. Book a FREE discovery session.
