Is Investing for Dividends Bad for Long Term Wealth?

This is part two (out of three) of Kernel’s investigation into Dividends and their purpose, attractiveness and use for New Zealand-based investors. Read part one “Should companies pay high dividends” here.

Occasionally, we receive enquiries about dividend growth strategies, which are popular among some retail investors due to a behavioural preference for regular payouts and building a passive income.

We also often see these investors sharing their dividend payouts on social media, celebrating these earnings as a hallmark of investment success. However, while dividends provide immediate gratification and an impression of passive income, this approach may not be the most effective way to build long-term wealth.

Focusing solely on dividend-yielding stocks can limit growth potential and reduce portfolio diversification. Simplistically, a company paying a dividend whether from past or present profits, is implying they can’t grow their company (and your money) better by retaining that cash.

A more balanced strategy, incorporating a diversified portfolio can offer a better path to sustainable wealth and reliable income streams over time.

Many investors favour high dividend-paying companies in order to build a passive income. Often, these dividend-paying companies distribute profits to shareholders every six months, with some companies doing so quarterly.

This potential to provide a regular and sometimes predictable (but not guaranteed or contracted) stream of cash flow can be particularly appealing for individuals seeking consistent income to supplement their earnings. Or for those wanting to retire early with a passive income.

Additionally, dividend payments may provide some protection against inflation as blue-chip companies, particularly those that have inflation-linked revenues, tend to have dividend yields that are higher than the rate of inflation.

Moreover, dividends can offer a form of diversification within an investment portfolio, since dividend paying companies tend to be more stable and mature. Historically, they have also exhibited lower volatility compared to their non-dividend paying counterparts.

Finally, reinvesting dividends, in other words, reinvesting the cash payment received back into more shares of the same company - can compound your investment returns over time, potentially accelerating long-term wealth accumulation.

While investing for dividends can offer some benefits, there are many drawbacks to consider.

First, a high dividend yield is not guaranteed into the future. Dividend yields are backwards looking, and a high yield may be based on the period when a company is more profitable, and subsequently issued lower guidance or “profit warnings” to market.

Despite general desires for stability and track records, dividend yields may fluctuate depending on market conditions and the company’s profitability, or even be cut during economic downturns or if a company faces financial challenges. It is ultimately a regular decision for the Board.

A prominent local example is Air New Zealand

Prior to the COVID-19 pandemic, Air New Zealand focused on paying out a stable and predictable cents per share dividend. When COVID hit, it put a pause to distributions for 3 years, with the new policy to set dividends using a target payout ratio of between 40-70% of underlying net profit after tax.

The airline also noted that it does not expect to have imputation credits to attach to any future dividends declared until such time as the company absorbs cumulative tax losses and begins paying cash tax. For investors, this has meant going from a stable dividend to no dividend, to now a fluctuating income source.

Dividends and capital gains are two sides of the coin and often involve trade-offs. This is because high dividend paying companies are often more mature and established companies with lower capital growth prospects and fewer areas to reinvest their profits.

Hence, relying solely on dividends as a passive income stream will potentially limit the exposure to growth opportunities in emerging sectors.

In New Zealand, dividends and interest income are taxable in most cases, meanwhile capital gains are often tax-free. For instance, let’s say you are a NZ tax resident, and you own shares in a NZ company.

Even if fully imputed and 28% is available as credits against other income, a dividend yield of 3.5% is taxable and will result in a net yield closer to 2.35% once tax is taken away at a 33% rate or a yield including imputation credits of 3.32%.

On the other hand, having your share price go up by 3.5% is usually tax-free (trader intentions aside). So, earning $1 from capital gains, in general, would give you better outcome compared to earning $1 from dividend payouts.

When investors choose to receive immediate dividend payouts, they gain access to cash in hand at no transaction/realisation cost which can be useful for covering expenses. However, this decision comes at the cost of foregoing the benefits of compounding growth.

When dividends are reinvested, they contribute to the compounding effect as the reinvested dividends generate additional returns. Over time, this snowball effect can significantly boost your investment returns. By choosing immediate payouts, investors sacrifice their long-term wealth accumulation.

Overall, investing for dividends as a passive income stream presents both advantages and disadvantages.

Dividend paying shares offer a regular source of cash flow and may also offer some protection against inflation. However, the dividend payout policy is subject to market conditions and company performance, potentially leading to fluctuating income and overlooking growth opportunities.

However, one of the key benefits of dividend investing lies in the option to reinvest dividends for long-term wealth accumulation, which will be discussed further in the following section.

One of the primary reasons for New Zealand’s high dividend payout policy is its dividend imputation regime – an uncommon practice among countries around the world.

As a result, New Zealand’s dividend strategy may provide investors with robust income. Figure 2 unveils the significant role and importance of reinvesting dividends in total long-term equity returns. Between 03 Jan 2003 and 30 April 2024, the price index increased by 129%.

Notably, during the same period, the total return index – factoring in reinvested dividends - rose by an impressive 504.2%. Moreover, gross with imputation credits index – which accounts for both reinvested dividends as well as any associated imputation credits- surged by 653.8%.

This data reveals that approximately 57% of the S&P/NZX 50 Index’s total return was due to reinvestment of dividends, and 23% was due to reinvestment of imputation credits.

