There are many theories that speak to the best method to save for retirement – a traditional asset allocation based time frame, inclusion of alternative asset classes to achieve broader reach and the consideration of dividends as a means to hedge against market risks. Here, we consider the advantages and disadvantages of utilizing dividends when saving for retirement.
Before determining whether dividends are the best option for retirement savings, it is valuable to understand how dividends work. When an investor purchases a stock, he or she becomes a proportional owner of the company based on how many shares of stock are purchased. Because of this relationship, profit achieved by the company is shared with the shareholder in one of two ways:
• A dividend is paid out on a per-share basis. whether an investor owns 100 shares, and the company declares a 50-cents-per-share dividend, the investor receives a total dividend payout of $50.
• The company’s stock price may increase over time, making the shares owned by the investor more valuable.
Dividends are typically paid in cash on a quarterly basis and must be owned by the ex-dividend date in order to pick up the declared dividend. Shareholders who own preferred stocks receive fixed-rate dividends, while common stock shareholders receive variable-rate payouts.
Advantages of Dividends
Most investors are concerned with poor investment performance, loss of principal and the fixed threat of high inflation. Dividends can provide a hedge against these risks while saving for retirement. According to Bloomberg, more than 40% of large capitalization stocks’ return since 1931 has consisted of dividends, creating a positive argument for the exercise of dividend-paying stocks within an investor’s long-term portfolio.
Although fairness investments are appealing to investors for the potential of higher returns, volatility within the market can be a cause for concern for investors saving for retirement. Focusing solely on capital appreciation through fairness investment may not provide the consistency investors need in order to achieve retirement savings goals. Adding dividend-paying stocks in an allocation can wait on mitigate loss in fairness positions.
Investors can exercise dividends to hedge against rising inflation for the long term. Although rates delight in been relatively low recently, inflation still has a corrosive effect on investment returns. Investors who hold positions in dividend-paying stocks may be better able to navigate higher inflation rates while saving for retirement.
Disadvantages of Dividends
Although there are reasons why investors may want to supplement capital appreciation in fairness positions with seemingly regular dividend payments, there are caveats to consider. Dividends are not guaranteed; reliance on consistent payouts could skew savings projections in the wrong direction. Should companies settle to not declare dividends, investors could topple short of their savings goals.
Dividends are taxed at a qualified dividends tax rate which depends on the income bracket that the investor falls into, while the gains associated with the sale of appreciated stock are taxed at the lower capital gains rate. Paying higher taxes can delight in a detrimental effect when the time comes to win income in retirement.
Although dividends can present an opportunity for consistent growth and a hedge against inflation, investors saving for retirement need to be aware of the potential drawbacks to this investment strategy.