“Income and cash flow are the priority in retirement.”

A dividend is a payment made from a company to its shareholders – often quarterly, but sometimes monthly. Dividends are a way for shareholders to participate and share in the growth of the underlying business above and beyond the share price’s appreciation.

Dividends are cash payments made on a per-share basis to investors. For instance, if a company pays a dividend of 20 cents per share, an investor with 100 shares would receive $20 in cash. Stock dividends are a percentage increase in the number of shares owned. If an investor owns 100 shares and the company issues a 10% stock dividend, that investor will have 110 shares after the dividend.

When publicly traded companies have extra cash on hand, it gives the management team some flexibility and options. With some extra cash, they can:

• Take that money and invest it back in the business – they might do that through expanding existing operations, building factories, possibly acquiring another company that can help them grow.
• Take that money and buy back shares of its own company – this strategy reduces the number of ways ownership of the company is sliced up, increasing the ownership. or
• They can pay out some of that money to people who own shares of the company as a way to “share the wealth” and reward them for owning the business (dividend)

Dividends vs. Bonds

Bonds are obligated to pay interest to bondholders on a regular basis, but there’s no obligation for a company to pay dividends. When income from dividend producing assets decline, retirees may realize they don’t have enough cash flow to pay all their expenses. In order to save cash, some non-essential expenses are often cut or eliminated.

Investors who rely on income, especially those in retirement, tend to gravitate to dividend stocks because bonds pay so little. They could be in for a big shock. Many steady dividends payers have said they will cut their dividends (AT&T) or eliminate them completely (Boeing). For people who live off of dividends, a severe cut would significantly affect the amount of money they have to live on.

Additionally, dividends are taxed at the more favorable capital gains tax rates. This can be an important benefit for retirees who likely don’t have a lot of write-offs,

Long-term investors should focus on total return (capital gains plus dividend income) when thinking about how to invest your retirement savings.

Dividends importance to total equity returns over the long term cannot be overstated. Ibbotson Associates data from 1927 to 2002 show that more than 40% of the compound annual growth of its large-cap equity index can be attributed to dividend payouts. That said, the contribution of dividends over shorter periods can exhibit a fair amount of disparity. Indeed, over the decades, it has ranged from a low of about 15% in the 1990s to a high of 71% in the 1970s.

Graphing the difference between ten-year compounded growth rates from dividends and capital appreciation for the years 1947 through 2002, a picture of alternating leadership begins to appear. Clearly, capital appreciation has been dominant in periods of lower inflation and stable interest rates due to the positive impact that it has on price-to-earnings (P/E) multiples. On the other hand, dividends have carried most of the burden of equity market returns in periods of higher inflation and volatile interest rates when P/E multiples were contracting.

Consider all streams of income — Social Security, pensions, IRAs, part-time work — when devising a broader strategy (and tax plan) for your retirement years. Given that “investors using dividend-paying stocks for income must have a strong constitution,” says Richard Steinberg, chief market strategist at The Colony Group.

Dividends are not guaranteed and are paid at the discretion of the board of directors. Unlike a bond, which must pay a contracted amount or be in default, the board of directors can decide to reduce the dividend or even eliminate it at any time.

References:

1. https://money.usnews.com/investing/investing-101/articles/how-to-live-on-dividend-income
2. https://money.usnews.com/investing/investing-101/articles/what-are-dividends-and-how-do-they-work