I'm not ready to retire just yet, but I'm already preparing financially for life after work (only 5,475 days to go!).
One of the cornerstones of my retirement plan is – you guessed it – dividends. For now, I'm happy to reinvest my dividend income, but in retirement I intend to use the cash to supplement my company and government pensions.
Here are five reasons to consider dividend-paying stocks as part of your own retirement strategy.
Dividends are less volatile than stock prices
Remember the financial crisis of 2008-09? Stock prices plunged about 50 per cent from peak to trough. But in most cases, companies kept paying dividends. A few even raised them. This highlights one of the main attractions of dividends: They're a lot more stable than stock prices.
Instead of obsessing about day-to-day market fluctuations, I prefer to track my dividend income, which grows steadily as companies hike their payouts and as I reinvest dividends and contribute new cash to my portfolio. Over the long run stock prices tend to rise, of course, but focusing on dividends helps to soothe the fears that accompany market setbacks.
Dividends protect you from inflation
Inflation may not pose much of a threat now, but in five or 10 or 20 years, who knows? If you buy a bond or guaranteed investment certificate, the income it churns out won't budge. But because high-quality dividend stocks – banks, utilities, pipelines and consumer staples stocks, for example – raise their dividends regularly, they protect you from the wealth-destroying effects of inflation.
"When you invest in common shares, you are a part owner of the company," says Robert Cable, director of wealth management at ScotiaMcLeod. "As that income stream grows, naturally the shares become increasingly attractive and so the money you've invested grows too."
I'm not against fixed-income securities – I own GICs myself – but the safety and security they provide, while important, has to be balanced against the lack of growth.
Dividends get a tax break
Unlike interest income, which is taxed at one's full marginal rate, dividends from publicly traded Canadian companies benefit from the dividend tax credit, which dramatically lowers the tax hit for investors.
For example, an Ontario resident with income of $80,000 in 2014 will pay tax of just 10.99 per cent on dividends, and a British Columbia resident making $135,000 will pay just 21.64 per cent, according to taxtips.ca.
As significant as the tax break is, many investors aren't even aware of it. According to a recent survey by BMO Nesbitt Burns, 59 per cent of respondents described themselves as "not very or at all knowledgeable about how dividend income is taxed." That lack of knowledge may be keeping them from enjoying the benefits of dividend stocks.
Separately, some retirees complain that the "gross-up" on dividends cuts into Old Age Security benefits. But for most people, it's a non-issue: The OAS clawback only kicks in for income above $71,592, and it affects only about 3 per cent of people, says Jamie Golombek, managing director, tax and estate planning, with CIBC Wealth Advisory Services.
Dividends help to preserve your capital
Many people are reluctant to deplete their capital in retirement, which is understandable. After all, nobody wants to outlive his or her money. The beauty of dividends is that they keep on giving: As long as you don't sell your stocks, you can spend your dividend income every year knowing that you won't have to run down your nest egg. Of course, in an emergency, selling part of your portfolio is still an option.
Studies have shown that stocks with growing dividends post superior returns over the long run. For example, RBC Dominion Securities examined the performance of stocks from December, 1986, through February, 2011, and found that dividend growers posted an annualized total return of 12.6 per cent – nearly two percentage points higher than stocks with stable dividends and more than five percentage points better than the S&P/TSX composite index. Companies that cut their dividends or paid no dividends at all trailed far behind.
Dividends stocks are not guaranteed. Companies do occasionally cut their dividends, and stock prices can fall. But devoting a portion of your portfolio to dividend stocks, making sure to diversify your exposure across companies, industries and asset classes, is a prudent retirement strategy for most investors.
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