Retiring on Dividends – Is Living Off Natural Yield Possible or Desirable?

So why is a natural yield strategy so widely denigrated.  The main criticisms levelled are:-

• Dividends are just a return of your own money – a 5p dividend on a 100p share leaves you with a share worth 95p and a likely tax liability.
• Shares which have high dividend yields are low growth
• Reduced diversification.  A portfolio based upon above-average yields will by definition eliminate 50% of possible companies in particular those which provide high growth.
• Limited International Diversification.  The USA represents 43% of the global market but the S&P 500  only yields 1.8% compared with 4.35% for the FTSE100 and 4.06% for the FTSE All Share which can lead to an over-concentration in the UK market which only represents 5% of the global market and had a return over the last 25 years of 6.4% compared with 10.1% from the S&P500 (dividends reinvested).
• Dividend income is lower than can be obtained through a withdrawal strategy
• Companies can cut dividends during difficult economic times
• Possible adverse tax implications if the portfolio is outside a tax-exempt wrapper

(i) The first point is moot – as although the payment of a dividend does reduce the nett asset value of the share by the dividend amount and at the moment a share goes ex-dividend there should be a reduction in share price equal to the dividend,  however, as Benjamin Graham famously said ¨in the short term the market is a voting machine but in the long run, it is a weighing machine” so if the 5p were retained by the company the market may well decide that it actually worth more or less depending upon the share price.  An investor may well prefer to have that money in his own bank account rather than let it be subject to the vagaries of the market.

(iv)  It is especially true of markets such as the USA that dividend yields are lower than can be obtained through a withdrawal strategy.  UK yields are currently at a historic high (FTSE 100 over 4.3%), so it is easy for a portfolio to yield 4%+, however, the average FTSE100 yield over the last 25 years is nearer to 3% than 4%.

 

(v) Yes companies go bust, and companies cut dividends. One only has to think about regular dividend payers such as royal Bank of Scotland, Carillion, BP and Centrica, however, regular dividend payers cut the dividend as a last resort and prioritise its payment often cutting internal investment (not always a wise decision) or increasing borrowings in order to maintain the dividend – as often the consequence of cutting it will result in the CEO having to resign. A well-diversified income portfolio mitigates the effects of such cuts.

(vi).   Tax in the USA has always favoured capital gains over dividend payment although in recent years there would appear to have been an equalisation of the tax situation.  In the UK providing investments are sheltered within a pension or ISA dividend and capital gains are tax exempt.  Outside of these capital gains up to £12,000/year per individual are exempt but dividends over £2000 are subject to tax.  As an aside, the pre-election proposals by the Labour Party to treat capital gains, dividends and income equally highlight the danger of accumulating significant capital gains outside a tax-exempt account and the value of “bed and breakfasting” gains to avoid a future tax liability should CGT rules be changed.

One of the criteria that Benjamin Graham gave for stock selection was that “each company should have a long record of continuous dividend payments”.  We have seen many example over the last few years of companies that have inflated their published audited profits (Carillion and  Patisserie Valerie come to mind) – profit can be a matter of interpretation but dividends are real and paid in cash and a company cannot invent 20, 30 40 years of dividend payments.  Earnings per share are enhanced through share buybacks – this can be beneficial to the shareholder and without doubt beneficial to the company´s executives whose bonuses are often based upon earnings per share growth.  As highlighted in the JP Morgan article the need to pay dividends imposes a discipline upon management to optimise their use of cash and not to invest in vanity projects.

There is a price to pay for having the relative safety of a dividend retirement strategy.  A UK-centric dividend portfolio is easy to construct and there are many funds and investment trusts that have historically provided a healthy and growing stream of dividends and outperformed the FTSE 100 and All Share. What more could a retiree want – an inflation-beating income for life and capital growth.   But is this the optimum solution for a retiree?  Firstly, not drawing down from capital reduces the retiree´s lifetime income.  Maybe this is the desired outcome but I suspect the majority of retirees would prefer to have a higher income rather than leave an over-sized inheritance.  Secondly, concentrating on the UK is likely to reduce the growth of the portfolio – a 2% difference in annual growth compared with a diversified international portfolio over a 30-year retirement is a gain of over £400,000 on a £500k initial portfolio.  Are these prices too high to justify a dividend strategy?

I have only just retired.  For over 10 years prior to retirement, I adopted a dividend strategy,  initially with individual shares but gradually moving into Investment Trusts.  My objective was to avoid the need to invest substantially in bonds in order to protect my portfolio in the run-up to and during the first few years of retirement.  My portfolio currently yields 4.8% after all charges, and dividends have grown at an annualised rate of 12% over the last 9 years and capital by 11%.  However, it is quite possible that a well-diversified growth portfolio could have provided me with a better total return.

What I learnt from the 2008 crash was that individual shares were risky, the crash of RBS stung!  The Investment Trusts that I held navigated the crisis well apart from the property sector and one trust that paid dividends from the capital –  European Assets.  Every other IT increased its dividends throughout the period 2007 to 2019 using its reserves where necessary to smooth out the payments.

Had I entered retirement with maybe a 60/40 or 50/50 equity/bond portfolio I am sure I would be withdrawing at a rate of 3.5% or so whereas now it is generating 4.8% in dividend income- nearly 40% more. It is possible of course that a non-dividend portfolio could have grown much faster and achieved a value that even a 3.5% withdrawal rate would have resulted in an income larger than the dividend income I currently receive.

What is very clear to me is that this is not the best long-term strategy.  I wish to have a more diversified portfolio with more growth potential and I do wish to maximise my income rather that leave a large inheritance. It is also likely that the UK yields will return to trend levels of 3% or so meaning it is probable that dividend growth rates will decline.  So whilst I´m in no hurry to change strategy – it is my intention that within 5 years I will have transitioned away from dividend income to a withdrawal strategy.