I thought this was a finance 101 topic but based upon what I read in the financial press maybe it’s not. For some reason people like dividends. Even I have fallen prey to the siren song of dividends, as the fact that Bank of America (BAC) now has a 5.2% dividend yield with a P/E ratio of 9.84 excites me. My perverse logic works something like this: the stock can’t go much lower and you’re practically guaranteed a 5.4% return on your money, which management wouldn’t be paying out if they didn’t think they could support it – so it must be a good investment. But the reality is that I was making this argument when the stock was at 55 and today it closed at 48.59. That’s a 12% drop. Nevertheless, over the last 5 years Bank of America has been a pretty good investment – but not necessarily because they have a high dividend.

From talking to people I get the impression that there are several misconceptions out there that need to be cleared up. First, let’s be clear that dividends are not a free lunch. Every time a stock goes ex-dividend the price of that stock goes down by a corresponding amount. The reason is simple: the company’s value has gone down by the amount of the dividend payment. It has less cash in the bank. Second, and related to the first point, higher dividends do not necessarily translate into a higher total stock return. When companies pay out dividends either 1) they are making a conscious decision to trade off future growth for a return of capital or 2) they are raising additional funds from one group of investors to transfer funds to another group of investors. In principle, all a company can do is tweak the balance between dividend return and capital gain return.

If you don’t find these arguments convincing you can review the academic work that has been done on this topic. Perhaps the best-known study was the 1961 paper by Miller and Modigliani [1]. Their mathematical proof, which is now generally accepted as correct, basically demonstrates the assertions made above. In addition, a 1974 Black and Scholes study proved empirically that high dividend stocks produced no better total return than lower dividend paying stocks [2]. The bottom line is that dividends just don’t matter – one way or the other.

Although there are a number of arguments in favor of paying dividends…

• Signaling effect – because a company is very reluctant to lower a dividend (it’s a really bad sign) they are equally cautious in raising a dividend. They only raise the dividend if they truly believe that the business has bright prospects.
• Desire for current income – some people, for example retired people, like to receive current income to fund their living expenses. (I never have understood this since for a few dollars they can sell some of their investments to generate cash for living expenses.)
• Clientele effect – some investors like dividends and do not suffer negative tax consequences from receiving them – e.g. pension funds, IRAs, endowments. By paying dividends a company is appealing to this target group.

…there are other arguments against high payouts that are even more compelling:

• Tax issues – it used to be the case, and in all likelihood it will soon be the case again, that dividends were taxed at a higher rate than capital gains. Therefore, by paying a dividend a company is forcing their investors to pay taxes.
• Creates a reinvestment burden – now that I have this dividend what do I do with it?
• Calls into question the company’s prospects for growth. The assumption is that if a company is paying a dividend they must not have very good investment opportunities. Typically, high growth companies don’t pay dividends because they have better uses for the capital.
• If a company has excess cash they can repurchase shares instead of paying dividends. This will drive up the price of the stock and return cash only to those shareholders that want it.

Despite all the evidence that dividends don’t matter the financial community loves to flap their jaws about the virtues of dividends. S&P even maintains a list of “dividend aristocrats” which are stocks that have upped their dividends for 25 or more consecutive years. When Lowes declared a quarterly dividend of eight cents per share and an increase in their share repurchase on May 25, 2007 everyone pointed out that the dividend represented a 60% increase and that they had paid a cash dividend each quarter since going public in 1961. Lowe’s CEO made the statement: “The additional share repurchase authorization and dividend increase are an indication of Lowe’s financial strength, and reflect our commitment to return capital to shareholders.” Apparently the signaling value of dividend increases isn’t so obvious because CEOs always spell it out for us.

Then there was this June 13, 2007 article in Forbes that begins with:

 

“Wednesday was one of those days Caterpillar investors can use to take their wives out to dinner. They got a large dividend increase, as well as a message of confidence from the company.

 

The board of directors of Caterpillar (nyse: CAT - news - people ) voted Wednesday to increase the quarterly cash dividend by 20%, or 6 cents, to 36 cents per share.

 

“This increase reflects the board of directors’ continued confidence in Caterpillar’s long-term outlook,” said CEO Jim Owens

Investors responded by sending shares up $1.85, or 2.4%, to $79.93.”

I found the assumptions in this article strange to say the least: 1) All Caterpillar investors are men 2) I should spend a return of capital and 3) Caterpillar’s stock price responded to the dividend increase as opposed to “the directors’ continued confidence”.

