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Brandon Renfro, Ph.D., CFP®, RICP®, EA
Retirement and Social Security Expert
Brandon Renfro is a Retirement and Social Security Expert and financial planner. He focuses on helping clients create a secure financial future in retirement and co-owns Belonging Wealth Management. He is also a former finance professor and writes for several publications.Read More
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Stephen Kates, CFP®
Certified Financial Planner™ Professional and Founder of Clocktower Financial Consulting
Stephen Kates is a Certified Financial Planner™ professional and personal finance expert with over a decade of experience working with individuals and families who need help with their finances. With experience as a financial advisor for two of the largest financial firms in the country, Stephen has worked with hundreds of clients to build comprehensive financial plans to grow and protect their wealth.Read More
- Published: May 23, 2023
- Updated: June 13, 2023
- 6 min read time
- This page features 2 Cited Research ArticlesKey Takeaways
- Dividend yield is the measure of a stock's dividend relative to its price.
- Retirees may consider dividend yield as they seek out dividend-paying stocks to generate income in retirement.
- Focusing on dividends to generate income in retirement exposes retirees to unnecessary risk.
What Are Dividends?
Dividends are a popular topic for many investors who are looking for ways to generate income and support themselves in retirement. Often, retirement investors who focus on dividends will consider a particular stock’s dividend yield when deciding whether to purchase it. Stocks with higher dividend yields pay larger dividends relative to the amount invested, which is exactly what these investors are looking for.
Understanding what dividends are, what they aren’t and what dividend yield means, will help you decide how they may fit into your retirement income plan.Building an income strategy is a complex exercise for any retiree. It is important to consider many sources of income in order to never depend on only one too much. Combining social security, pensions, annuities, dividends, bonds, and security sales allows retirees to balance and diversify their income.
Understanding Dividend Yield
Cash dividends are payments made to company shareholders. The source of this money is the issuing corporation’s net profit. Since stock represents ownership in the company, shareholders are entitled to their respective share of the company profits, and dividends are one way for them to receive it.
However, a key element that is often overlooked is that dividends are not anything other than a return of capital that belongs to you anyway. Companies can either choose to reinvest earnings to increase business value (which belongs to the shareholders) or pay them out as dividends.
Dividends are not “extra” cash, according to an article from the Chicago Booth Review. You can see this very directly in the way that a stock’s price adjusts when dividends are paid. Suppose you hold a $25 stock. If that stock pays a $1 dividend, then its price will fall by $1 when the dividend is paid. You’ll be holding $1 in cash and a stock that is worth $24.
How Is Dividend Yield Calculated?
Dividend yield is calculated by dividing the annual dividend by the stock’s price per share. For example, if a company pays a $1.50 annual dividend and has a $75 stock price, then it has a dividend yield of 2%.
Why Are Dividend Yields Important?
Dividend yields are important because they allow you to compare the dividend payments of two companies whose stock prices differ. So, if you want to compare the $75 stock that pays a $1.50 dividend to a $40 stock that pays a $1 dividend, then you simply need to compute the dividend yield for both.
The $40 stock has a 2.5% dividend yield, so it is better from the perspective of a dividend investor, assuming all other characteristics are equal. You get more dividend per dollar invested in that stock.
Stock Price and Dividend Yield
When thinking about dividend yield, it may be tempting to focus only on the dividend. However, that is only half of the equation. Because it is a ratio, dividend yield is affected by both changes in the amount of each dividend paid, as well as changes in the stock’s price.
While dividend investors generally consider higher dividend yields to be a good thing, beware that a rising dividend yield could be the result of a falling stock price. At the same time, a falling dividend yield can be the result of a rising stock price. It would be important to consider those price changes and what it means for the dividend yield.3 Minute Quiz: Can You Retire Comfortably?Take our free quiz & match with a financial advisor in 3 easy steps. Tailored to your goals. Near you or online.
Risks and Challenges of Dividend Yield for Retirees
Dividend investing is often applauded as a safe way to generate stable income in retirement, but there are some risks associated with this strategy. This isn’t to say that dividends or the stocks that pay them are bad, but misunderstanding can lead to misuse.
Dividend-paying stocks often derive from very good companies, which is why they can pay the dividend in the first place. However, over-reliance on dividends for an income stream isn’t as safe as it may seem.What To Consider Before Investing in DividendsWhat are the Top Types of Investment Risk?
- Dividends must be paid from earnings. If the company isn’t profitable, it may have to reduce or cut its dividend.
- Corporations are not obligated to pay dividends. In fact, dividend yields have been falling for years.
- Focusing on high-dividend-paying stocks will likely lead an investor to concentrate their portfolio in stocks that have similar characteristics, reducing diversification. Lack of diversification can expose the investor to unnecessary risk.
- Dividends decrease the investor’s ability to plan for and control their cash flows and distributions. In a taxable account, this could result in inefficient taxation, which could lead to paying more retirement taxes than you would otherwise.
Benefits of Dividend Yield for Retirees
The technical benefits of dividend yield as income for retirees are largely overplayed or misunderstood, but that doesn’t mean there is no benefit to dividends at all. After all, dividends are real, and the cash does come to you. It can be very comforting to see cash dividends hit your account.
Dividends are also an important component of total return, but this implies that dividends are reinvested — not spent.
Dividend-Paying Stocks vs. Non-Dividend-Paying Stocks
Dividend payout decisions are up to each corporation, but there are some general distinctions between the types of stocks that pay dividends and those that don’t.
What Is the Difference?
Dividend-paying stocks are typically those of larger, mature companies with a strong and reliable history. Their size and success are what give them the ability to pay dividends, although not all these stocks — called “blue chip” or value stocks — do.
Stocks that don’t pay dividends tend to be smaller, younger and growth oriented. These companies may not have sufficient earnings to pay dividends yet or they may be choosing to reinvest that capital to drive further growth. However, there are also stocks that fit this profile that do pay dividends.Never Miss Important News or Updates with Our Weekly NewsletterGet money-saving tips, hard-to-find info and tactics for a successful retirement in our free weekly newsletter.
FAQs About Dividend YieldsWhat are some benefits of investing in dividend-paying stocks?Dividends provide a stream of cash flow that may make it psychologically easier for some to spend their money in retirement if a more comprehensive investment and withdrawal plan doesn’t align with their retirement income planning preferences.What are some potential risks and challenges of dividend investing?Dividends are not guaranteed. They may provide a cash flow that is poorly timed to meet your expense needs, create tax drag and reduce diversification.How can you reinvest dividends for compounded growth?Dividends are not bad, and dividend reinvestment is an important component of a stock’s total return. However, it is important that dividends are reinvested rather than thought of as excess cash flow. Fortunately, this is often easy to do. Many dividend-paying stocks and funds offer dividend reinvestment plans (DRIP) that allow you to automatically reinvest your dividends into additional shares.Last Modified: June 13, 2023
2 Cited Research Articles
- Schmidt, D, (2023, March 03) What is a Good Dividend Yield? How to Decide. Retrieved from https://www.nasdaq.com/articles/what-is-a-good-dividend-yield-how-to-decide
- Maiello, M. (2017, March 06). Dividends Are Not Free Money (Though Lots of Investors Seem To Think They Are). Retrieved from https://www.chicagobooth.edu/review/dividends-are-not-free-money-though-lots-investors-seem-think-they-are
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