Income

Better than Dividends!

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In the article  6 Problems with Dividends for Income [December 2013] you saw a long list of disadvantages of dividends when compared to selling from your investments to generate any required income.  Yet, retirees still like dividends.  Why is that?  The reasons are psychological, and several are listed below:

  1. Disciplined spending:  By limiting spending to dividends, you can resist the temptation to spend the principal.  It gives structure.
  2. Avoiding selling at a loss:  Dividends are given whether the investments are up or down.  A dividend withdrawal at a decline doesn’t require actual selling at a loss.
  3. Avoiding regrets over missed gains:  If you spent dividends, it feels like you spent cash.  But, if you sold from your investments, and they gained substantially, you may regret the sale.  People tend to regret action more than inaction.

Since income can be generated by selling from the portfolio instead of dividends, it is best to avoid focusing on high-dividend investments just for the sake of income generation.  By sticking with selling, you gain control over the amount, timing and regularity of income, as well as investment choice and improved tax-loss harvesting.

The missing piece is the psychological comfort.  That can be obtained by sticking to a conservative cap on withdrawals from the portfolio (typically 3%-4% of the peak value of the investments).  Having an outsider (investment advisor, family member, close friend) track the withdrawals can strengthen the discipline.  As a Quality Asset Management client, you receive the available withdrawal amount in your quarterly email, so you can view your investments very clearly as a sustainable income stream.

Disclosures Including Backtested Performance Data

6 Problems with Dividends for Income

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If you own a company with a $1 share price, and it pays a 5c per share dividend, you get 5% in investment income.  While this is a natural solution for retirement income, it has problems.  Some of them stem from the way dividends work:  The share value goes down to 95c (reflecting the cash that the company paid out and no longer has) + you get 5c in cash, leaving you with an unchanged total of $1.  That is, until tax time.  You have to pay taxes on the 5c, reducing the value of your investments.  Below is a list of problems, created by this effect among other factors:

  1. Amount:  More dividends than needed result in unnecessary taxes.
  2. Timing:  The dividend is in cash, not invested, until using the money (called “cash drag”).
  3. Irregularity:  Dividends can be increased or decreased unpredictably – too much creates cash drag & too little creates income stress.
  4. Tax Loss:  If your stock is down, you use dividends for income instead of selling losing shares for income.  Selling losing shares can provide a reduction in taxes.
  5. Limited Growth:  Companies tend to pay dividends when they have limited growth prospects (e.g. utility companies).  Some of the fastest growing companies pay no dividends.
  6. Rebalancing:  By using the dividends for income, you miss out on selling from the biggest gainers in your portfolio to rebalance while generating cash.

Selling from stock investments is far superior:  you can sell from your fast-growing companies, the exact amount needed, when needed, combined with rebalancing & tax-loss harvesting.

Advisors often avoid this optimal solution, since it requires more work and careful planning.  Specifically, it requires setting dividends to reinvest, while carefully planning when to sell to avoid wash sales (i.e. selling at a loss within 30-days of the automatic dividend reinvestment).

Disclosures Including Backtested Performance Data