Debunking Dividend Myths: Part 3

This post is the third in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

It’s awfully hard to get excited about fixed-income investments these days. During most periods in the past, bonds and GICs paid interest rates significantly higher than the average stock dividend. But not today: five-year GICs are now pulling down about 3%, while 10-year federal bonds are earning less than 3.5%. The dividend yield of the S&P/TSX Composite Index is about a point lower than that, but it’s easy enough to build a stock portfolio that pays 4% or more.

No wonder I frequently hear from investors who have ditched fixed-income investments altogether in favour of dividend-paying stocks. Indeed, some popular dividend gurus advocate throwing fixed income to the dogs altogether, no matter what market conditions happen to be. “I don’t understand why people switch to bonds in retirement,” writes Tom Connolly of the popular Dividend Growth website. “Have you ever known a bond to increase its interest rate?” Lowell Miller, author of The Single Best Investment: Creating Wealth with Dividend Growth, opens his book with a whole chapter devoted to bond bashing: “Let me put it bluntly: bonds are a bad investment.”

Both of these authors argue that stocks with a track record of growing dividends can provide an income that rises every year, even if the stocks themselves fall in value. Bonds, meanwhile, pay a fixed coupon until their maturity date. “In 2008, our dividend income rose in spite of the turmoil by 9.9%,” Connolly wrote in 2009. “Did your income rise by 10% last year?”

It’s true that dividend-growth stocks can provide a steadily rising income for investors in retirement. But any investor contemplating an all-equity portfolio should make absolutely certain they understand what they’re doing.

Dividend stocks are not “bonds with growth”

Connolly scoffs that bonds do not raise their interest rates, but that’s never been the reason for including them in a portfolio. Investors buy bonds because the interest income is guaranteed. (Unless the issuer goes bankrupt, of course, but this is a negligible risk with government bonds, and an extremely small one with investment-grade corporate bonds.) One might ask Connolly, “Have you ever known a stock to reduce its dividend?” Of course, this happens frequently, even with blue chip companies. Remember, a company is not legally bound to pay dividends, but it must never reduce the coupon on its bonds.

The other consideration is the risk of capital loss. Bonds fall in value when interest rates rise, but stocks can suffer declines that are far more gut-wrenching. A portfolio of dividend-paying stocks might well have seen its income go up by 10% in 2008, but it likely lost 30% to 40% of its overall value before the market bottomed.

Consider that in dollar terms: imagine a retired investor with a $1-million portfolio generating $40,000 a year in dividends in 2008. Assume (generously) that every company she owns raised its dividend by 10% that year, bumping up her income by $4,000. Meanwhile, the portfolio’s value would have dropped by as much as $400,000. If you can stomach a loss like that in retirement, then an all-stock portfolio is perfectly appropriate for you. But few people can. Derek Foster couldn’t do it, and he was under 40 when he sold everything in a panic. Ask any financial advisor how clients in their 60s and 70s handled the crash of 2008–09, and how much solace they took in the fact that most of their stocks continued to pay dividends.

A more balanced approach

There is an alternative for investors who want rising income in retirement. It’s based on the highly influential research of William Bengen, first published in 1994 and updated many times since then. Bengen determined that investors with a portfolio of 50% stocks and 50% bonds can safely withdraw 4% in the first year, followed by inflation-adjusted withdrawals each succeeding year. For example, our investor with $1 million can take out $40,000 in year one. If inflation is at 3%, she can raise her withdrawal to $41,200 in year two, and $42,436 in year three.

Bengen ran his simulations using decades of historical returns and inflation scenarios, and found he that a portfolio drawn down using this “4% rule” has an extremely high likelihood lasting throughout retirement. Upping the stock portion to 75% allowed retirees to raise their withdrawal rate even further, so long as they could accept the additional risk. Bengen’s research revolutionized retirement planning and is widely followed by financial professionals.

The point is that it’s not necessary to rely solely on dividend-paying stocks to provide a cash flow that keeps pace with inflation. Keeping 25% to 50% of a portfolio in bonds will dramatically reduce a portfolio’s volatility and still provide retirees with the rising income they desire.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.

21 Responses to Debunking Dividend Myths: Part 3

  1. The Dividend Ninja January 24, 2011 at 11:55 am #

    Hi Dan, yes we have discussed this before :) Any portfolio that is 100% any kind of stocks is not prudent and plain foolish. I think people do forget about Asset Allocation, and when things are good on the stock market (as they are now) – throw all caution to the wind. Yet those are the times when a balanced portfolio is essential :) since you have no way to know which way the tide can turn. Bond funds and plain old cash provided a harbour of safety in 2008!

    On another note, I don’t understand how people can assume Dividend Stocks are actually a replacement for Fixed Income, but yes its true people have ditched their fixed-income for growth. Poeple easily get bored with “average” returns. Although Bond Funds (and related fixed income) will decrease or even plummet with interest rate increases – so will stocks. And yes it is also a fact that companies will cut their dividends long before they cut their bond coupon payments (if at all).

