Dividends are great for investors. They augur well for earnings growth, provide a degree of security in uncertain times, are likely to comprise a relatively high proportion of returns going forward and provide a relatively stable source of income. Including reinvested dividends, the Australian share market has surpassed its 2007 record high. It’s important that dividend imputation is not weakened in Australia to ensure dividends are not taxed twice.

Prior to the 1960s most share investors were long-term investors who bought stocks for their dividend income. Investors then started to focus more on capital growth as bond yields rose relative to dividend yields on the back of rising inflation. However, thanks to an increased focus on investment income as baby boomers retire, interest in dividends has returned. This is a good thing because dividends are good for investors in more ways than just the income they provide.

Australian companies pay out a high proportion of earnings as dividends. This is currently around 65% compared to around 45% for global shares. However, some argue that dividends don’t matter – as investors should be indifferent as to whether a company pays a dividend or retains earnings that are reinvested to drive growth. Or worse still, some argue that high dividend pay outs are a sign of poor long-term growth prospects, that they are distraction from business investment or that they are often not sustainable.  And of course, some just see dividends as boring relative to speculating on moves in share values. My assessment is far more favourable.

Seven reasons why dividends are cool

First, dividends do matter in terms of returns from shares. For the US share market, it has been found that higher dividend payouts lead to higher earnings growth. This is illustrated in the next chart, which shows that for the period since 1946 when US companies paid out a high proportion of earnings as dividends (the horizontal axis) this has tended to be associated with higher growth in profits (after inflation) over the subsequent 10 years (vertical axis). And higher profit growth drives higher returns from shares. So dividends do matter and the higher the better (within reason). There are several reasons why this is the case: when companies retain a high proportion of earnings there is a tendency for poor hubris driven investments; high dividend payouts are indicative of corporate confidence about future earnings; and high payouts indicate earnings are real.

Source: Global Financial Data, Thomson Reuters, AMP Capital

Second, dividends provide a stable contribution to the total return from shares, compared to the year-to-year volatility in capital gains. Of the 11.7% pa total return from Australian shares since 1900, just over half has been from dividends.

Source: Global Financial Data, AMP Capital Investors

Third, the flow of dividend income from a well-diversified pool of companies is relatively smooth. As can be seen below, dividends move in line with earnings but are smoother.

Source: Thomson Reuters, RBA, AMP Capital

Companies like to manage dividend expectations smoothly. They rarely raise the level of dividends if they think it will be unsustainable. Sure, some companies do cut their dividends at times, but the key is to have a well-diversified portfolio of sustainable and decent dividend paying shares.

Fourth, investor demand for stocks paying decent dividends will be supported as the ranks of retirees swell.

Fifth, with the scope for capital growth from shares diminished thanks to relatively high price to earnings ratios compared to say 40 years ago, dividends will comprise a much higher proportion of total equity returns. More than half of the total medium-term return from Australian shares is likely to come from dividends, once allowance is made for franking credits.

Sixth, dividends provide good income. Grossed up for franking credits the annual income flow from dividends on Australian shares is around 5.7%. That’s $5700 a year on a $100,000 investment in shares compared to $2150 a year in term deposits (assuming a term deposit rate of 2.15%).

Source: Bloomberg, RBA, AMP Capital

Finally, while Australian shares are still 10% below their 2007 high, once reinvested dividends are allowed for (ie looking at the ASX 200 accumulation index) the market is well above it.

Source: Bloomberg, AMP Capital

Another way to look at dividend income

How powerful investing for dividend income can be relative to investing for income from interest is illustrated in the next chart. It compares initial $100,000 investments in Australian shares and one-year term deposits in December 1979.

Source: RBA, Bloomberg, AMP Capital

The term deposit would still be worth $100,000 (red line) and last year would have paid $2,200 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1,111,435 as at December last year (blue line) and would have paid $47,792 in dividends last year (blue bars). Or around $62,240 if franking credits are allowed for. Over time an investment in shares can rise but a term deposit is fixed.

But don’t dividends crimp capex?

 

This issue has been wheeled out repeatedly since the GFC. But it’s ridiculous. First the rise in dividends this decade has mainly come from cashed up miners and it’s hard to argue they should invest more after the mining investment boom. Second the dividend payout ratio is not high historically. Third the reasons for poor business investment lie in: business sector caution after the GFC & the rise in the $A above parity, which squeezed competitiveness; the fall back to more normal levels in mining investment; and the shift to a capital lite economy based around IT and services. Don’t blame dividends for poor capex.  

Source: Thomson Reuters, RBA, AMP Capital

Why dividend imputation is so important

Dividend imputation was introduced in the 1980s and allows Australians to claim a credit against their tax liability for tax already paid on their dividends in the hands of companies as profits and boosts the effective dividend yield on Australian shares by around 1.3 percentage points. However, over the years it has been subject to claims that it creates a bias to invest in domestic equities, that it biases companies to pay dividends and not invest and that it benefits the rich.  This is all nonsensical as dividend imputation simply corrects a bias by removing the double taxation of company earnings – once in the hands of companies and again in the hands of investors. The removal of dividend imputation would not only reintroduce a bias against equities but would also substantially cut into the retirement savings and income of Australians, discourage savings and lead to lower returns from Australian shares.

