Why Total Return Investing is Superior to Dividend Income Investing
The Dilemma: What Should She Do with Her Money?
Marie, 67 years old, was widowed three years ago after forty years of marriage. Together, she and her husband Robert had raised their family of three children and created thousands of memories together in the house that they had owned for almost as long as they had been married. However, with her children grown and without a partner to share in the chores of homeownership, she decided it was time to downsize.
After considering her Old Age Security (OAS), Canada Pension Plan (CPP), the CPP Survivor’s Pension, her workplace pension as well as the 60% survivor’s benefit from her late husband’s pension, and the modest Registered Retirement Income Fund (RRIF) she had started drawing on from her and her husband’s retirement savings, she realized that she had what she needed to fund her basic needs with some money left over. With these supports in place, she felt good about selling her house, which netted her $500,000.
However, she was troubled by this large sum of money. Most of her financial resources came from income streams rather than assets. The RRIF wasn’t that large, and she let the financial planner at her credit union work out the withdrawal strategy from that source of money.
The proceeds from her house sale were different, though. Not only was there some sentimentality attached to the money because of the source, but it was not money that was designated for retirement. She thought maybe she should use it for her rental needs, but that expense was already covered by the income she was receiving.
Jane thought about giving it to her children, but she didn’t want to do that only to find that she needed the money later on and wind up putting a burden on her kids. On the other hand, she didn’t want to hang onto it only to pass it on to her kids once she was gone. She wondered if there was a happy medium.
Solution 1: Invest for Income
A couple of months after the proceeds from the house sale were put into her chequing account, she was having coffee with a friend and disclosed her struggle. Her friend suggested she invest the money for income. That was what she had heard some other retirees do on one of the social media platforms she followed. She didn’t know anything about that but Marie liked the idea of income.
What is Income Investing?
Marie really didn’t know what income investing was all about, so she made an appointment with Jane, the financial planner at her local credit union. Jane explained that income investing was less concerned with growing Marie’s money to a larger sum than with generating income from it. Typical income investments include:
- Guaranteed Investment Certificates (GICs): these can pay out interest as frequently as every month or can let it compound year over year only to pay it out at the end of five years.
- Bonds are essentially promises to pay interest on money that is borrowed by an entity such as a business or government, and then return the principal at the end of the agreed term. In the context of the credit union, bonds are available through the purchase of mutual funds.
- Dividend stocks are like any other stock, in that they represent an ownership stake in a company. However, not every company pays out a dividend and many companies do not pay out very much of their earnings in the form of dividends. Those companies that pay out higher levels of dividends tend to be somewhat more mature and have less use for their earnings, so they return a larger portion of their earnings in the form of dividends. Again, in the context of a credit union’s offerings, this source of income can be accessed through specialized mutual funds that narrow their investing focus to dividend-paying companies.
However, Jane said that with $500,000 in cash available outside of an RRSP or RRIF and potentially a long life ahead of her, Marie might do well to consider other investment approaches. Jane referred Marie to an affiliated advisor.
The Appeal of Dividends and Interest
Marie’s next visit was with Jason, a portfolio manager with an affiliate relationship to Marie’s credit union.
Jason observed that, during our employment years we receive income regularly (although some people, such as those who work in commission-based sales roles, might have irregular incomes) that we use to pay for our living expenses. In retirement, most of us would like to receive income with a similar degree of regularity. We can get that with GICs.
Likewise, we can receive interest payments from bonds, typically semi-annually, or through a bond ETF, as frequently as monthly. Bond issuers can and do default on their payments, but that happens infrequently, so they are often viewed as reliable sources of income.
Although not with the same guarantees, Canadian dividend payers have been quite reliable over the years. Jason pointed out that dividends are drawn from a company’s earnings so the more a company pays out the less is retained in the company for business development purposes. However, a well-run company will be judicious with its dividend payments to not jeopardize the continuing profitability of the company. Individual companies often pay dividends quarterly, e.g., January, April, July, and October, but ETFs that focus on dividend-paying stocks frequently make monthly distributions, and they will often set the distribution amount to the same level each month. This makes it appealing for investors looking for steady incomes.