    Basically I have no way of knowing which way the tide will turn. Of course I love dividend stocks and the stream of dividend income (my blog name is the give away), but I wouldn’t want to load up 100% stocks in this time of uncertainty.

  2. Steve in Oakville January 24, 2011 at 8:45 pm #

    Dan,

    Thanks very much for this post, and in particular, the link to the retirement planning article by Bengen. It was very interesting and straightforward and provided some great & practical rules of thumb that cleared things up for me.

    I was surprised by the data suggesting never to have more than 50% bonds in a retirement portfolio (and ideally closer to 25%) – that flies in the face to much of what I’ve come across. I think it’s useful to realize that he was going with ‘worst case’ situations for some of his evaluations, but that’s probably the right way to plan!

    Steve

  3. Mark January 24, 2011 at 9:31 pm #

    XDV yield is not 5%, it is 3.3%. Once every three months XDV pays a large distribution, probably because the majority of stocks pay out during the same month. A better way will be to add up the last three distributions for calculations.

    26-Jan-2011 0.08737
    24-Dec-2010 0.04680
    24-Nov-2010 0.03790
    26-Oct-2010 0.09000
    27-Sep-2010 0.03774
    26-Aug-2010 0.04852

  4. DividendLover January 24, 2011 at 11:27 pm #

    @mark take a closer look at what you posted looks like the distribution is monthly to me

  5. Canadian Couch Potato January 25, 2011 at 1:28 am #

    @Steve: Glad you enjoyed this. I found the Bengen research very interesting, too. I agree with you: I doubt I would want 50% of my retirement nest egg in stocks. Of course, a lot of this depends on the amount you’ve saved, and other sources of income. If you only need to draw down 2% or 3% a year, you can keep a lot more in fixed income and probably sleep better.

  6. Mark January 25, 2011 at 6:50 am #

    Yes, monthly:
    Jan: $0.08737 / 20.94 * 12 = 5%
    Jan,Dec,Nov: (0.08737+0.04680+0.03790) / 20.94 * 4 = 3.3%
    The distributions are not the same month to month, so they have to be averaged over three or six months.

  7. Michel January 25, 2011 at 6:52 am #

    Very well written article. Thanks. The yield on XDV is 3,6% at this time. Question: Your retirement analysis, (Bengen’s) assumes no other income stream, but Bengen’s states that upping your stocks to 75% allows you to withdraw more. Would you say that upping your stocks to 100% would provide you with even more income? For people with a good safe pension plan, for example.

  8. Canadian Couch Potato January 25, 2011 at 9:31 am #

    Thanks to everyone who pointed out that I overstated the yield on XDV. I got the quote from Scotia McLeod, bit clearly it was inaccurate. I’ve changed the post accordingly.

    @Michel: Yes, Bergen does say that a 100% stock portfolio would provide more income. That’s not in dispute. The issue is whether an investor could handle the volatility in retirement. As you say, if someone had a solid pension that met their daily expenses and the income from their portfolio was just gravy, then sure, that might be quite reasonable.

  9. Think Dividends January 25, 2011 at 9:32 am #

    Dividends are superior to Fixed Income in Retirement:
    1) You get paid quarterly (bonds pay semi-annually)
    2) You get tax efficient income

    In your example, that $1 million portfolio will produce more income after-tax with dividends. Who cares if the portfolio drops $400K as long as the income keeps rolling in. Dividend investors rely on cash flow not capital gains.

    Manulife was the only blue-chip Canadian dividend stock to cut its dividend during the financial crisis. That’s no big deal in a diversified portfolio of 20-30 dividend stocks. Dividend Funds also outperformed Canadian Equity Funds during the crisis.

    My dividend income has increased every year since 2005 and thanks to CN Rail’s 20% increase today, it will be higher in 2011 too.

    Wake me up when Government Bonds yield 8% again.

  10. Canadian Couch Potato January 25, 2011 at 9:39 am #

    @ThinkDividends: The point is not that one is superior to the other. There’s no question that an all-stock portfolio is likely to yield more income, and that dividend income is tax-advantaged. The issue is the dramatically different level of risk.

    “Who cares if the portfolio drops $400K as long as the income keeps rolling in”? I can assure that many, many people care about losing hundreds of thousands of dollars of capital in retirement. If you’re not one of them, that’s fine. My aim is to help people understand that it is a very real possibility, and let them decide if they are willing to take that risk.

  11. Think Dividends January 25, 2011 at 10:24 am #

    @ Canadian Couch Potato: It’s great that you are advocating diversification and asset allocation, but the last time I checked paying $105 or $110 for a bond results in a GUARANTEED LOSS of capital when the bond matures.

  12. My Own Advisor January 25, 2011 at 10:30 am #

    I’m with the Ninja – any portfolio that is 100% any kind of stocks/equities is risky.

    Sure, equities feel great for most when the market is flying high (unless you’re a buyer of stocks) but when they tumble 30% (and they will again someday) people aren’t so chipper (unless you’re a buyer of stocks).

