Published On September 16th, 2020 by Nate Parsh
Here at Sure Dividend, we strongly believe that investors following a dividend strategy are well on their way to creating wealth.
We believe that using the Dividend Kings, those stocks with at least 50 years of dividend growth, and the Dividend Aristocrats, those stocks with at least 25 years of dividend growth, as the foundation of portfolio, can lead to successful retirement planning.
Not everyone agrees with us however…
There are several complaints that are made against using dividend growth investing as a strategy for saving for retirement, often by people appearing on various financial channels.
Dividend growth investing is often dismissed by these commentators for several reasons, but the most often used are that the yield of a security won’t offset a steep decline in price and that the taxes on dividends greatly reduces results.
While these complaints do have some merit, we advise against taking this advice from “experts”. This article will counter two main arguments against our preferred retirement planning strategy in an effort to show the reader why we feel dividend growth investing is worth the work in the end.
Yield Won’t Make Up For Significant Loss, But It Will Lessen The Blow
One of the main arguments we hear against dividend growth investing is that the dividend yield cannot make up for a significant lose in share price. This is true. If a security declines 20%, the dividend yield likely won’t compensate you for that decline.
The dividend yield in this case does offer two benefits. First, if security ABC declines 20%, but pays a 3% dividend yield, then the actual loss is not as high as just the change in price. This isn’t true for a stock that doesn’t pay a dividend. A 20% loss is a 20% loss.
The other benefit deals with the reinvestment of the dividend. If the dividends received are reinvested in the security then they purchase shares at a reduced rate. If the investor still feels confident in the underlying company even after a 20% decline in value then the reinvested dividends just purchased a security at a much-reduced price. In fact, the reinvested dividend acquired even more income.
Consider this example. The investor has an investment of $10,000 in company ABC. The average purchase price for these shares was $100. Shareholders receive $3 in annual dividends, which equates to annual income of $300. Instead of taking the dividend in cash, the investor chooses to automatically reinvest these dividends.
ABC suddenly has a decline of 20% and shares are now valued at $80 per share. The stock trades at this price for an entire year. Along the way, the dividends are reinvested. Instead of buying 3 shares at a price of $100, the annual dividend of $300 is now buying 3.75 shares. These new 3.75 shares are now producing $11.25 of annual income compared to $9 of annual income that the stock provided with the security price at $100.
And this is before a dividend increase. Let’s assume that ABC gave a 10% dividend increase that coincided with the steep drop in security price. The 100-share position now pays $3.30 of dividends per share, giving the investor annual income of $330. That $330 reinvested purchases 4.13 shares, which now produce $12.39.
Had ABC not offered a dividend, then the value of the position following a 20% decline would be $8,000. However, since ABC does pay a dividend, the total value of the stock, which is the original shares plus the 4.13 resulting from the dividend reinvestment, is $8,330.40. Instead of a 20% decline, the reinvested dividend reduces the loss to 16.7% instead.
What’s more, dividends mean that investors who rely on their portfolio for income – like those in retirement – don’t have to sell when the market is down. Instead, they can rely on their dividends. This eliminates forced selling to create cash flows that can be detrimental when the market is down.
Dividend reinvesting won’t save you from steep declines in value, but it can lessen the impact of such a severe drop while also allowing providing more income. And if the investor is a long-term investor and has confidence in the company then they should find solace in increased number of shares the dividend can purchase.
Income Can Grow Even If Taxed
Another point often raised against dividend growth investing is the tax implications. As with previous point regarding a steep loss, it is true that dividends are taxed depending on your income level and the type of dividend that you receive.
For a dividend payment to be considered a ‘qualified dividend’, it must:
- Be paid by a U.S. company or a qualifying foreign company
- Isn’t listed as a company that does not qualify with the IRS
- Meets the holding period requirement.
The holding period requirement is that the investor held the stock at least 60 days prior to the ex-dividend date.
For single filers, tax rates on qualified dividends for 2020 are as follows:
- 0% for ordinary income below $38,600
- 15% for ordinary income between $38,600 and $425,800.
- 20% for ordinary income above $425,801.
For married, filing jointly, tax rates on qualified dividends for 2020 are as follows:
- 0% for ordinary income below $39,375.
- 15% for ordinary income between $39,376 to $434,550.
- 20% for ordinary income above $434,551.
The more ordinary income the investor has, the more they will pay in taxes on dividends received. Still, this doesn’t mean investors in a higher tax bracket should abandon dividend growth investing.
Let’s suppose an investor in the middle bracket has an initial investment of $10,000 invested in the Company DEF. The security has the following characteristics:
- Dividend yield of 1.8%
- Expected dividend growth of 5% annually
- Stock price appreciation of 5% annually
- An investment period of 25 years
Dividends are automatically reinvested in the security. The investor also purchases $1,000 of addition shares each year. For this exercise, we will use this dividend reinvestment calculator to determine results.
Even with the 15% tax rate on dividends, the investor’s originally position of $10,000 and $25,000 in additional investments result in an ending position of $108,767 and annual income of nearly $1,956.
In this scenario, the total return is just over 210%. This is an excellent return on investment. And this is from one position offering a low yield and mid-single-digit growth for both share price and dividend growth.
Let’s suppose this investor is looking to invest $100,000 safely, and that their investment offer an average yield of 2.5%, dividend growth of 7.5% and security price growth of 7.5%. The annual investment is $10,000 and the length of investment period remains at 25.
Using these inputs, the value of the portfolio would balloon to more than $1.9 million for a total return of more than 452%. Annual income would be above $48,000. Again, even with the dividends being taxed at 15%, the investor has secured for themselves a sizeable nest egg throwing off a lot of annual income.
Of course, if these investments were held in a tax deferred account, such as a traditional or Roth individual retirement account, then the dividends would grow tax free.
In the case of the investor with a $10,000 investment in a single security, the value would reach $114,000 after 25 years. This single position would generate $2,060 in annual income. For the investor with a $100,000 portfolio, the value would be $2.8 million after 25 years and annual income produced would be almost $52,000.
Dividend growth investing has some critics, those that feel the dividend yield won’t matter much in the face of a considerable loss of value. They also lament having to pay taxes on dividends.
However, both of these complaints are weak arguments against dividend growth investing. In the case where the security value dropped by a large amount, the dividend yield actually acted as a buffer against loss as well as purchased additional shares of a company that just raised its dividend. In the case of taxes, the investor still had excellent results even when using modest expectations for future growth.
This exercise reinforces our belief that dividend growth investing is worth the work.