Using dividends to earn an income

When it comes to passive income most people think of property, yet a share portfolio can also be used to generate an income – one that is well diversified, tax efficient and does not require any tenant management.

income from sharesWhen it comes to investing in shares most people focus on the share price. This is not surprising given that the value of the All Share Index is covered in most news reports and market pundits watch every price movement as if their lives depend on it.

The real genius behind share investing, as investment guru Warren Buffet will tell you, is actually the dividend or income you receive from your investment. By building up a share portfolio of high-dividend-yielding investments, you can generate a relatively stable income.

A dividend is a sum of money paid from a company’s profits to its shareholders. While a company’s share price in the shorter term can be driven by market sentiment rather than fundamentals, dividends on the other hand are the real measure of a company’s health. A company cannot pay out money it hasn’t earned and therefore dividends are a good measure of a company’s growth and real earnings. Over time quality dividends will be reflected in the company’s share price so investors have the added benefit of longer-term share price growth.

The key to dividend investing is leaving the investment long enough for the dividend yield to grow and provide you with a decent income. Currently the average dividend yield for companies listed on the JSE is around 3% – that may not sound as attractive as bank account which is paying 5%, however South African companies have been growing their dividends well above inflation.

The Marriott Dividend Growth Fund – a domestic equity fund – has grown its distribution by 8% in excess of inflation since 2003.

That means within ten years an investor’s income yield relative to his original investment value would be 7% in real terms and unlike interest in the bank, the rate of income continues to grow. After 20 years you would be receiving a 14% level of income per annum in real terms which makes this a very attractive option for saving towards retirement where you would be able to live off the income.

You also have the benefit of capital gains on the original investment which you would not receive from a bank account. Dividends are also more tax efficient as they are taxed at a rate of 15% compared to rental income or interest income which would be taxed according to your personal income tax rate.

Dividend-paying shares

While the average dividend is around 3%, you can build up a share portfolio targeting shares that tend to pay a higher dividend. Companies such as Standard Bank, British American Tobacco and MTN all have dividend yields of above 4%.

If you had invested R10 000 in Standard Bank at the beginning of 1998 it would be worth nearly R60 000 today and you would be receiving R2 570 in dividend income this year. That means your income this year alone is 25% of your initial investment.

Certain unit trusts, such as the Old Mutual High Yield Opportunity Fund or the Marriott Dividend Growth Fund focus on income from shares and will contain companies with above-average dividend yields as well as companies that have good prospects to grow their dividends. As Feroz Basa, who manages the Old Mutual High Yield Opportunity Fund points out, research on the JSE’s returns shows that dividends have contributed over half of total returns over 25 years.

Duggan Matthews, investment professional at Marriott says when investing for income one needs to select companies that are consistent ‘salary’ payers – these are companies with a track record of consistent dividends and which are not cyclical in nature.

These tend to be companies that make up a basic basket of goods and services consumed by households – such as retailers (Spar, Mr Price), telecommunications (MTN, Vodacom) and banks (Standard Bank, FirstRand).

Each year they grow their profits and each year they increase their dividends. In contrast mining companies are not consistent dividend payers as they tend to be very cyclical and their profits are determined by forces outside their control such as the price of gold or platinum.

How to build up a dividend portfolio for retirement

A dividend portfolio strategy in retirement can provide a relatively stable retirement income. I still remember in 2009, after the market had halved in value, my mother asked me why she was still receiving her regular monthly income from her retirement portfolio when all her friends had lost money. The simple reason was that she was receiving dividends, not selling shares to generate her income.

A R1 million investment in the Old Mutual High Yield Opportunity Fund when it launched in 1998 would have paid you R2.4 million in income over the period – this year alone that R1 million investment would pay you R236 000 in income – effectively a 23% yield on the original value. Apart from the dividends, the fund has also grown by R3.3 million in capital.

During the market crash South African companies were still growing – Shoprite was still selling groceries, Standard Bank was still making money from banking and SABMiller was still selling beers. So their earnings continued to grow along with their dividends. Dividends are inherently more stable than share prices so those investors who relied on the dividend income were unaffected by the market movements.

Marriot, who specialise in investing for income, recently introduced a retirement annuity which aims to produce a specific income in retirement by building up a high-quality dividend portfolio.

Unlike traditional funds which set targets to achieve a specific capital return, the Marriott Dividend Growth Fund targets income and offers on an online tool that helps you calculate how much income your retirement annuity would produce in retirement.

Duggan Matthews, investment professional at Marriott, says while predicting future share prices is very difficult, future dividends are far more predictable. “An accurate projection of a likely investment experience allows younger investors to set up a savings plan that will ensure the income from their investments will be enough to maintain their lifestyle in the latter years,” says Matthews.

If by the age of 40 you had saved R500 000 for your retirement in shares that continued to grow their dividends at 8% above inflation, in 20 years’ time that R500 000 would generate you an income in today’s terms of around R70 000 a year. The capital value of that R500 000 in 20 years’ time is simply not relevant. The income it can produce it what matters most to a retiree.

• If you invested R1.8 million in Woolworths the dividend income would pay for R5 000 worth of groceries per month – for the rest of your life.
• If you invested R700 000 in Sasol the dividend income would pay your annual petrol bill (based on 20 000km a year of travel) for life.
• If you invested R100 000 in SABMiller the dividend income would pay for a case of beer a month for the rest of your life.
– Source Sanlam Private Wealth

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