Table 1 below illustrates the investment outcome of two investors with investor A planning to cash out all periodic dividends as their regular source of income and investor B deciding to auto-reinvest the dividends, disregarding any associated costs.

Suppose they both invested in the S&P/NZX 50 with an initial amount of $10,000 and made no further contributions.

Over a 5-year span, investor A, who opted for immediate dividend payouts, ended up with a portfolio that was $4,069 (averaging across different investment start dates) lower than investor B, who reinvested dividends.

Notably, as the holding period extended, this disparity in investment outcomes grew even larger. Remarkably, after 20 years, the gap had widened to $51,831!

While reinvesting dividends offers significant benefits for long-term wealth accumulation, the investment mechanism chosen in the first place can impact the costs and overall returns. Investing directly in a range of NZ shares, and subsequently reinvesting dividends via direct investment in NZ shares has consequences.

There are additional costs such as brokerage fees and the ongoing research and monitoring of individual companies. 

While participating in a company's Dividend Reinvestment Plan (DRP) allows shareholders to automatically reinvest dividends without incurring brokerage fees, it's essential to recognise that buying and selling shares still involve such fees.

Over time, these fees can impact returns, particularly for smaller investors. By contrast, investing in an unlisted index fund typically comes with no transaction fees. This is because, with an unlisted index fund, you buy and sell units directly with the fund manager.

Furthermore, it should be noted that in New Zealand, DRPs are indeed not as common as in some other countries.

Some might argue that index funds incur management fees, whereas investing directly in shares typically involves no management fees.

However, it’s noteworthy that investing in individual shares demands research and ongoing monitoring of the specific companies, transaction fees, and tax calculated at an investor's RWT rate compared to a fund's PIR rate, which is capped at 28%.

Additionally, the potential lack of diversification inherent in direct investment exposes investors to higher company-specific risks, which can magnify portfolio impact if a specific company underperforms or fails.

In order to compare these two different cost structures, we back-tested the impact over the last 10 years. The table below shows the impact of transaction fees and management fees on the investment outcome of two investors with: 

• Investor A - investing directly in the 20 companies in the S&P/NZX 20 index

• Investor B - investing in an unlisted index fund tracking the S&P/NZX 20 index

Though both investors reinvested dividends, investor A needed to pay the brokerage fees for the periodic dividends amount being reinvested while investor B doesn’t have to pay that cost. Meanwhile investor B must pay a management fee which we have assumed to be 0.25%p.a. the same as Kernel’s NZ 20 Fund.

Suppose both investors had $10,000 to invest on 30 April 2014 and each month invested $1,000 for 10 years to build wealth. 

When it comes to calculating brokerage fees for buying and selling shares in New Zealand, for each time of buying or selling shares, suppose that investor A must pay a 1.9% transaction fee on the amount invested (or sold), up to a fee cap of $25 NZD.

Table 2 below summarises the impact of fees on the investment outcome of the two investors after 10 years of accumulating wealth. We use the gross with imputation credits (gross with IC) index series to calculate the monthly gross returns with dividends and imputation credits reinvested and use the price index return to calculate the monthly price return without dividends reinvested.

The difference between the two series reflects the dividend return from which the monthly dividend amount is derived.

Each month during the period from 30/04/2014 to 30/04/2024, in addition to the $1000 contribution, investor A needed to reinvest the monthly dividend amount and had to pay brokerage fees on the total transaction value.

The average monthly brokerage fee was $25. The value of the periodic brokerage fee was then adjusted for the gross with IC returns to calculate the total amount of fees investor A should have saved after 10 years if reinvested instead. The total cost under this approach was $5,232, and the investment outcome after fees was $210,173.

Investor B, despite not having to pay transaction fees, needed to pay annual management fees at 0.25% of Net Asset Value. We also adjust those fees for the Gross with IC returns to see how much money investor B would have saved after 10 years if fees were reinvested instead.

The result stands at $2,835. Considering the investment outcome after fees, investor B’s total amounts to $212,571.

So, compared to directly buying and selling NZ shares, investing in a low-fee index fund would be more cost-effective.

Particularly in this example, investor A would have saved 1.13% of the investment outcome if choosing to invest in an index fund.

• Initial investment amount: $10,000

• Monthly contribution: $1,000

• Average monthly dividend amount: $361.97

• Average monthly price index return: 0.75%

• Average monthly Gross with IC return: 1.15%

Last but not least, it’s essential to note that these calculations do not account for taxes. For investors subject to a 30%, 33%, or 39% RWT (Resident withholding tax) rate, the disparity in returns would likely be more significant, especially given that our index fund offerings are PIE funds, with tax capped at 28%. 

• Brokerage fees (Average per month): $25

• Investment outcome after fees: $210,173

• Value of brokerage fees if reinvested: $5,232

• Management fees: 0.25% of NAV per year

• Investment outcome after fees: $212,571

• Value of management fees if reinvested: $2,835

This consideration could substantially affect the comparative advantage of investing in the index fund versus directly buying and selling shares.. 

Next up in Part 3, we look at alternatives and whether a regular drawdown from a diversified fund or portfolio, might be an attractive alternative for those with passive income needs.