Canadian eligible dividends are tax efficient for taxable Canadian investors. This is one of the reasons that the mystical dividend investing strategy continues to have a cult-like following. As attractive as the tax rates on dividends are, dividends do still produce taxable income. A dividend-focused strategy will likely have most of its return coming from dividends. This means that even if the portfolio is producing more income than you can spend, you are still paying tax on the excess. There are also structural issues with a dividend-focused portfolio: a portfolio constrained to Canadian dividend paying stocks cannot possibly be sufficiently diversified. Structural issues aside, in this paper we will look at the capacity of a Canadian dividend focused portfolio to build wealth and fund retirement expenses on an after-tax basis.
Making some assumptions
We will assume that a taxable portfolio worth $1,500,000 is the only asset of a 65-year-old individual with the goal of funding a $4,500 monthly after-tax living expense for the next 31 years. We will assume that their expenses are funded from a combination of their portfolio and Old Age Security.
Setting up the analysis
For the first part of the analysis, we will compare the ending wealth, assuming straight line returns, of a Canadian dividend focused portfolio to a globally diversified and rebalanced total market portfolio. In applying the expected returns to the analysis, we assume unrealized capital gains remain unrealized unless a sale in the portfolio triggers a gain. Realized capital gains are assumed to be triggered annually regardless of any specified withdrawals to simulate the tax costs of rebalancing. The dividend focused portfolio is assumed to only earn Canadian dividends and unrealized gains.
Table 1 - Expected Returns (Equities)
| Foreign Dividends | Canadian Dividends | Unrealized Capital Gains | Realized Capital Gains | |
|---|---|---|---|---|
| Canadian Dividend Focused | 0.00% | 4.04% | 2.00% | 0.00% |
| Globally Diversified Rebalanced | 1.31% | 0.80% | 1.97% | 1.96% |
Data Source: PWL Capital
Looking into the future
Running this scenario for 31 years results in an ending net worth of $3.18M for the dividend focused portfolio, and $3.35M for the globally diversified and rebalanced index fund portfolio. This result is primarily driven by the relative tax efficiency of the globally diversified portfolio. While this may seem counterintuitive, the taxation of each scenario can be seen in Table 2. The dividend gross up results in an adverse interaction with both the age credit and OAS clawback.
Table 2 - Income Tax Projection
| Dividend-Focused Portfolio | Globally Diversified Rebalanced | |
|---|---|---|
| Investment | ||
| Foreign Dividends | $0 | $19,650 |
| Taxable Canadian Dividends | $83,628 | $16,560 |
| Taxable Capital Gains | $0 | $14,700 |
| OAS Income | $6,453 | $6,453 |
| Total Income | $90,081 | $57,363 |
| OAS Clawback | $2,126 | $0 |
| Taxable Income | $87,956 | $57,363 |
| Federal Tax on Taxable Income | $15,468 | $9,169 |
| Tax Credits (Non-Refundable) | ||
| Personal Credit | $1,771 | $1,771 |
| Age Credit | $0 | $641 |
| Dividend Credit | $12,561 | $2,487 |
| Total | $14,332 | $4,900 |
| Regular Federal Tax | $1,135 | $4,296 |
| Ontario Income Tax | ||
| Basic Ontario Tax | $7,392 | $4,087 |
| Ontario Tax Credits | $8,886 | $2,285 |
| Ontario Surtax | $1,619 | $0 |
| Total | $2,369 | $1,803 |
| Total Tax (Including OAS Clawback) | $6,462 | $6,099 |
Data Source: NaviPlan
Sequence of returns
We have now seen that a dividend focus is not a sure-fire way to build after-tax wealth. One of the other risks that dividend investors are exposed to is a false sense of safety. The notion that you will be paid to wait by collecting dividends when stocks are down can make dividend paying stocks seem safer than they are. Dividend stocks are still stocks. Based on the history of the DJ Canada Select Dividend Index we can estimate an annual standard deviation of 11.80%. That’s a lot of volatility for a retiree, but volatility is only one measure of risk. A more tangible measure of risk might be the risk of running out of money. From this perspective we can use Monte Carlo analysis to compare the outcome of an investor using an all-equity dividend focused strategy to an investor using a globally diversified 60% equity 40% fixed income portfolio.
It is clear that, on average, an all-equity dividend-focused strategy can be expected to outperform a 60/40 portfolio on an after-tax basis in terms of building wealth. This is simply due to the higher expected returns of stocks more so than the tax attributes of dividends.
Table 3 - Expected Returns (60/40)
| Foreign Dividends | Canadian Dividends | Unrealized Capital Gains | Realized Capital Gains | |
|---|---|---|---|---|
| Canadian Dividend Focused | 0.00% | 4.04% | 2.00% | 0.00% |
| 60/40 Portfolio | 1.70% | 0.48% | 1.33% | 1.33% |
Data Source: PWL Capital
Based on these expected return assumptions we would expect an ending net worth of $3.17M for the dividend investor, and $1.95M for a globally diversified 60/40 investor.
The story gets much more interesting when we also consider the impact of the expected volatility on the long-term outcome. The Dividend-focused portfolio has an expected return of 6.04% with a standard deviation of 11.80%. The 60/40 portfolio has an expected return of 4.84% with a standard deviation of 7.09%. Based on a $4,500 per month draw, we can compare the results of relying on each of these portfolios using Monte Carlo analysis.
Table 4 - Probability Analysis
| Goal Success Rate | 90th Percentile Ending Wealth | 50th Percentile Ending Wealth | 10th Percentile Ending Wealth | Earliest Age Assets Depleted | |
|---|---|---|---|---|---|
| Canadian Dividend Focused | 94.40% | $6,198,188 | $2,182,697 | $312,337 | 83 |
| 60/40 Portfolio | 98.40% | $3,063,997 | $1,544,148 | $458,468 | 91 |
Data Source: NaviPlan
Despite a lower average return and therefore lower average ending wealth, the 60/40 portfolio offers a higher probability of achieving the ultimate goal of funding retirement expenses until death. The 60/40 portfolio also offers a higher average ending wealth in the 10th percentile of outcomes. Most importantly, in a worst-case scenario, the 60/40 portfolio lasts 8 years longer than the dividend-focused portfolio. If the primary goal is to build wealth, then it is true that an all stock portfolio is likely to provide the best result. However, the volatility of equities may be sub-optimal for funding retirement income.
Idiosyncratic risk
So far, we have shown that a dividend-focused Canadian equity strategy is suboptimal in terms of building wealth (compared to other equity portfolios) and funding retirement goals (compared to a 60/40 portfolio). The other risk that needs to be considered is idiosyncratic risk. It is not possible to sufficiently diversify using only Canadian stocks that pay dividends. Idiosyncratic risk cannot be planned for or modelled, but it can quickly wipe out a portfolio.
Conclusion
As we have seen from the preceding analysis, a Canadian-dividend-focused investment strategy does not necessarily result in superior tax efficiency. We have also seen that the statistical reliability of an all-equity portfolio may be suboptimal for a retiree. Finally, the idiosyncratic risk of a dividend portfolio is a substantial risk that is easily mitigated through proper diversification.