Robin Powell
This article is important to pensions though it’s aimed at people with portfolios of directly held shares.
Pension funds of course don’t pay a dividend, they pay a pension which is an encashment of the fund.
But people base their drawdown on the income they can get from equities and bonds and that’s where the 4 or 5% rule comes from. Of course the intention to take a rising income that this low level of withdrawal allows for isn’t always followed. Indeed the way people buy annuities suggests that most people think the income they get in retirement is level and has no inflation protection.
The adviser who was there at outset may not be there in years to come and there’s no incentive on adviser or provider to see your income increase. This is not a bad thing if you want to build up capital in your “pot” but it is not the way that pensions work.
The guided retirement funds will pay an increasing income and so will collective pensions (aka CDC).
So I conclude by extending Robin Powell’s post to explain that thinking of pensions as what can be afforded by drawing the dividend income and the bond payment is an admission that the capital need always be there. A much better way for most people to think of pensions is of a retirement wage paid as long as you or your spouse (if you have gone) are alive.
Whether the assets to meet payments come from capital growth or dividends/coupons is of no interest to the pensioner, what matters is that an income is paid for life.
As an undergraduate in the early 1970s I struggled to accept the dividend irrelevance proposition, created by Franco Modigliani and Merton Miller in 1961. This stated that a company’s payout policy did not affect its stock price or overall value.
According to M&M, in a perfect market [that almost ever-present academic trope], a cash dividend reduces the stock price by the exact payout amount, leaving total shareholder wealth unchanged.
Robin’s post (The Times article on which it’s based is behind a paywall) successfully dismantles the “income is separate from capital” fallacy, but I would argue it does not disprove the case for genuinely skilled dividend-growth investment managers.
For a pension fund, as opposed to a UK resident individual, the better position is neither “dividends are special” nor “dividends are irrelevant”.
Dividends are merely one component of total returns. The ability to generate, sustain and grow dividends may, however, be a useful indicator of business quality and business management’s capital-allocation discipline.
Prudent trustees, I would suggest, can retain a preference for investments capable of growing their income streams (dividends or rents) if their investment managers can demonstrate that the strategy delivers more than cash yield.
Performance monitoring should focus among other things on evidence of the investment managers’ skills in accessing durable free-cash-flow growth, conservative balance sheets, sensible valuations, and diversified (but not over-diversified) exposures, which can deliver competitive “risk-adjusted” total returns, after fees.
Thanks for this contribution Derek!
As a pension scheme we greatly appreciated your introduction to Decomposition Analysis where the yield from an investment is broken down into Current Yield (e.g. distributable profits), Growth in the current yield, and Revaluation Yield (anything else). We found this particularly helpful when considering the comparisons between market quoted and private market investments as in the latter typically only a Revaluation Yield is projected.
Also for pension scheme funding – dividend yields no longer seem to be the basis for evaluation of growth assets as was often the case before 2004. This may be one of the reasons for the decline in UK equity holdings by UK pension schemes.
Robin replied thus over on LinkedIn:
“Fair point, Derek. I should have been clearer who I was writing for. Outside a wrapper the tax point bites; for a tax-exempt fund it doesn’t arise at all.
“The trustee question is a different one, ie whether an income screen changes what you own.”
To which I added this rejoinder:
The trustee question depends on whether or not the scheme is immature in DB or DC terms, in which accumulation may be more justifiable.
But as DB matures it’s necessary to seek more distributions (or realisations) to fund pensions in payment.
In a DC world it depends whether the journey plans drawdown or annuitisation at maturity. Income can still play a significant part in drawdown, allowing the capital to continue with some accumulation.
Asset managers do not like dividends or interest payments because they reduce administration charges almost universally based on value of assets under management.
Even in a single issue gilt distribution fund held to provide a non tax paying pension fund the cash flow to pay benefits, the coupon interest payment from the Government is first rolled up into the unit price and then the subsequent matching payment to the pension fund is treated as a sale of units disinvestment and subject to administration or transaction charges. The unit price is therefore decoupled to some extent from the market price of the underlying gilt and may be influenced by cash buffers held in the fund.
A pension fund and some SIPPs do have the option to hold Gilts directly and avoid these distortions as well not requiring an intervening custodian. However these rarely figure on the shelves of the investment consultant retailer and CIO costs replace the fund manager’s charges.