    This makes a balanced portfolio essential, for me at least. I would never keep cash “lying around” but I do hold some bonds in the form of XBB in my RRSP. Dividend-payers are never a replacement of bonds for me.

    So I ask, why not do both? Hold a few dividend-paying stocks unregistered, get the tax credit, etc. and keep some bonds as registered investments? Win-win.

    Like Think Dividends and Ninja, I love dividend stocks and the passive income they provide me, it’s my primary investment strategy but that doesn’t mean, for me at least, I’m comfortable with a casino-like all-in equity approach.

    Great discussions again Dan.

    BTW – when are these articles and some of the comments going into MoneySense?

  13. Canadian Couch Potato January 25, 2011 at 12:17 pm #

    @MyOwnAdvisor: Thanks for your thoughts. I agree completely with the idea of using a combination of dividend-payers and fixed-income investments. Every investor just needs to find the proportion that works for their individual needs and risk tolerance.

    @ThinkDividends: Again, there is this artificial distinction between capital and income. A bond purchased at a premium will suffer a capital loss on maturity, but the reason it’s trading at a premium in the first place is that its coupon is higher than current rates. The yield to maturity (and therefore the total return) is known in advance, and should be approximately the same whether the bond is sold at par, at a discount or at a premium. The only difference is tax, and in an RRSP or other sheltered account (the recommend place for any fixed income investment), this is irrelevant.

  14. The Dividend Ninja January 25, 2011 at 3:15 pm #

    @Think Dividends
    “Who cares if the portfolio drops $400K as long as the income keeps rolling in. Dividend investors rely on cash flow not capital gains.”

    Really? You would enjoy a nice glass of Shiraz while calmy reflecting how even though your entire portfolio has crashed it still earns you 3-4% income? With all due respect I’m skeptical. Actually Bonds even if they decline in value will still earn you the coupon rate, regradless of premium or spread. If you hold a bond to maturity you effectively pay par value becuase of the spread between the coupon rate and the price of the bond. For most corporations bond coupon rates are actually higher than the dividend yield on their common stock.

    Dividend Income is nice, I agree with you on that, but personally I like to spread my risk out :)

  15. Think Dividends January 26, 2011 at 6:53 am #

    @ Dividend Ninja: Actually my portfolio did go down by close to that amount in 2008, but I wasn’t concerned. I am a professional investor (I am a CFA and it is my day job). I buy businesses not stocks. I’ve done indepth analysis on all my holdings and did not suffer any dividend cuts since I started managing my portfolio for income. 2008 was a great year for me because I was able to allocate my capital towards my best ideas and I was able to purchase great businesses at fire sale prices. I was also able to lock in some yields at close to 12% like RioCan and Crescent Point. When I buy a stock, it is usually with a 10+ year time horizon. I am not opposed to owning bonds, but my forecasted return on the asset class looking 10 years out is negative once you take taxes and inflation into account. Before I purchase anything, it must meet my required rate of return, so in my portfolio diversification becomes a byproduct of where I see the best opportunities, therefore I don’t own any bonds at the present time.

  16. db January 26, 2011 at 9:15 am #

    With dividends regardless of what Mr. Market does or does not do on any given day, week or month you’re getting paid to be “an owner”. I don’t want to be “a lender” when the most I can expect is to be repaid. Inflation is the silent bond killer.

  17. Eric January 26, 2011 at 10:40 am #

    Safe short-term government bonds (or GIC) can be seen as an insurance policy against market volatility. I consider myself a very good driver but my car is insured for events beyond my control. The stock market is so umpredictable….

  18. Glammis February 2, 2011 at 4:39 pm #

    This article and comment string is eye opening. However, there is no distinction between normal and preferred dividends. My advisor has told me that preferred shares are basically bonds unless the market takes a hit much bigger than the recent one. Anyone care to comment?

  19. Still learning December 2, 2012 at 11:34 pm #

    I have found the whole series on this topic very informative. It seems obvious that there are valid points on both sides. It is clear that a dividend paying stock is not a substitute for a bond in many cases, but if your retirement portfolio is large enough to generate sufficient income to fund your needs, then an dividend ETF would have both the predictability and possible tax advantages to reccomended it. It seems to come down to asset allocation. Have you posted anything on this topic ( apart from the general couch potato reccomendations? )

  20. DaveW December 28, 2012 at 7:43 am #

    People are not comfortable with their wealth dropping by 40% in a market correction yet they are more than comfortable watching it lose purchasing power year over year by leaving it in a low-yield fixed income product as inflation trundles along.

    Headline inflation is a highly subjective number and relying on it as a way to adjust your withdrawals is also fraught with risk.

    Traditional asset allocation based on “assets” – bonds vs stocks vs precious metals is so ingrained in investing culture that it is accepted without question in most cases. Perhaps assets should be allocated by risk which is a much different thing than slicing stuff up into “bonds” and “stocks.”

    Of course, what is risk? That is the question indeed! I can guarantee you that risk is not volatility, another classic investing association.

    Some things to ponder (of course, none of us are right!)…

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