Over the first few years of early retirement I noticed a disturbing trend… dividends were increasing at a much too rapid pace!
Between 2012 and 2017, the dividend payout of VTI / VTXAX grew at an annual rate of more than 9%! The growth rate on our portfolio was even higher (14%+) which brought annual dividends from $28,139 in 2013 to $36,760 in 2015. Annual inflation over the same period was only about 1.5%.
While dividend growth investors were most certainly overjoyed, I was busy reducing our dividend income.
Please, corporations of the world… stop paying so many dividends.
Returning Shareholder Value
We own stock with the expectation that, in the long term, we will receive both income and price appreciation as companies innovate and grow. Historically, the total return has exceeded both inflation and the return of other asset classes. This is why our portfolio is primarily equities.
Smaller firms are often cash limited, but as the company and profits grow excess cash is often returned to shareholders. The two most common ways are:
- Pay dividends
- Buy back shares of stock
In terms of book value, dividends and share buybacks are equivalent. One puts cash in your hands today, the other increases the value of the remaining shares which can be sold for a capital gain. In the short term, the market may have different opinions. The Economist does a fair job of summarizing this (up to the point where they call Warren Buffett delusional.)
When it buys its shares or pays a dividend, a firm is transferring cash to its owners. In neither case does this alter the underlying value of the firm, which is determined by its expected cash flows and their riskiness. Instead all that happens is that the financial instruments with a claim on those cash flows are reshuffled: the value of the firm’s equity declines, its cash falls (or debt rises) and investors’ cash holdings rise, all by an identical sum. In both cases, owners’ wealth is also unaffected: those who sell shares in a buy-back end up with more cash and fewer shares; those who do not end up with a bigger slice of a smaller pie.
The text book version is also very nice.
Equivalence notwithstanding, preferences are passionate, which I imagine may make an appearance in the comments. (The Canadian Couch Potato does an excellent job of reviewing the opinions.)
Passion is nice, but so is math. And the math says six of one, half dozen of the other.
Why Reduce Dividend Income?
So if they are equivalent, why reduce dividend income? One word: control. (And maybe a 2nd word: taxes)
Corporations pay dividends on their schedule, not mine. And their schedule may result in a higher tax bill and/or the reduction of income based benefits (e.g. ACA subsidies, tuition assistance, Saver’s credit, other tax credits…)
These are all strong likelihoods for anyone in the accumulation phase with taxable accounts.
For somebody in the withdrawal phase, today’s dividend income also has the potential to increase future taxes; every dollar of unqualified dividends is one less tax-free Roth IRA Conversion dollar, and every dollar of qualified dividend is one less tax-free harvestable capital gain.
To reduce dividend income, I didn’t do anything fancy. As part of normal year end tax management in 2015, I simply sold the last of our remaining individual stocks. (See our asset allocation.)
At the time, this was less than 10% of the total portfolio. However, it was producing more than 10% of total dividend income and 25%+ of unqualified dividends.
Contributions to my solo Roth 401k and to his/her individual Roth IRAs (0 tax in, 0 tax out) slightly reduced the post-tax/taxable ratio of the portfolio. The remaining proceeds were added to our brokerage account holdings of VTI and VXUS. The combination of fewer shares held in taxable accounts and the lower yield of VTI / VXUS reduced total dividend income by ~9%. (When I looked in Dec, this portion of the portfolio had grown by 10.4%, whereas the basket of deplorable stocks I once held had grown 8.3%.)
As additional benefits, I’ve increased diversification (replaced 10 stocks with 9,641) and increased small-cap exposure (replaced BIG companies with small ones.)
What are companies doing?
While I’m asking companies to take it easy with their dividend increases and do more share buybacks, what are they actually doing?
It turns out, they are taking it a little easy with their dividend increases and doing more share buybacks.
The historical average dividend yield since the beginning of time for the S&P500 is ~4.4% (Shiller data) whereas for the past 15 years or so it has been more like 2%. This is also roughly the current yield of VTI.
But post financial crisis, with share buybacks included total “yield” is ~5%. Nice. Keep trending in that direction, please.
The rapid growth in dividends in recent years was raising potential issues for control of income and taxes. To slow it down a notch, I sold all of our individual stocks and replaced them with index funds. This reduced total dividend income by ~9% and eliminated the source of 25% of nonqualified dividends.
The preference of buybacks vs dividends for corporations does seem to be trending towards buybacks. Thank you corporations of the world!
Do you have a preference for Dividends or Buybacks?
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