A common problem I find when reviewing an investment portfolio for a new client is that there is an over reliance on dividend paying stocks or funds.

There is a misconception out there that if you pick an investment paying good dividends then you can use the dividends as your income in retirement and you don’t need to sell any shares or units.

The underlying capital remains untouched during your retirement.

It sounds good in theory, but the problem is what happens to the underlying value of those shares or units in real terms once you take into account the impact of inflation.

 

Dividend Heroes

 

The Association of Investment Companies (AIC) keeps a list of investment trusts that have consistently increased their dividends for 20 years or more in a row. They are labelled ‘dividend heroes’.

At the top of the table at the time of writing there are investment trusts like the City of London Investment Trust that has increased their dividend every year for the last 57 years in a row!

An investment trust is a fund similar to the more common funds found in pensions like an open-ended investment company (OEIC) or unit trust but with a few differences.

Investment trusts vs OEICs and Unit trusts

 

The main difference with an investment trust is that it is closed-ended. Shares of the trust are traded on an exchange and the price of these shares doesn’t always reflect the value of the underlying companies it is invested in.

Whereas an OEIC or unit trust are open-ended meaning units are created or disposed of when investors buy or sell.

The other big difference is that an OEIC and unit trust has to pay out all of the income it generates to investors. An investment trust can hold back up to 15% of the income it makes which it can then use to maintain or increase dividends when markets might be in a bad place.

Dividend investors will focus on something called the dividend yield.

A dividend is the share of the profit a company makes. It’s often referred to as a yield, so it is easier to compare to other types of investment.

The yield is the dividend divided by the share price.

Or rent divided by the property price.

Or interest earned divided by the amount you have in savings.

The yield is going to be a very important number in this game because if someone is paying a good level of dividend you might have to pay a high price for it meaning you are more exposed to potential falls in value.

Let’s have a look at the top three ‘dividend heroes’.

 

#1 – City of London Investment Trust

This investment trust focuses on UK listed companies. The top 10 holdings include the likes of Shell, HSBC and BAE systems.

At the time of writing the dividend yield was around 5%. Meaning if you invested £1million it could provide you with a yearly income of £50,000 without having to sell shares in the trust.

However, what we need to focus on is what has happened to the underlying capital over the last 10 years.

The price of a share in the fund has gone up 7.20% over the last 10 years. So, you may be thinking that’s not bad. Not only have you had dividends, but your underlying capital has grown too. But has it?

If we factor in inflation using the Retail Price Index your underlying capital has actually been eroded by around 42%. Meaning your original £1million is now only worth £580,000. Nearly half of your purchasing power has been wiped out in 10 years.

What if you still have another 10 or 20 years of retirement to go?

 

#2 – Bankers Investment Trust

This trust is much more globally focused with the top 10 holdings including Microsoft, Amazon, Visa and Toyota.

The share price has achieved a return of 97.18% over the last 10 years. So already a much better return than the previous investment trust due to being much more globally diversified rather than just focusing on UK stocks.

So, in this scenario you could have had your dividend and your underlying capital has nearly doubled over the last 10 years. Sounds great so far but of course it has not doubled in real terms as we need to factor in inflation.

When doing this the trust still has impressive returns of 47.3% after inflation.

So, it’s still looking very positive so far however the dividend yield at the time of writing is 2.28% so on a £1million investment you would currently only be able to generate £22,800 a year in income. Much less than the previous investment trust above. If you needed more income you would need to start selling down shares.

 

#3 – Alliance Trust

Finishing off the top three ‘dividend heroes’ is another investment trust that invests globally.

It has very impressive share price return figures over the last 10 years of 170.07% before inflation and 120.19% after inflation.

So even after factoring in inflation you would have still doubled your underlying capital over that last 10 years.

This trust does include a large exposure to technology stocks that have done particularly well over this period.

However, the dividend yield at the time of writing is just 2.08%. Meaning a £1million investment would generate an income of £20,800 a year.

According to the Retirement Living Standards research a ‘comfortable’ retirement requires an income of £31,300 per year for a single person and £43,100 for a couple.

 

Dividends vs total return

 

The problem with focusing on dividends alone is twofold.

Firstly, if the dividend yield is high, it could be that the underlying companies are not valued or rated very highly so future returns for the underlying capital could be lower. Causing issues with falling capital in real terms.

Secondly, a fund with a good underlying investment strategy may produce greater returns for the underlying capital but the yield will likely be lower at the start.

Dividends are really important in any investment strategy.

Take the returns of the FTSE100 UK share index.

The return over the last 10 years just focusing on price alone is 21.85%. If we add in the dividends produced it takes the total return to 79.05%.

Dividends re-invested means dividends earned can buy more units in a fund.

So, the better approach to take, even for retirement income, is to focus on TOTAL RETURN.

Don’t worry about selling down units because if the performance of these units is better you won’t need to sell down as much.

Remember you need inflation beating returns to increase your purchasing power because that’s what money is at the end of the day, purchasing power.

Focusing on dividend paying stocks or funds means you are concentrating your investment into certain areas of the market.

Higher dividend paying companies tend to be more established and not focused on growth as they are returning all the profits to shareholders rather than re-investing it to grow the business.

You need to ensure you are well diversified and capturing the global market return.

This could even be done with one fund nowadays.

The MSCI AC world index has achieved a return of 539.03% over the last 20 years. Five times the rate of inflation.

So, you need to focus on inflation beating returns, not income.

Remember a £1million investment today generating 5% income (£50,000) per year is not going to be worth £1million in 10/20 years’ time if returns don’t beat inflation.

You’re not going to be able to buy as much and your kids might not be impressed with their inheritance!

If you would like to stress test your retirement plans or even to get a plan in place then please get in touch for a free no obligation 15-minute call. We would be happy to review your position, explain where you stand and what you need to do to get the outcome you desire. We have created hundreds of happy and protected retirements over the years. This could be you too.

Risk warning:

Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.