January 4, 2018
Regular readers will be aware of my love for dividend investing.
There’s nothing quite like making an investment, and in return, receiving an increasing sum of cash deposited straight into your bank account. No hassles. No bills. And very little paperwork. But it gets even better!
I believe dividend investing is a perfect fit for those of us aiming for early retirement. This is especially true in Australia! And today I’ll show you why.
Since I’ve started sharing my thoughts on investment openly, I’ve come across some folks who disagree with my approach. And that’s perfectly OK. In fact, it’s kinda good. Often, we learn the most from the people who disagree with us!
Anyway, I want to delve deeper into why I prefer dividend investing over other retirement income strategies. And clear up some issues I come across when people question it’s legitimacy.
When I first came out with this article, there were some concerns over my approach. Namely, the figures I used for dividend returns and whether those numbers are sustainable.
To be clear, I was trying to highlight the advantage of dividend investing in Australia (partly due to franking credits), and how much income can be produced by investing in Aussie shares – using dividend yields at that time.
I wasn’t saying you should rely on a 6% ‘withdrawal’ rate. I was saying that I think you can live off the dividend income from your portfolio (whatever that may be), while keeping some cash aside to smooth out any drops in dividends during retirement.
So I think some folk were quick to judge and wrote it off as irresponsible, without seeing the whole picture. But it’s my error for not making my thinking clear enough! Something I hope to remedy with this post.
Basically, I think due to the 4% rule studies which are mostly US based, some are convinced that living on returns higher than this, by definition, is unsustainable and a complete no-go. I’m not saying those studies aren’t reliable. They’re done by far smarter people than me!
But I am saying that there’s a few things that get overlooked and a blanket rule isn’t always fair (watch the pitchforks come out now!).
The US stockmarket and the Aussie stockmarket are different animals. And dividend investing itself, is different too. So let’s examine those differences, and see what we can learn.
Firstly, I’m no market expert. And I don’t have half the experience or knowledge that many people have. But here’s what I see, when I look at the two markets.
The first thing to note, is the difference in dividend yields. In recent times, the S&P 500 has traded on a dividend yield of around 2% (currently it’s 1.8%). While the ASX 200 has traded on a dividend yield of around 4 – 4.5%, or 5 – 6% including franking.
In the US, the payout ratio is typically around 50% for the S&P 500. But here in Australia, the payout ratio tends to be around 75% for the ASX 200.
Essentially, this means Aussie companies pay out more of their earnings as dividends to shareholders. And therefore, US companies reinvest more earnings back into the business.
Well, it could be many reasons. In the US, many companies are very innovative and growth focused. Because of this, they retain as much cash as they can, to grow.
Also, they don’t have the franking credit system that we have, so paying dividends can more often lead to lower after-tax returns, once the shareholder has paid tax.
And in Australia, because of franking credits, companies are encouraged to pay out a higher level of dividends – since the franking credits are useless to the company, but very valuable to shareholders.
Here in Oz, we have a large amount of old, established and relatively slow growing businesses. And quite often, these companies don’t have great growth prospects. So they tend to pay out much of their earnings as dividends.
Sometimes they may see few growth opportunities, so they decide to do the smart thing and not burn cash chasing unlikely growth. Instead, they sensibly pass most of the profits on to shareholders.
Other times, they may give in to dividend hungry shareholders, and end up paying out too much of their earnings. This can eventually lead to a dividend cut.
Given the above points, it’s no shock that the US sharemarket trades on a higher Price/Earnings ratio (meaning it’s more expensive) than the ASX. Because of lower payouts and higher growth expectations – people are willing to pay a higher price for a company/market that should grow earnings at a faster rate.
All else being equal, you would probably expect the companies with lower payouts to have better growth, and possibly better shareholder returns. But, it’s not a given.
I’ve actually seen research showing that companies paying out higher levels of dividends, performed better. This could be due to having an established and dominant market position, with less need for cash to grow.
Curiously, it could also be that the higher payouts force the company to be more disciplined with their capital, leading to better decisions and therefore higher returns.
Or, it could be that growth focused companies often spend without restraint because they’re chasing more growth and market-share in their industry (which may or may not pay off).
Either way, it doesn’t matter. At the end of the day, it’s just not as simple as it seems. High and low dividend payouts can be both good and bad.
Now, these returns are hypothetical. Nobody really knows the future, let alone me! But all we can do, is take the numbers we have today and make our own estimates for the future. And for simplicity, we’ll just look at earnings and dividend growth. We won’t consider share prices, for now.
Let’s take the US market first. And we’ll assume that US companies can grow their earnings strongly into the future, due to the factors above.
So, a dividend yield for the S&P 500 of 2%. Plus earnings growth of 6%.
