Dividends and the Power of Compounding
Income is an important source of returns and stability in any investment portfolio. This is especially true in a retirement plan where consistent returns help participants achieve retirement readiness. Income also helps in the decumulation phase of retirement, when savers need to turn their nest egg into a steady source of income. The recent low interest rate environment has made income generation more difficult. As a result, some investors have been turning to dividend-paying equities to meet income objectives.
The Benefits of Dividends
A dividend is a percentage of a company’s earnings typically paid to shareholders on a quarterly basis. Companies target a dividend payout ratio, which is the total amount of dividends paid to shareholders relative to the net income of the company. The balance of the net income is retained by the company to reinvest in the business. From an investor’s perspective, dividends provide income. One key benefit to holding dividend-paying stocks versus bonds is the ability for a company to increase their dividend. In a dividend-paying stock, as the company’s payout ratio or earnings increase, the stream of income also increases. Alternately, bonds have a fixed coupon payment and cannot be adjusted (it also cannot be decreased, like dividends can). For dividend-paying stock holders, the first half of 2019 saw 195 companies on the S&P 500 increase their dividend, versus just five that reduced their dividends (1).
Companies tend to only pay dividends once they are confident that they can continue to do so on an ongoing basis. The health of a company is more obvious when it comes to dividends because they are cash payments and, unlike balance sheets and earnings, cannot be manipulated. However, simply buying the highest-yielding company stocks is not necessarily the best strategy. In fact, a recent study by Wellington found that the returns of S&P stocks ranked by payout ratio resulted in the second-highest quintile being the best performers. The highest quintile did well, but did not keep pace due to the unsustainably of high payout ratios (3). Many asset managers are not solely focused on the size of company’s dividend, and instead look to the sustainability, as measured by the dividend payout ratio. Companies that pay out too high of a percentage of their profits as dividends may not be reinvesting enough in their business. Additionally, they may not able to keep up with their dividend payments in the future. One of the most ominous pieces of news for a company is a dividend reduction, as share prices can decrease dramatically.
Dividends in the Current Market Environment
In a low interest rate environment, fixed income instruments provide less interest and income to investors. As a result, investors seek out dividend-paying companies. This increase in demand is generally supportive of share prices for dividend-paying stocks. At their last meeting, the Federal Reserve minutes hinted at an interest rate reduction, should the current weakness in the economy persist. The market, as measured by Fed Funds futures contracts, is anticipating two rate cuts moving forward. Additionally, rate cuts are potentially on the horizon due to recessionary fears. Dividend payers hold up well compared to non-dividend stocks and broad equity market indices, like the S&P 500. The crash of 2008 saw the S&P 500 retreat by 37%, where the Dividend Aristocrats Index (i.e., an S&P 500 index constituent that has increased their dividend payout for 25 consecutive years or more) lost only 21.9% (3).
Companies that pay a low dividend, or no dividend at all, have not kept pace with the returns of companies that pay consistent dividends. While high-growth companies with double digit prospects have been in vogue recently, and in other periods like the 1990’s, dividend payers have won out in the long term. The chart below compares the S&P 500 Dividend Aristocrats Index to the S&P 500.
The Compounding Effect
Many investors do not realize the role that dividends play in the returns of equity portfolios and indices, particularly the S&P 500. And returns are not solely the result of price appreciation. The equities in the S&P 500 pay their dividends on a quarterly basis and are reinvested. The performance of the index, and index funds that track it, factor into these dividends. In fact, 43% of the S&P 500 returns from 1930 to 2018 are attributable to dividends; a staggering figure to many investors (4).
Similar to interest from a savings account or bond portfolio, the reinvestment of dividends in an equity portfolio has a compounding effect in the long-term. The reinvestment of dividends, when equity markets are going through periods of volatility and decline, allows investors to acquire shares at inexpensive prices. This compounding effect reinforces the importance of a long-term focus for retirement savers.
(1) ETFs to Capture Rising Dividends, WealthManagement.com
(2) The Power of Dividends – Past, Present, and Future, Hartford Funds
(3) The Long-Term Allure of Dividends, Kiplinger
(4) The Power of Dividends – Past, Present, and Future, Hartford Funds
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.
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