A classic trope of retirement is that you want to be invested in something that produces cashflow to replace the income you earned when working.
For many people that is their pension, for others it might be a rental property portfolio. In typical investment vehicles that would typically be investments in bonds or companies that pay a dividend.
Companies pay dividends when they make profit and want to simply hand some of that money directly to shareholders.
This is pretty straightforward, and easy to understand why dividend stocks are appealing. If you hold enough shares in a company and the dividends paid out each month are more than you spend on your cost of living, thats a pretty nice and easy set up and you don’t really need to change anything on an ongoing basis.
The problems with this, however, start to surface when examining this set up with a little more scrutiny.
Firstly, if a company is paying a dividend, then by very definition they can find no better use for the money they have other than simply handing it over to shareholders. This is not a good thing.
Any company that has room to grow, or is growing, could most likely use that money to expand their operations and grow the value of the company higher. Simply handing the money to shareholders can often imply that the company has little prospect of growing further, and as such the value of the company is less likely to grow over time. Given that your shares are direct ownership of the company, that means your investment is less likely to grow.
Secondly, the dividend yield on broad market ETFs are very low. The fan favourite Vanguard all market fund $VWRD has a dividend yield of 1.51% at time of writing. To achieve an income of $120,000 in retirement you would need to hold $7,947,020 of the fund; though to build in a buffer to allow some room if th yield decreases, you’d realistically want to be holding north of $8,000,000.
Even if you did do that, you’d be spending only 1.51% of your portfolio each year which is much below the classic 4% rule and would realistically mean you are not getting the most value you could get out of your portfolio to increase your quality of life.
Finally, as a non-US investor dividends are subject to a US withholding tax of 30%, though this is reduced to 15% in the $VWD fund as it is domiciled in Ireland and benefits from a tax treaty. The tax applies only on dividends from US based companies within the ETF, but given the nature of the US market, these would likely be 40%-50% of all dividends paid out.
So they are tax inefficient, indicative of unproductive companies, and low yielding.
There are some alternatives, such as actively managed funds that generate income and pay this out as a dividend. A fund I have been looking at recently is $JEPG, an actively managed fund from JP Morgan that executes call option strategies to generate the income and currently yields 7.59% at time of writing. Given that this fund is entirely Europe domiciled and doesnt rely on dividends paid by underlying companies, it avoids and US withholding tax and the yield is high; however long term growth of the value of the fund is the trade-off here as the fund has grown by a meagre 6.13% over the previous 5 years.
In essence, the fund acts more like a high yielding bond, but would be significantly hit in a market downturn in a way that high quality bonds would not be.
When you strip things back to first principles, how the growth in your portfolio is generated is important, but it is less important that the key metric we should be optimizing for – total return.
Dividends feel inherently good in a retirement portfolio as the periodic receipt of the income feels like a paycheque and, I believe more importantly, the fact that you do not need to routinely sell off part of your portfolio removes the feeling that you are drawing down your portfolio and trimming your potential future returns.
Throughout building your retirement portfolio you have always sought to obtain more. More shares of an ETF, more bonds, more bitcoin. This builds up a level of security and safety as you continue to accumulate more and add additional years to your retirement runway.
Selling off of assets is the exact opposite of that. It carries with it the psychological trauma of feeling that you’re selling the family silver to cover day to day spending, and that this is not a sustainable plan for an indefinite retirement period.
However, having spent some time thinking about this issue, I’ve really tried to push past this way of thinking.
As a minority shareholder in a dividend paying company you have no steer in how the company generates its income that pays out the dividend. If a company chooses to sell off its assets to make the dividend payments, you’d essentially just be outsourcing the icky feeling of selling the family silver to the company – and realistically have no idea that its happening.
This almost certainly is happening in some companies that make up the Vanguard ETF above. All we are doing here is hiding that action by being several steps away from the person that pulls the trigger on that decision.
You could replicate this fairly easily by moving your portfolio over to a corporate entity that you are the sole shareholder of, then optimising the portfolio for maximum total return whilst wearing your fund manager hat, and then simply paying out a monthly dividend via the corporate entity to yourself wearing your shareholder hat.
You’d get a steady monthly dividend, and growing share value, whilst also optimising for total return on the fund.
But, since you’re the schitzo hat fuck that is executing all parts of this set-up, you’d not escape the same psychological feeling of selling the family silver to fund your cost of living. The comforting feeling that you do get when you are not seeing how the sausage is made from dividends from a public company.
I think at the heart of this, then, is just your level of comfort with the psychology of drawing down from your portfolio, provided you maintain the focus on the only key metric that counts – total return of the fund.
Even having spent time to think about this deeply, I still don’t know if I can fully wrap my head around this idea, even though I know it logically does make sense.
The psychological draw of dividend paying funds is persistent and hard to shake.