Total return = 8%. (Maybe a bit generous, but just go with it.)
And the ASX with a dividend yield of 4%. Plus (slower) earnings growth of 3%.
Total return = 7%.
For some reason, let’s say we know the US market has a higher return for the foreseeable future. Does that mean we should focus our investing there? My answer is, not necessarily.
Dividend investors are looking to generate a strong, yet sustainable, growing income stream with their savings. By investing in the ASX, which provides higher dividend income, we can create a larger level of income for our limited dollars.
Sure, if we each had $10 million to invest, different story. Then, we’d have no trouble generating plenty of income from overseas shares. But we’re not! We’re working with much smaller sums than that! And we’re trying to create a decent income with our savings.
In my opinion, the better choice for dividend investors wanting to retire early, is the Australian sharemarket.
So, in our example, we have a higher return from US stocks, because of the higher growth rate. But we forgot something. Franking credits!
Remember, when we’re investing in diversified LICs (like Argo or AFIC for example), our dividends come with the full benefit of franking credits.
Now our 4% dividend yield, becomes 5.7% grossed up. Plus earnings growth of 3%. Total return = 8.7%.
(To calculate a fully franked dividend, take the dividend and divide it by 0.7)
Honestly, we really do have a huge home-ground advantage by investing in our own backyard!
Overall, even if our market shows earnings growth of only 2% per year, versus 6% growth for the US – we end up with almost the same return (around 8%).
The difference is, our returns are mainly income focused, instead of growth focused. There’s nothing wrong with that. In fact, income-heavy returns are perfect for early retirees.
And we need not starve either! This slow-growth scenario would likely still be enough for dividends to keep up with inflation.
(Side note – As a household, our spending is actually lower than it was 8 years ago when we joined forces. And it seems to creep lower each year. Maybe that won’t always be the case. But it’s almost entirely within our control, which is important.)
So personally, we’re not worried about a super-slow-growth scenario. It’s kind of a non-issue for us. I would expect many frugal households experience this too. With a little attention, it’s not hard to make sure your expenses grow slower than inflation.
Franking is mostly ignored in market and return comparisons. And since it’s not a tax deduction, but a tax credit (real cash), this is plain nuts! Sure, this brings it’s own risk that it could be taken away.
But I’m not sure it’s any more of a risk than anything else – personal/company tax rates, economic conditions, demographics etc.
And besides, even without it, we still have more attractive income returns and likely competitive total returns – as I outlined above.
As an aside, it would take roughly 20 years, for the low yielding US shares, to catch up with the income paid by Australian shares.
And that’s even assuming a much lower growth rate here and lower total returns. See the example here in my other post on dividend investing.
So depending on how you look at it, Australia is perhaps a boring place for share investing.
Since the US market has been racing along for close to 10 years now, many Aussies are looking abroad to invest. And it’s not hard to see why.
In the US, there are some of the most exciting and innovative companies in the world. But because of this, their share prices are flying high and many are double or triple what they were just a few years ago.
In comparison, Australia has been slowly and steadily inching back towards it’s pre-GFC high. Our market has certainly been boring in comparison to the US, no doubt. But it should be noted, dividend investors have still been receiving a strong level of income, which has been rising since the GFC low.
My thoughts on this are split. If you’re focused on getting the highest total return, then you will have been much better served investing in the S&P 500 (for the last 10 years at least). But if you’re following a dividend investing approach for solid income, you’re probably still better off investing in the Aussie market.
The dividend yield is double, plus we get franking credits, which makes the gross yield currently about triple the US!
To be honest, which market outperforms in the next 10 years is anyone’s guess.
Quite often, one market will perform better for a decade or so. Then, in the next decade, the other country’s market will do better.
At the end of the day, it’s not even about which market outperforms. What it’s really about, is which type of investment is going to meet your personal needs/goals.
For those of us passionate about early retirement, we need a strong and steadily growing income stream. So our dividend investing is better focused on the market best suited to provide that – the ASX.
Here’s my simpleton take on things – Australia appears set to be one of the higher-growth developed countries. We have high population growth, relative to many other nations. And this bodes well for company earnings (more customers) and therefore dividends into the future.
Now it’s true, the ASX is a concentrated market with over 35% financials and the top 10 companies making up around 50% of the entire market’s value. But we can reduce this risk by also investing in LICs that focus on small/mid sized companies. I spoke about this here (I’ll review some of these LICs in the future).
This way, we get a much more diverse spread of companies, which operate in different sectors, while still generating strong dividend income. And by increasing our diversification this way, we benefit from the broad growth in the Australian economy.
But obviously, if you feel Australia is going down the crapper, this won’t matter. And investing overseas makes a lot more sense!
