Why Dividend Income in Retirement Doesn't Matter as Much as You'd Think



I recently met with a couple in their 60s looking to retire in 7 years and in need of investment advice. They accumulated a large sum of cash and wanted to know what they should do with it. Like many people thinking about investment strategies to fund their retirement, the couple expressed interest in buying dividend stocks considering their money market was only paying .5%.


Quick Recap - What is a Dividend?


A dividend is nothing more than a passive return on your investment in the form of income. If you invest $100,000 into a stock or fund paying a 4% dividend, you'll in-turn receive annual income of $4,000 from that investment each year. Not rocket science.


Seeking investments with high dividend yields is a popular investment strategy amongst retirees for a variety of reasons. One, it's a fairly simple concept for most people to grasp, and people like simple. Second, it requires little to no work after the initial investment is made other than verifying if and when you receive your dividend. Lastly, many retirees who don't have a pension need some type of income stream in retirement and as such, think only in terms of income when selecting an investment strategy.


Go Wide and Short, not Narrow and Deep


When assessing a target market for a new business venture, seasoned entrepreneurs recommend going an "inch wide and a mile deep," meaning focusing one's efforts on a narrow niche instead of marketing to the masses. This is sound advice for aspiring small business owners as it increases their chances of standing out in a crowded market. When it comes to the stock market, however, investors may be better suited to think more broadly about their options for generating retirement income than narrowing in on dividends alone.



It's Also About Appreciation


Rather than focus purely on investments with the highest dividend yield, retirees should consider taking a total return approach toward investing. The total return of an investment includes both the income it pays AND capital gains, or how much it appreciates over time. In other words, it includes the growth of the investment on top of the income.


To better illustrate the benefits of this concept, assume you retired in 2011 and determined you needed $40,000 a year from your $1,000,000 IRA, or a 4% withdrawal rate. After researching different stock index funds, you settle on three potential investments (data as of 3/15/21 and subject to change):

1. iShares Core High Dividend ETF (HDV) - Dividend yield 4%, or $40,000 of projected annual income.


2. SPDR S&P 500 ETF (SPY) - Dividend yield 1.4%, or $14,000 of projected annual income.


3. Vanguard Growth Index Fund (VUG) - Dividend yield .6%, or $6,000 of projected annual income.


Each fund invests in large blue-chip companies located in the U.S., though the iShares ETF (HDV) favors companies with high dividend yields while the SPDR (SPY) and Vanguard (VUG) funds are structured to mimic the S&P 500 and growth stock indices, respectively.


Here is the price action for each fund from 2011 through March 15, 2021 (HDV in dark blue):


If you include dividends, the average annual (total) returns since March of 2011 for each fund were as follows (data taken from Charles Schwab):


1. iShares Core High Dividend ETF (HDV) - Total Return 9.68%


2. SPDR S&P 500 ETF (SPY) - Total Return 13%


3. Vanguard Growth Index Fund (VUG) - Total Return 16%


If you were income-driven and selected the high dividend strategy, you'd have done pretty well as the fund exceeded expectations given it paid 4% in annual income and appreciated another 5.68%. However, had you taken a total-return approach and diversified evenly into value (HDV), growth (VUG) and the broader market (SPY), your portfolio would have returned roughly 12.7% (33% multiplied by each total return figure above) on average, per year.


Hindsight is 20/20 though, right? I could have just cherry-picked these funds and used a limited time frame (10 years) to reinforce my point: fair enough. Let's then take this analysis a step further. What if we looked at the market as a whole and went back in time to the 1950s to see the impact dividends and capital appreciation have had on stock performance.



Dividends vs. Capital Appreciation


Over the past 70 years, you'll see that capital appreciation has contributed more to total returns in the S&P 500 than dividends:


Source: JPM's latest Guide to the Markets


One of the main reasons dividends account for a smaller piece of the pie is the continual divergence in sector weightings within the S&P 500 over time. Currently, the technology and healthcare sectors represent more than 40% of the large-cap market, yet pay a measly 1.4% dividend on average. Companies in these sectors tend to be more growth-oriented and favor investing excess cash back into their businesses as opposed to shelling it out to shareholders. With more reinvestment, R&D and share buybacks, growth companies often exhibit a higher rate of capital appreciation over time than the more traditional dividend-payers. And up until this year, growth has significantly outperformed value for as long as I can remember.


On the other end of the spectrum, sectors know for rewarding investors with savory dividends in the 3% - 4% range including utilities, industrials, energy and staples make up a paltry 20% of the S&P 500 in the aggregate.


A Little More Work for A Lot More Benefit


Taking a total return approach towards investing does have its setbacks. First, it requires you to be somewhat active as you'll need to sell certain investments throughout the year to cover cash shortfalls if dividend income isn't sufficient. This requires a thorough understanding of your short and long-term cash needs and a proactive distribution strategy so you're not being forced to sell a position in a down market.



The total return approach may also result in taxable gains from the sale of securities if your money is held in a brokerage account. Accordingly, be sure to consider tax-loss harvesting to minimize your tax liability and try to avoid realizing gains on securities held less than 1 year as they'll be subject to ordinary income tax.


Lastly, you may require a substantial amount of income from your portfolio in retirement, making the total return approach too administratively cumbersome to manage effectively.


Final Thoughts


The point here isn't to dismiss dividend strategies altogether, or to suggest their underperformance relative to growth stocks and the broader market will continue. After all, dividends have, and always will play an important role in any investment strategy where distributions are needed to fund retirement costs. However, dividend income is not the be-all, end-all factor when determining how to allocate your money. As with most things in life that reap the highest rewards, the easiest options aren't always the best.

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Image by Aaron Burden

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