Even more blatant dividend propaganda was forced upon us with the May 21, 2007 Barron’s cover story entitled “Still Too Stingy”, which called for a return to good old fashioned dividends as an alternative to share repurchases. The article laments the fact that dividend payouts are on the decline and points out that millions of baby boomers are nearing retirement and seeking higher yields. The article has several particularly annoying quotes from Edward von der Linde, the manager of the Lord Abbett Mid-Cap Value fund, “Shareholders own the company. The earnings are their cash. Give it back.” Regarding the potential for an increase in federal dividend taxes, he says “Since when is my tax status the business of management?” and he argues that share repurchases “give money to people who want to go away. Why not give the money to all shareholders equitably? The only way that the board of directors and management can directly affect shareholders is via the dividend.” [3]

I just don’t understand this point of view. I own a company’s stock because I want to be invested in that company. I don’t want them returning a portion of my investment on a periodic basis. When they do that I have to reinvest the money and they involuntarily trigger tax consequences, which company management should be concerned about. Let’s face it, one of America’s best-loved stocks, Berkshire Hathaway, has never paid a dividend and no one is complaining. Conversely, even the Barron’s article points out that initiating a dividend payment has not helped Microsoft’s stockholders.

I will concede one point to the dividend payment camp that was actually raised in the Barron’s article. There are several examples of companies buying back their shares at inflated market prices that are ultimately not sustained. To avoid this problem companies need to be judicious about when they buy back their stock. Of course, it’s hard to imagine a CEO announcing that they are going to discontinue their stock repurchase program because they believe that their stock is overvalued.

December 12, 2007 Addition

I just read another Barron’s article [4] about stock buybacks that further supported this last point with some very compelling data. In the graph to the left Standard & Poor did an analysis that showed that the more aggressive a company was in repurchasing their shares the worse their stock performance was. Aggressiveness was calculated as the percentage of a company’s market capitalization that was repurchased. Part of the problem is that the more aggressive companies borrowed heavily to support their repurchase programs. It’s possible that companies that used excess cash to execute these repurchases faired much better, but that was not discussed in the article.

[1] M. H. Miller and F. Modigliani, “Dividend Policy, Growth, and the Valuation of Shares”, Journal of Business, Volume 34, pp. 411 – 433, October, 1961
[2] F. Black and M. S. Scholes, “The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns”, Journal of Financial Economics, Volume 1, pp. 1 – 22, May, 1974
[3] Andrew Bary, “Still Too Stingy”, May 21, 2007, Barron’s
[4] J. R. Brandstrader, [$$]“Buybacks That Bite Back“, December 10, 2007, Barron’s

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Once you retire, if you start drawing from your investment and savings accounts in the wrong order, you greatly increase the odds that your money will run out or that your heirs will be left with less than they could have inherited.

Common mistake: Many retirees as­sume that they should start withdraw­ing money from their IRAs, 401 (k)s and other retirement accounts as soon as they retire-retirement is, after all, what this money is intended for.

Reality: Your financial future could be a lot brighter if you leave retirement accounts un­touched for as long as govern­ment rules and your financial situation allow. That way, you sharply reduce your annual tax payments.

Example: Two people retire at age 65. Each has a total of $1.4 million-$1.1 million in retirement accounts, such as IRAs and 401(k)s, and $300,000 in taxable nonretirement accounts. Each earns an 8% annual return on his/her overall investments and-drawing on both principal and investment re­turns-spends $8,000 per month on expenses. How they diverge: Mr. A starts living off his retirement accounts as soon as he retires-and sees his sav­ings run out at age 98. Ms. B lives off her taxable investments for as long as possible before tapping tax-protected retirement accounts-and still has $1.2million remaining at age 98 (see chart).

THE BEST ORDER

Once a retiree passes age 70 1/2, gov­ernment rules require specific minimum annual withdrawals from most tax-deferred retirement accounts, including traditional IRAs and 401 (k)s. A retiree’s tax bracket, health and personal priori­ties can alter the order in which assets should be withdrawn. These caveats aside, most retirees should tap accounts in roughly the fol­lowing order…

1. Taxable income. Pension distri­butions, earned income from re­tirement jobs and income from divi­dends and interest in accounts other than IRAs and 401 (k)s should be spent first. If you already have begun to receive Social Security payments, that money should be used as well (If you have not yet started receiving your Social Security benefits, see item 4 below.)

