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Q Can you use the Couch Potato strategy to build a dividend-paying portfolio? I would like to increase my annual dividends now that I am close to retirement and was wondering if there was a way to clean up my ETF portfolio without having to sell units and rebalance when I need extra cash for expenses.
– January
AND. One of the many challenges of retirement is adjusting to new investment goals. You’ve been adding money to your portfolio over decades and watching its value increase over time. You’ve no doubt owned dividend-paying bonds and stocks along the way, but it probably wasn’t your primary goal to make money from them. Now that you’ve started making regular withdrawals, you may feel compelled to move away from focusing on growth: you now want to focus on income-oriented investments instead.
However, retirement does not require a fundamental change in your investment strategy. Just because you need cash flow from your portfolio doesn’t mean you have to invest in dividend-paying stocks. In fact, I would advise against this strategy for several reasons.
Jan, you mentioned that you want to avoid selling ETF units when you need extra money for expenses. Many investors share this preference: receiving a $10,000 dividend is like getting a paycheck, and selling a $10,000 investment is like “digging into your capital.” But this is something of a myth.
Businesses have choices about what to do with excess cash. The company may reinvest the cash in the business (which should lead to a gradual increase in the value of the shares) or may pay out the cash in the form of dividends to shareholders. As an investor, there is no theoretical reason to prefer one over the other. Remember that when a company pays a dividend, its share price falls by an amount approximately equal to the amount of the cash distribution on the ex-dividend date. In other words, dividend-paying companies are “digging into capital” by making payments to their shareholders.
The point here is not that there is anything wrong with dividend stocks. The point is simply that while they may generate more income than non-dividend-paying stocks, there is no reason to expect their total return to be higher. Excluding taxes, a stock that grows 8% in price is equivalent to a stock that grows 5% and pays a dividend of 3%. An investor who owns a non-dividend-paying stock can simply sell some of the stock to generate the cash flow it needs, and should not hesitate to do so.
Favoring dividends doesn’t make much sense for registered accounts like RRSPs, RRIFs or TFSAs because selling shares to free up cash won’t generate any taxable capital gains. In fact, if your portfolio is diversified globally with U.S. and international stocks (and it should be), dividend-paying stocks are less tax efficient if held in RRSPs and TFSAs because the dividends may be subject to foreign withholding tax.
If you invest in a taxable account, the situation is completely different. If you fall into the low tax bracket, dividends from Canadian stocks are taxed at a very low rate, even compared to the capital gains you would generate from selling the stock. You can therefore make a good case for favoring Canadian dividend stocks in an unregistered account designed to generate retirement income. (You’ll need to diversify by holding fixed income and foreign stocks in your tax-sheltered accounts.)
Please note that dividends from US and international stocks are not eligible for tax relief: they are taxed at the same rate as interest income. That’s twice the rate you would pay for capital gains. So after taking taxes into account, this is a case where an 8% capital gain is much better than a 5% capital gain plus a 3% dividend.
Focusing on profit rather than total return on investment presents another problem: it can often result in unnecessary risk taking. Eliminating all companies that don’t pay dividends will inevitably make your portfolio less diversified. This is especially true in Canada: it is not unusual for Canadian dividend ETFs to have 60% or more of their holdings concentrated in banks and financial institutions.
The pursuit of yield may also tempt investors to fill their portfolios with too many real estate investment trusts (REITs), high-yield bonds, and preferred stocks, all of which should constitute only a modest portion of a properly balanced portfolio.
All of this means that the preference for generating cash flow from dividends rather than selling ETF shares is largely psychological. This makes some investors feel more comfortable, but there is no reason to expect this strategy to improve your portfolio’s performance and may even increase taxes and risk. Even in retirement, you can effectively generate all the cash flow you need with a traditional Couch Potato portfolio, which relies on a combination of dividends, interest and capital gains.
Dan Bortolotti, CFP, CIM, is a portfolio manager and financial planner at PWL Capital in Toronto.
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