Your retirement portfolio may be made up of a number of dividend-yielding securities. For some investors, dividend investing is their primary plan for retirement income, whilst for others, dividend income may be just one part of their retirement income strategy.
When focusing on dividend income, it’s important to understand what dividends are, and potential drawbacks if you plan to retire primarily on dividend income. Some investors are under the impression that dividend-paying stocks are safer than other categories of stocks. Some investors may believe that the payouts from dividend stocks are guaranteed. However, dividends are not guaranteed and may not be the best way to receive retirement income depending on your personal situation and investment strategy.
Dividends are just one way for companies to provide returns to their investors. Stocks can also provide return to shareholders in the following ways:
Some investors think of dividend payouts as guaranteed, safe or free. They aren’t. A company can reduce or eliminate the payouts at any time, which could be a risk for retirees who plan to rely solely or primarily on dividend payouts. Investors may also think a company that pays dividends to its shareholders is more likely to be healthy and profitable. That too may not always be the case.
Investing in a dividend stock may seem like a buffer against volatility, since you could receive a payout even if the stock market is down. But keep in mind that when a company pays a dividend, the share price may fall in response. This typically happens on the ex-dividend date or the date after a stock starts trading minus the value of its next dividend payment. The general assumption is the stock price will drop by the dividend amount on that date, but that doesn’t always happen. Other factors that impact the stock price may come into play and cause the price to rise or fall.
Another potential misconception some dividend investors have is that dividend income is similar to interest. Both are technically income—that is how you report them when you file your taxes. And there is nothing inherently wrong with either as a source of cash. The main difference is that interest is a return on principal whereas dividends are a return of principal.
Dividends, like most forms of income require you to pay taxes. However, unlike other income sources, dividends have a unique tax treatment in the UK. Those who receive dividends are only required to pay taxes when the income they receive is above their annual dividend allowance. For the 2019-2020 year, the annual dividend allowance is £2,000; anything over the allowance is taxed at a specified rate based on your income tax band.[i] If you have an Individual Savings Account (ISA), it can be beneficial to hold dividend paying securities as you are not required to pay income taxes on dividends from an ISA.
If you include dividend stocks as a part of your retirement planning, you should be aware of several considerations, including your cash flow needs, inflation’s impact and diversification.
When determining how much money you will require to meet your expenses in retirement, you should have an understanding of how much you will require from your investment portfolio. Since a dividends can be cut at any time, you should plan for alternative ways to generate income from your retirement savings.
When inflation rises, it reduces your purchasing power. Dividend income may not always keep up with inflation, so your purchasing power could fall over time. Since 1925, inflation has averaged approximately 4% per year.[ii] If you rely on dividends for living expenses, you should understand how inflation impacts purchasing power over time. If your dividend growth rate is less than inflation, your money may not be able to afford as many goods and services.
In addition to inflation’s impact, investors should also consider whether their portfolio is well-diversified. Many dividend-paying stocks are in certain sectors such as Consumer Staples and Utilities. If you are primarily investing in the highest dividend-paying stocks, it could inadvertently expose your portfolio to concentration risk—the risk of holding too much of your portfolio in similar assets. The problem with over-concentrating on specific sectors is their growth tends to be cyclical—they cycle in and out of favour. When the sectors you are overexposed to underperform, stock prices will be lower and additionally, your dividends could be impacted. This is one of the reasons your portfolio investments should be diversified appropriately—to spread risk.
There are several ways in which a retirement portfolio can generate cash flow in retirement. Instead of relying on dividends for income, you may be able to selectively sell individual stocks, an approach we refer to as “homegrown dividends.” As part of your regular portfolio maintenance, you could prune back outsized positions or sell stocks or other assets that no longer make sense to own. Whilst investors can incur trading commissions through this strategy, it can be a flexible and potentially tax-efficient way to generate cash flow in a taxable account, especially for investors with larger portfolios.
If you want to learn more about what strategy could work for you—no matter where you are in your retirement planning—contact Fisher Investments UK today. We may be able to help.
[i] Souce: UK.Gov, as of 05/01/2019. Annual dividend allowance for 06/04/2019 — 05/04/2020.
[ii] Source: Global Financial Data, as of 13/02/2019. Based on UK Retail Price Index from 1915 — 2018.Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.