Can you use the Couch Potato strategy to build a dividend-paying portfolio?

Q. Is it possible to use the Couch Potato strategy to build a dividend-paying portfolio? I’d like to increase my annual dividends now that I’m close to retirement and was wondering if there’s a way I can structure my ETF portfolio without having to sell units and rebalance whenever I need extra cash for spending.
– Jan

A. One of the many challenges in retirement is adjusting to your new investing goals. For decades you’ve been adding money to your portfolio and watching its value increase over time. You no doubt held bonds and dividend-paying stocks along the way, but it probably wasn’t your main objective to earn income from them. Now that you’ve begun making regular withdrawals, you may feel compelled to move away from a focus on growth: Now you want to target income-oriented investments instead.

But retirement doesn’t require you to fundamentally change your investment strategy. Just because you need cash flow from your portfolio doesn’t mean you need to load up on dividend-paying stocks. In fact, I would recommend against that strategy for a few reasons.

Jan, you mention you want to avoid selling ETF units whenever you need extra spending money. Many investors share this preference: Receiving $10,000 in dividends feels like getting a paycheque while selling $10,000 worth of investments feels like you’re “digging into your capital.” But this is something of a myth.

Companies have a choice about what to do with their surplus cash. A company can reinvest cash in the business (which should lead to gradual increases in share value), or it can pay out cash as a dividend 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 cash payout on the ex-dividend date. In other words, dividend-paying companies are “digging into capital” when they make distributions to their shareholders.

The point here is not that there’s anything wrong with dividend stocks. It’s 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. Ignoring taxes, a stock that increases in price by 8% is equivalent to one that increases by 5% and pays a 3% dividend. The investor who holds the non-dividend paying stocks can simply sell some shares to generate the cash flow she needs, and she shouldn’t be reluctant to do so.

The preference for dividends doesn’t make much sense in registered accounts, such as RRSPs, RRIFs or TFSAs, since selling shares to free up cash won’t generate any taxable capital gains. In fact, if your portfolio is globally diversified with U.S. and international equities (and it should be), dividend-paying stocks are less tax-efficient when held in RRSPs and TFSAs, since the dividends may be subject to foreign withholding taxes.

If you’re investing in a taxable account, the situation is quite different. If you’re in a low tax bracket, dividends from Canadian stocks are taxed at a very low rate, even compared with the capital gains you would generate by selling shares. So you can make a good argument for favouring Canadian dividend stocks in a non-registered account designed to generate retirement income. (You would need to diversify by holding fixed income and foreign equities in your tax-sheltered accounts.)

Note that the dividends from U.S. and international stocks are not eligible for the tax credit: They are taxed at the same rate as interest income. That’s double the rate you would pay on capital gains. So after accounting for taxes, this is a case when an 8% capital gain is significantly better than a 5% capital gain plus a 3% dividend.

There’s another problem with focusing on yield rather than the total return of your investments: It can often cause you to take unnecessary risk. Eliminating all companies that don’t pay dividends will inevitably make your portfolio less diversified. That’s especially true in Canada: It’s not unusual for Canadian dividend ETFs to have 60% or more of their holdings concentrated in banks and financials.

The hunt for income can also tempt investors to fill their portfolios with too many real estate investment trusts (REITs), high-yield bonds and preferred shares, all of which should make up only a modest portion of a properly balanced portfolio.

All of which is to say that the preference for generating cash flow from dividends rather than selling ETF shares is largely a psychological one. It makes some investors feel more comfortable, but there is no reason to expect this strategy to improve your portfolio’s performance, and it may even increase your taxes and your risk. Even in retirement, you can effectively generate all the cash flow you need with a traditional Couch Potato portfolio that relies on a combination of dividends, interest and capital gains.

Dan Bortolotti, CFP, CIM, is a portfolio manager and financial planner with PWL Capital in Toronto.

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