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 & Outcomes (Equities)

  INTEREST AND 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

CALCULATION OF TOTAL INCOME DIVIDEND-FOCUSED PORTFOLIO GLOBALLY DIVERSIFIED REBALANCED PORTFOLIO
Investment
  Interest and 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 & Outcomes (60/40)

  INTEREST AND 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 50THPERCENTILE ENDING WEALTH 10THPERCENTILE 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.