2. Traditional IRA and/or tradition­al 401(k) distributions if your tax bracket Is low. This is an exception to the general rule that you should leave tax-deferred retirement accounts untouched for as long as possible. If your retirement income is low enough to keep you in the 10% or 15% tax bracket, withdraw money from your tax-deferred retirement savings just un­til you reach the taxable income limit of the 15% tax bracket. In 2007, the limit is $63,700 for a married couple filing jointly and $31,850 for an individual. Example: After deductions, a retired married couple’s taxable investment income, pension benefits and other retirement income total $50,000 for 2007. They withdraw $13,700 from their traditional IRA and remain in the 15% tax bracket.

Better: If you can live without this income for now, instead of taking a distribution, convert a portion of your traditional IRA to a Roth IRA (whose assets will never be taxed in the future), but not so much that the converted as­sets push you out of the 15% tax brack­et. (The converted assets count toward your income for tax purposes.)

3. Taxable investments and savings. Among these assets-including stocks, bonds and mutual funds outside of retirement accounts-there are three basic steps to consider…

First, sell those that have dropped in value and are no longer attractive so that you can use the capital losses to offset capital gains.

Second, draw on any assets that are in cash (including money market funds) and fixed-income investments, such as matured bonds and matured certificates of deposit (CDs). By reduc­ing these assets, you lower the amount of taxes you pay on future interest and dividends. If this action shrinks your overall allocation for fixed-income investments, you can raise the amount of fixed-income investments you have in IRAs and 401 (k)s.

Third, sell taxable investments that have appreciated in value but are no longer attractive, especially those that have appreciated the least. Any long ­term capital gains-on assets held for more than one year-are taxed at no more than 15%.

4. Social Security benefits. Retirees who have not yet begun to receive Social Security benefits might consider delaying the start of their benefits until as late as their 70th birthdays if they can afford to do so.

Retirees can receive Social Security checks at age 62. However, the size of the checks will increase by 7%, 7.5% or 8%-depending on the year the retirees were born-for each year they delay from age 62 until 70. There is no ad­vantage to delaying the start of benefits past age 70. Retirees who will benefit from waiting…

Have enough other retirement as­sets and income to cover their expenses and don’t have to dip into their tax-deferred retirement accounts (except as mentioned in item 2) and…

Are healthy and come from families in which members tend to live a long time. The longer you expect to live, the more sense it makes to delay the start of Social Security benefits. If your health or family history suggests that you might not live much past age 84, start benefits by age 66.

5. Traditional IRAs, 401(k)s and oth­er tax-deferred retirement accounts. Withdrawals from these accounts gener­ally should be delayed as long as possible to take maximum advantage of tax-deferred investment growth. Eventually, however, either your financial situation or tax rules may force you to start with­drawing money.

Strategy I: Married couples who must tap into tax-deferred accounts before tax laws require should draw on the older spouse’s accounts first. That way, the older spouse will have already met part of the minimum required distribution.

Strategy II: Tax laws typically require that annual withdrawals from tax-deferred retirement accounts begin April 1 of the calendar year following the year in which the retiree turns 70 1/2. Most retirees, however, should begin taking withdrawals in the same calendar year that they turn 70 1/2, not the one after. That way, you don’t end up taking two required distributions - the initial one and the second one - in a single year, which could push you into a higher tax bracket. (See IRS Publication 590, Individual Retirement Arrangements, or www.paytaxeslater.com/calculator to calculate required withdrawals.)

Exceptions: Minimum required distributions from a traditional 401(k) often can be delayed as long as you are still working for the company that sponsors the 401(k). You also might be able to delay minimum distributions until age 75 on contributions made before 1987 to a 403(b), a type of retirement account offered by nonprofit organizations.

6. Roth IRAs. Assets held in Roth IRAs and Roth 401(k)s generally shouldn’t be spent until all other assets have been exhausted, because there are no future taxes on Roths - including on investment gains - even for heirs. And there are no minimum required distributions for you or your surviving spouse from your Roth IRA. To avoid minimum required distributions on your Roth 401(k)s, roll them into your Roth IRA.

Types of Accounts

Tax-deferred retirement ac­counts. These include traditional IRAs and 401(k)s for which taxes have not yet been paid. No taxes are paid as long as the money remains in the account, but taxes must be paid at regular income tax rates on any with­drawals, including interest, dividends and even capital gains.

Roth IRAs and Roth 401(k)s. Tax­es were paid before the initial contri­butions were made, and no further taxes will ever have to be paid on the initial contributions or the interest, dividends and gains (as long as cer­tain conditions are met).

Reprinted with the permission of:

Bottom Line/(name of publication/website)

Boardroom, Inc.
281 Tresser Blvd, 8th Floor
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www.BottomLineSecrets.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.