Monday, July 22, 2024

Retirement 20 years away. Should I invest in dividend-paying stocks

Retirement 20 years away. Should I invest in dividend-paying stocks


Reader has been told to focus on growth stocks, but rate hikes have left him unable to contribute to savings

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By Julie Cazzin with Andrew Dobson

Q: I often read about dividend investing as something that should be done closer to retirement. For someone like me, with 20 years to go until retirement, I’ve been told to focus on growth stocks versus dividends. With the recent interest rate hikes, I find myself not being able to contribute much to my savings anymore, so would now be a good time to switch my portfolio to be more dividend-oriented and reinvest the dividends? Or should I keep them in a growth-style exchange-traded fund (ETF), but not make regular contributions?  — Thanks, Barry

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FP Answers: Dividend-paying stocks have traditionally been a popular investment focus for investors looking for a combination of income in the form of regular dividend payments and growth, based on the price of the stock.

Dividends usually indicate a certain level of profitability for a company as they are usually issued by more stable and profitable enterprises. The ability to pay a dividend can be an indication of consistent positive cash flow. You may notice there are endless websites, books and videos that specifically focus on dividend investing, Barry, and the idea is particularly popular in Canada.

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One aspect that dividend-stock investors tout is that dividends allow an investor to receive an income stream without having to sell their shares. They can also reinvest dividends over the long term to compound their returns over their investment holding period. This concept is so wildly popular that most brokerages in Canada offer dividend-reinvestment plans at no additional cost to investors, which allow for much effective compounding of dividends.

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In Canada, dividend-paying companies usually pay eligible dividends that are taxable at a lower rate than regular income and the rate varies depending on your income level. These types of dividends are more tax efficient than foreign dividends for non-registered accounts, especially for retirees who tend to be in lower tax brackets. Dividends paid from companies outside of Canada are taxable at full tax rates such as on salary or interest.

Though these eligible dividends have great tax attributes, they are still taxable, unlike capital gains, which can be deferred for many years. So, with dividends, you may be bumping up your tax by receiving income you don’t necessarily need.

In a tax-preferred account such as a registered retirement savings plan (RRSP) or tax-free savings account (TFSA), where most investors hold their investments, the special tax treatment for Canadian dividends does not really matter since the dividend tax credit is not available for investments held in tax-preferred accounts.

Some investors feel the recurring income that comes from dividends is a risk-mitigation strategy for their portfolios. The rationale is that even when the stock market declines in value, it does not mean companies will necessarily cut or halt dividend payments. For well-managed, industry-leading and mature companies, dividends may continue uninterrupted or even grow during market corrections and bear markets.

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Stocks that pay dividends also have the potential to increase in price by way of capital growth. However, this capital growth may be lower because dividend-paying companies have less to spend on expenses such as research and development, mergers and acquisitions, and stock buybacks.

Canadian banks are a good example of companies that have paid dividends for several decades, but have also seen significant and, in some cases, double-digit returns in price appreciation over multi-year periods.

In your case, Barry, if you have 20 years until retirement, I do not see a compelling reason to completely move your investment strategy to dividend-paying stocks or ETFs since a more balanced approach could be more beneficial. Even for a retiree, a dividend strategy is just a preference, not a requirement.

Canadian companies are often the most popular dividend-paying stocks for homegrown investors due to company history, brand recognition, tax preference, etc., but this does not mean that you cannot access great dividend-paying companies in other markets.

The United States features hundreds of dividend-paying large-cap companies that can enhance your portfolio diversification. Because of the more diverse nature of the U.S. economy, you may see stocks in certain industries that favour more growth, but still pay a small dividend. This is the case with many technology and health-care stocks, which are often considered growth sectors.

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This dynamic of growth versus dividends and the unique difference between the Canadian and U.S. markets is most evident when reviewing the yield for the major stock market indexes for each country.

The TSX 60 tracks the largest 60 publicly listed stocks in Canada and has a current yield of about 3.1 per cent. Dividend yield is a way to express the annualized percentage of your portfolio that is expected to pay a dividend. This number changes as the value of the stocks changes, but, overall, it is a good indicator of the income that can be generated from a portfolio without having to sell shares.

The S&P 500’s dividend yield is currently about 1.3 per cent, or less than half that of the TSX 60. How have the two indexes performed over the past 10 years? One might expect to have a higher return for the higher-dividend-paying index. But the 10-year total annualized return for the TSX 60 through May 31, 2024, was 8.1 per cent; for the S&P 500, it was 14.6 per cent.

The potential fallacy here is that a focus on dividend yield or tax preference alone will result in the best performance. Investors are essentially trading long-term growth for immediate taxable income and a narrower focus in their investment universe.

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Recommended from Editorial

If your time horizon is 20-plus years to retirement, Barry, and then likely many more years in retirement holding an investment portfolio, it could be beneficial to view your investment decisions from a balanced standpoint.

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.

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