For someone like Marie, who wants to leave the principal untouched, this income-oriented approach may feel the most suitable. Marie is enthusiastic when she hears this. This addresses her intentions exactly.
The Limitations of the Income Investing Approach
However, Jason noted that this approach has its limitations and introduces certain risks. This was not to say that Marie should not incorporate some element of income investing in her portfolio. Certainly, GICs and fixed-income ETFs can play a role in reducing volatility in, and diversifying, an investment portfolio as GICs do not change in price at all, and fixed-income products, like bonds or funds that hold bonds, tend not to fluctuate in value as dramatically as equities. The caveats have more to do with income equity investing.
Decreasing Diversification
Jason reiterated that not all equities pay dividends so a focus on dividend-paying equities will reduce the number of stocks in a portfolio, whether the investor chooses to invest in individual securities or use investment funds that focus on dividends. In addition, because of the tax treatment of dividends from Canadian-domiciled companies, investors in Canada tend to focus almost exclusively on Canadian stocks. Canada represents approximately 3% of the value of the world’s stock markets, so holding nothing from the other 97% of the investing world would concentrate Marie’s portfolio even further.
Increasing Risk
The flip side of decreasing diversification is increasing risk. Why? Because when you reduce your range of investments, you increase the possibility of significant loss. It’s a case of concentrating your eggs in very few baskets.
To illustrate this, while the world’s stock markets have been under considerable pressure this year, Canadian dividend payers have been hurt more than many other sectors.
Chart source: TD Direct Investing
These three lines represent the year-to-date price movements of three Vanguard Canada ETFs. The red line represents VEQT, the Vanguard All-Equity ETF Portfolio, which holds 13,619 stocks. The second line, in green, is VCN, the Vanguard FTSE Canada All Cap ETF, which tracks an index of 174 stocks. The last line, in blue, is VDY, the Vanguard FTSE Canadian High Dividend Yield Index ETF, which holds 53 stocks. Although this is a price-only chart, which therefore excludes dividends, one should remember that both VEQT and VCN also pay out dividends; they just don’t make it a factor in deciding what to invest in. It appears that the higher dividend yield of VDY (4.81% versus 3.18% for VCN and 1.95% for VEQT) is insufficient to make up for the price drop. To be fair, though, measured over a different time frame, the results would be different. But that also illustrates the point that an investment portfolio more narrowly focused on dividends will tend to result in greater volatility.
Solution 2: Total Return Investing
Be Indifferent to Dividends
Jason made the case that Marie should focus on a total-return approach to investing. She would still have dividend income, as the dividend yield for VEQT indicates, but by being indifferent to dividends as an investment consideration, Marie can own a proportionate amount of the world’s stock markets, instead of a narrow slice of the Canadian stock market.
Tax Implications
A total return approach can be more tax efficient. Remember that Marie is retired and is no longer contributing to an RRSP to generate a tax deduction. Marie indicated earlier that her income was already sufficient for her needs. That means she doesn’t need to bring in yet more taxable income. Granted, she does not have a (Tax-Free Savings Account) TFSA yet. She should certainly maximize that account but that will still leave $412,000 ($500,000 – $88,000) that she cannot shelter from tax in 2023. A lesser amount of dividends means that more can be left to grow on a tax-deferred basis.
Income When She Needs It
To the extent that Marie needs some additional money beyond the income her portfolio will generate – for example, for a once-in-a-lifetime family vacation – she can always sell off a portion of her assets to release money and generate a tax-efficient capital gain. Jason was aware that Marie did not want to touch her principal, but by “creating” her own dividend through a periodic sale, if necessary, she gets the money she needs while allowing her assets to grow more when she doesn’t need the money.
Anticipating the Results
Buoyed by this well-rounded investment strategy, Marie looked forward to her retirement years with much less anxiety about her finances. She understood that her balanced portfolio with its emphasis on total return would have the highest probability of addressing the purposes she had for her spending, including occasional substantial gifts to her children, while maintaining and possibly even growing her investments.
This is the 220th blog post for Russ Writes, first published on 2023-10-23
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
Image: Nick Youngson CC BY-SA 3.0 Alpha Stock Images