For many retirees, dividend investing feels like the perfect solution. Regular dividend payments create a predictable income stream, mimicking the paychecks they received during their working years. This psychological comfort—knowing that cash will keep coming in without having to sell investments—makes dividends especially appealing for those in retirement. Plus, dividend-paying companies are often seen as stable and reliable, adding to the sense of financial security.
But is dividend investing really the best strategy for retirees? While it offers stability, it also comes with limitations. The promise of dividends can sometimes mask underlying risks or inefficiencies, such as the potential for dividend cuts, tax inefficiencies, and limited growth prospects.
In this article, we delve into the seductive appeal of dividend investing for retirees but also explore why a broader, total return approach might offer more benefits for long-term financial health in retirement.
Why do Some Investors Favor Dividend Investing?
Dividend investing is a favorite option for many retirees, and for good reason. Dividend investing offers:
• Income Stream: Dividends companies (or funds) offer a yield that pays regular cash flow to investors. As of this writing, the S&P 500 offers a yield of only 1.24%, a high yield dividend fund offered by Vanguard pays out a 2.59% yield, over twice as much as the S&P500.
• Stability: Companies that pay dividends are typically larger companies that have more stable and reliable revenue, which helps them to pay out the higher yield. That also gives a perception that dividend stocks are safer than high-growth stocks that are seen as more volatile.
• Psychological Comfort: Retirees are often comforted by seeing (and receiving) dividend payments hit their account, while still owning the investment. They don’t have to sell shares, but still have real money that they can spend.
• Reinvestment Opportunities: Reinvesting dividends can also be used to reinvest in that dividend fund, or use the cash to put into other types of investment opportunities.
Even though dividend investing does have some clear benefits, there are some drawbacks to this type of strategy that you need to be aware of before making any investment decisions. .
The Traps of Dividend Investing
While many of the benefits of dividend investing are legitimate, as with all things finance, there is a risk of making something out to be too good to be true. That’s the case with dividend investing, as there are some risks that are there even though they aren’t as widely discussed as the potential benefits. Here are some traps investors must be aware of:
•The Dividend Fallacy: Numerous investors assume that because a company pays a high dividend, it can be a great investment. Yet this is not the reality. A high dividend can sometimes be a red flag. If a company’s stock price has witnessed a massive decline, the yield appears seductive but that’s only the case because the business itself might be suffering.
• Dividend Traps: Simply because a company pays dividends now doesn’t mean it will always commit to the decision. Businesses that face challenging economics can either cut or eradicate their dividends entirely.
• Limited Growth: Companies that pay high dividends will naturally reinvest less in their own business, as that free cash flow is going to investors and not back into the business. This might be the best option for dividend friendly investors; however, this does restrict future growth.
• Higher Taxes: In non-retirement accounts (like an Individual or Joint account), dividends are taxed as ordinary income. If you have a number of dividend funds in your non-retirement account, you can reasonably expect to pay higher taxes than if you had low-dividend funds (more on tax treatment below).
6 reasons why you should Create Your Own Dividend Instead
While I do get the appeal of dividend investing, I am partial to focusing on achieving the best total return (within an appropriate level of risk) and then creating your own “dividend” when you decide you need the money. Here’s a number of reasons why:
• Potentially Higher Returns: Instead of searching for companies (or funds) that issue dividends above a certain percent, when creating a portfolio for clients I seek out funds that will focus on capital appreciation. These funds might have low dividend yields but will be focused on growing their business, which will potentially allow for higher returns in the future.
One example: VYM (a Vanguard high dividend fund) has AT&T as it’s largest position, and rightfully so as it offers a juicy 4.29% yield. What’s the issue with that? Well, AT&T has returned an -11.07% over the last 5 years. However, VOO (an S&P500 index fund) has Apple as it’s largest position. Over the last 5 years, Apple, despite offering a meager .41% dividend yield, has grown 212.55% over that same 5 year period. Which would you rather have?
While the disparity won’t be the same in every situation, the point remains the same: You can end up with more money in your pockets by focusing on total returns, which can then be used to create your own dividend (by simply selling some shares).
•Tax Efficiency: As mentioned above, dividends (in a non-retirement account) are taxed at ordinary income rates. Yet if you focus on total returns, then you would be subject to capital gains taxes (so long as you held onto the investment for over a year). Capital gains tax rates are lower than ordinary income tax rates, so you’ll be paying less in taxes come every April.
• Flexibility: Investors can decide when and how much to sell according to the market conditions and personal financial circumstances (and don’t have to rely upon the schedule of dividend payments that the dividend companies dictates).
• More Investment Options + Diversification: Dividend investing limits investors to a subset of companies that pay dividends, typically larger companies. Total return investing allows you to create a portfolio that covers higher-growth large size stocks, stocks from smaller companies that may not even be profitable now but could be in the future, and some international companies.
• Risk Management: Some dividend stocks are concentrated in specific industries, such as utilities or consumer staples. A total return strategy spreads investments across multiple sectors for better variegation.
• Less Reliance on Dividend Policies: Companies can cut dividends during economic downturns, or company-specific downturns. Obviously if you bought with the assumption that a dividend yield would remain in tact, that could impact your income, as well as make it tough to remove that position (if that fund is in a non-retirement account and there are tax implications from selling it).
A better way to invest
Even though dividend investing has a number of advantages, and plenty of appeal, it does not come without risks. And I simply don’t think it’s the best way to allocate your portfolio, especially when we’re thinking of a 30 plus year retirement. By focusing on total return investing, you can potentially have better returns, more flexibility, lower taxes and more diversification. That’s how I recommend my clients invest their money, and odds are, if we chat, that’s what I’d say to you. If you do want to have a chat about your portfolio, feel free to book a call with me here. t