By Brad Thomason, CPA
Dividends? Like ‘em. But you gotta be a little careful.
As you no doubt know, dividends are periodic payments made by some companies to their shareholders. They, along with interest payments, are the most common types of investment income. For many retirees, they go a long way towards covering the portion of the household budget not paid for by Social Security.
But I don’t quite trust them. Not completely. Not as a long-term means to secure income.
I like them when they come, and I think that in general they are based on stable enough stuff that we shouldn’t just think of them as a bonus that we’re a little surprised to actually get. But neither are they necessarily a permanent, enduring solution to the question of funding the monthly bills for decades to come.
There are three key things you must keep in mind when it comes to dividends. If you do, it will emerge as obvious to you too that thinking of dividends as a bulletproof income tool is a bit of a bridge too far.
The first point is that dividends are optional. As a general proposition, every single dividend payment has to be proactively and explicitly approved by the company’s board of directors. While they may have a long track record of doing so, and attendant pride at the length of the unbroken run, they don’t have to pay one next quarter just because they have the last 100 quarters. There is no legal requirement to pay a dividend, which is one of the chief reasons that companies use stock as a financing route instead of debt, on which they would be required to pay interest.
Point two, even if they do pay a dividend, the dollar amount may change radically from what the last one was. It is true that under normal circumstances they are not prone to fluctuate from quarter to quarter; and when they do it is more typical for them to go up a little each time, rather than bouncing around all over the place. But the fact that they are both optional and decided upon one quarter at a time means that if the board is feeling a little nervous about the company’s financial position, near-term profitability prospects, or really any other concern, they may decide that preserving cash is more important than paying the dividend. Even if they don’t vote to end it, they may vote to cut it.
Frankly, we could stop right there. Basing your income on something that may change from period to period and may not even be paid at all, is plenty to call the whole thing into question.
But like I said, there’s a third matter.
Being a dividend recipient means being a shareholder. Even if the dividend keeps getting paid out, and even if it stays the same amount as when you bought the stock, there’s no guarantee that the shares themselves will hold the same value you paid for them.
Now you might take the position that as long as the dividend stays where it was, a drop in price is really not your problem. And it may not be, not for many years. But should the day ever come (because of inflation, because of medical expenses, etc) that your old level of income doesn’t quite do it anymore, you may have to sell some stock to pay the bills. On that day, the fact that it fell from $40 a share to $20 during your holding period is going to matter. All of the sudden, those dividends will start looking less like actual income and more like a consolation prize for the losses you were taking (but not feeling).
Taken together, that’s enough to prompt a bit of caution. A need for some moderation.
If you have a good set of holdings which is currently producing enough dividend income for the current needs, so be it. But just understand that even though it works today, it may not work forever. It bears thinking about what your next plan needs to look like, before the day comes that you need it. Simultaneously, make sure that your attention on the payments themselves doesn’t distract you from the potentially more substantive matter, the resale value of your shares.
In practice, this set of concerns argues for basing some of the income on interest; and making sure that some of your money is invested in assets which remain at the same valuation levels all throughout the holding period. Bonds, annuities and even CDs, all have some potential for involvement on those fronts.
There’s plenty of room for customization, from one person to the next, as to which instruments and how much of each. But as a general proposition, an approach to income that’s based 100% on dividends is a plan that I think you ought to be nervous about. Nervous enough to change it, or at least nervous enough to spend some time thinking about how to change it should the need ever arise.
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