I’m optimistic about the future. But I also don’t want to get carried away and expect too much from my investments. While my figures seem too generous to some, we have personally built in some safety margins.
Firstly, we have more savings (equity) than required to meet our income needs. Next, we also keep a decent amount in cash (around 1-2 years living expenses) to smooth any times dividends are reduced.
We’d also look to spend less in that situation, or create some part-time income to make up the difference. And our expenses are likely to grow slower than inflation, giving a further safety margin if dividends grow very slowly for a long time.
There are many types of backup plans you can put in place (future article planned).
It’s worth noting, estimating future investment returns need not be complicated.
Even John Bogle himself (founder of Vanguard) uses a very simple equation when he looks at the markets.
He says in this interview, that a reasonable expectation of future returns is…
Today’s dividend yield, plus earnings growth – what he calls ‘fundamental return’.
And then the change in valuations (Price/Earnings ratio) higher or lower – which Bogle calls ‘speculative return’.
It’s important to realise that this change in valuations, is nothing to do with the earnings of the companies. Therefore, also has nothing to do with the dividends paid out by those companies.
It’s merely the share prices people are willing to pay. That’s why Bogle calls this part of the equation ‘speculative return’.
Dividend investing for early retirement is far more reliable, because it’s based on fundamentals (dividends plus earnings growth), and not reliant on the speculative side of things (fluctuating prices).
Who cares what people are willing to pay for shares tomorrow or next year? What we care about is the economy and company earnings, which is where our dividends come from.
Funnily enough, he’s also said – we should be investing for income, focusing on the dividends in retirement and not stock prices! It’s refreshing to see such a simple thought process, for such a titan of the investment industry.
So it seems to me, dividend investing is a fairly sensible way to go about retiring on shares. And the figures we’ve used above, also seems to be fairly realistic.
I’ve noticed some people get stuck in the weeds trying to calculate future returns. And agonising over formulas and charts to see how much of their portfolio they can live off.
To me, it’s simple. Provided we’re invested in quality LICs or Index Funds, where the dividend income can reasonably be expected to rise (at least) with inflation over time – we can simply use the dividends to live on. And also keep some cash to cover any bumps in the road.
The less flexible you are with your lifestyle, spending, ability to work – the more extra cash you’ll likely need.
Related Post: Long Term Investing & Shrugging Off Sharemarket Falls.
There’s another way that dividend investing fits snugly into our financial independence plan. And it’s another perk of the tax system.
Currently in Australia, we have a tax-free threshold for individuals of $18,200, plus a ‘Low Income Tax Offset’. So it works out, we can actually earn $20,500 of income per year, and not be up for a single dollar of tax! (Check this calculator to see for yourself)
What this means is, a couple can earn $41,000 per year tax-free. Effectively, our own retirement spending can be funded from $700k of Aussie LICs that are yielding 4% fully franked (5.7% gross). And we’ll pay absolutely no tax on this income.
Above this level of income, regular tax rates start to apply. But still, it’s a pretty generous system. Maybe the government feels sorry for us living on a low income 😉
Dividend investing in Australia, can potentially allow you to retire on a juicy income stream which is very low tax, or even tax-free!
I’m not saying it’s a perfect strategy. But I am saying, it makes a lot of sense for our situation (and likely many others too). Most importantly, there’s no need to sell-off shares for income during retirement – something I’m not a fan of, as I outlined in this article.
Dividend investing may not be for you. And that’s OK. We all need to choose an approach we’re comfortable with.
But I hope this makes my thinking more clear. And why I favour dividend investing – which is really just investing, but with an income focus. I don’t see much of this discussion by other bloggers, so I wanted to share my thoughts.
Maybe it’s just me, but I feel as though owning 100-200+ different businesses in Australia – through LICs or an Index Fund is reasonably diversified. And with much higher dividend yields here, plus the benefit of franking credits, the income is just too good to pass up.
Then, we can also add international shares if we want to reduce our risk and diversify our funds further. Personally, we’ll be doing this later, once our Aussie portfolio is fully established and covering all our bills. I see international shares as a ‘nice to have’, not a ‘must have’.
Here’s one way to think about it:
Focus on building the required dividend income for financial independence first, through Aussie shares. Then with any additional funds, look to add international shares for dividend growth, and to further diversify. I looked at different allocations to each in this post.
It may seem flawed or biased to some, that’s fair enough. But putting this all together, I think dividend investing is perfect for Aussies shooting for financial independence!
If you want to see exactly how to implement this Aussie Dividend Strategy, download my free PDF guide: “Your Simple Step-by-Step Guide for Passive Income” – Get your copy here to read at your leisure.