Why I’ve Changed My Mind About Dividend-Paying Stocks

Go ahead and call me a flip-flopper: Last year, I wrote about 3 investment-related matters where I had revised my thinking.

And lately, I’ve been mulling another change of heart: the role of dividend-paying stocks in a portfolio, especially for retirees who are in drawdown mode. While investment wonks might refer to a dividend preference as irrational, or “nonpecuniary,” in polite terms, I’ve concluded that a dividend focus isn’t a dealbreaker for retirees, provided they don’t chase income at the expense of diversification and their tax bills.

The Case Against Prioritizing Dividends

For most of my career, I was squarely on Team Total Return. I liked dividends as much as the next person, but I agreed with the conventional academic wisdom: Focusing on dividend-payers narrows your opportunity set and, in turn, your portfolio’s long-term return potential. Better to build a portfolio with the best possible risk/reward characteristics, encompassing both dividend-payers and non-dividend-payers, and when it comes time to withdraw from it, pull cash flows from whatever cash flow source makes the most sense. In some markets, that might mean spending dividends, and in others, spending capital gains might be more advantageous.

Market behavior has bolstered the “don’t prioritize dividends” argument. Dividend income has shrunk as a percentage of the market’s total return over the past several decades: Dividends contributed 73% of the market’s total return in the 1970s, but it has ranged between 12% and 16% over the past four decades.

That shows up in the performance of dividend-focused investments, too. For example, Vanguard High Dividend Yield Index VYM, one of the best dividend-focused exchange-traded funds, has returned 11.98% on an annualized basis over the past 15 years. Meanwhile, Vanguard Total Stock Market VITSX

, which tracks the performance of all publicly traded stocks in the US, has returned 13.40% over that same stretch.

Dividend-payers also have an irrefutable tax disadvantage relative to non-dividend-payers. Even though the tax rate on qualified dividends is on an equal footing with the long-term capital gains rate—15% for most investors—dividend investors are ceding a level of control. After all, if you own a dividend-payer in a taxable account and it makes a distribution, you owe taxes on that money regardless of whether you reinvest the income or spend it. You can’t tell the dividend-payer to hold on to the distribution until you need it or have the funds on hand to pay the taxes. By contrast, the person who owns a capital-gains-producing asset—say, Berkshire Hathaway BRK.B—makes the decision about when to realize the capital gain and, in turn, pay the taxes.

How I Learned to Stop Worrying

Those are all pretty solid arguments. I’d still argue that people in accumulation mode—actively saving for retirement or any other goal—should take a catholic approach, diversifying across dividend-payers and non-dividend-payers alike.

Where I’ve changed my mind, though, is the role of dividend-payers in retirement. Even as dividend-payers have posted lower returns over the past few decades, their volatility has also been lower. The aforementioned Vanguard High Dividend Yield Index ETF, for example, has a standard deviation of 13 over the past 15 years, whereas the Total Market Index’s standard deviation is 14.6. The year 2022 provided a tangible example: While Total Stock Market lost 19% that year, the dividend-focused ETF lost less than 1%.

But the major attraction with dividend-payers in retirement is the “bird in hand” feature. A study called “Retirees Spend Lifetime Income, Not Savings,” by David Blanchett and Michael Finke found that retirees are more comfortable spending their nonportfolio income than they are cracking into their savings. However, it stands to reason that dividends occupy a comfortable middle ground: Cashing a dividend check (or having dividends sent to your cash account) is simply easier than venturing into your portfolio to figure out what to sell. Selling feels bad. Given that lack of friction, it’s no wonder that so many retirees anchor their portfolios in dividend-paying stocks and funds. It’s certainly some version of mental accounting that may diminish returns a bit, but if getting some of their income through dividends helps retirees feel more comfortable spending in retirement, it’s a trade-off worth making.

I’ve concluded that the tax issues aren’t a dealbreaker, either. After all, most retirees are on the quest for regular income anyway, so taxes would generally be due regardless of whether they’re pulling from appreciated assets in their taxable accounts or spending dividends. The tax disadvantage of dividends was much greater before 2003, when dividends were taxed as ordinary income.

Some Caveats

But as much as I’ve gotten more comfortable with retirees anchoring their equity portfolios in dividend-paying stocks, it’s important that they keep risk controls and tax efficiency in mind if they do so. While dividend-payers have tended to be less volatile than the broad market, they’re no fixed-income substitute. During the global financial crisis, for example, dividend stocks slumped badly: Vanguard High Dividend Yield VHYAX lost about 45% of its value from peak to trough, a bit more than a total market index fund would have. Bank stocks were the major source of pain for that fund and other dividend-trackers, as they slashed their dividends at the same time their share prices slumped. Fixed-income assets, on the other hand, have a much better track record of holding their ground in equity market shocks, especially recessionary environments. Our annual State of Retirement Income research has consistently found that the highest safe withdrawal rates across a number of withdrawal methods generally correspond with balanced asset allocations, because they better protect against sequence risk.

It’s also important to note that dividend-payers tend to cluster more in certain industries than others: Financials, energy, and utilities stocks have a heavy emphasis in dividend-focused indexes, whereas technology stocks are underrepresented relative to the broad market. In my model Bucket portfolios, for example, I’ve typically included total market index exposure alongside dividend-growth strategies to help smooth out sector biases.

Finally, the distinction between qualified and nonqualified dividends is a crucial one: Qualified dividends are dunned at a rate that’s in line with the long-term capital gains rate, whereas nonqualified dividends face ordinary income taxes. To the extent that investors own companies or funds kicking off nonqualified income, such as REITs and some non-US stocks, it makes sense to do so in a tax-sheltered account, while prioritizing qualified dividend-payers for taxable accounts.

One or more of the Vanguard Funds mentioned in this report track an index created or licensed by Morningstar.