Labor’s proposal to make franking credits in excess of a taxpayer’s tax liability non-refundable could be argued to remove an anomaly in the tax system as dividend imputation was designed to prevent the double taxation of dividends, not to stop them being taxed at all. But a problem is that many Australians have planned their retirement around receiving such refunds. This is a subject for another note. But it is worth noting that Labor’s proposal does not affect at least 92% of taxpayers who will continue receiving franking credits as they have a sufficient income tax liability (as will pensioners who will be exempted). If it sets off a broader wind back of franking credits, then it would be a bigger concern.

Concluding comments

Dividends provide a great contribution to returns, a degree of protection during bear markets and a great income flow.

For investors needing income the trick is to have a well-diversified portfolio of companies paying high sustainable dividends.

 

 

 

 

 



Comments

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Peter Ashley Schaeffer

Will unused franking credits accumulate in SMSF the same way as they do in companies, and can be used at some future date against a tax liability. Peter

Brian Harry Meynell

Shane. Are AMP shares a "good bet" as a recovery stock?(given how far they have fallen since the Banking Royal Commission)

Lyn Wells

I think pensioners and part pensioners(Aged) will be punished Shane. Bowen succumbed to pressure to exempt these people up to a date set last year. Anyone going on to a pension or part Aged pension will NOT be exempt from the loss of franking credits. How unfair is that?

Lyn Wells

I can’t follow the popular slogan that the loss of return of franking credits only affects 8% of people?? Surely it affects everyone with super with Aussie shares. Basically less money returned to the fund from the ATO regardless of what income it can be offset against. It will still mean lower returns for all .

Michael Ryan

Dividends certainly can be great and can be useful where management might reinvest at a lower return on capital. However it needs to be mentioned that dividends should not be equated to other types of income like interest or rent - dividends reduce your capital investment given the drop in share price immediately following the ex-div date. Essentially dividends don't actually contribute anything to your total return as they give rise to an equal drop in capital value. The caveat to this is the franking credits on top which are typically not completely priced into share prices. You must rely on market factors for the share price to subsequently recover - it isn't guaranteed. So using evidence of how much dividends make up your total return and using that to justify their importance are all flawed points (if dividends were not paid, effectively your total return would be the same but be completely made up of capital growth). I believe most investors fail to understand this and are hence creating sub-optimal portfolios for retirement based purely around maximising dividends rather than maximising return for a given level of risk. Media, finance professionals and even fund managers seem to also misrepresent dividends on these points which doesn't help the general public at all. Dividend imputation is very important and there isn't any talk about a return to double taxation. Many investors will be unhappy about losing the refund of franking credits of course but the reality is that its a policy that needed to be changed at some point due to the rising cost to the taxpayer and the fact it can only get worse with an ageing population and a need for large infrastructure investments for our growing population. The principle people ignore is that if a company earns a profit then it should pay tax on that profit. If we are to have a fair tax system than those profits should remain taxed at the minimum relevant company tax rate, not 0%. People will argue an opposing principle is that the company profit should be taxed at whatever the ultimate shareholder's tax rate is - I agree with this, but any earned income should still have tax collected on it - it shouldn't go tax-free. I understand that virtually all other developed nations follow this principle.

Peter Meehan

What doesn't seem to get mentioned in the scrapping of the rebate of excess tax paid (cash franking credit refund) in the franking credits debate is that a taxpayer (i.e.shareholder) who is denied a refund is denied the benefit of the $18,000 tax free threshold that every other taxpayer enjoys. Imagine the outcry if an employee who had excess tax deducted throughout the year was denied a refund for overpaid tax. Same principle.

Alex Jones

@Micheal Ryan " People will argue an opposing principle is that the company profit should be taxed at whatever the ultimate shareholder's tax rate is - I agree with this, but any earned income should still have tax collected on it - it shouldn't go tax-free." So, surely you should actually be arguing for the lifting of Superannuation tax rates in pension mode from the now 0% on assets up to $1.6m. The entire point of the recommendations from inquires around dividend taxation in the 80s and 90s was to tax corporate dividends as if it was income earned from any other source, like wages. We have a very progressive tax system, what could be fairer than that? The dividend imputations system is not really to blame for refunds, if everyone's marginal tax rate was 30% or over there would be no refunds, perhaps something Labor would eventually like, it simply reconciles corporate profits with a business owner's tax rate. In fact it is not the point of the system to ensure that 'at least some tax is paid', it's to make sure it is paid at the correct rate of the ultimate beneficiary of the income. Once again, don't like big refunds to Super funds, ask Labor to campaign for a new 10% tax on pension mode, reckon they will go for it? Of course not, they want to win and people actually understand percentage tax rates going up or down. Finally, because other countries don't have a system which reconciles tax rates correctly to the ultimate beneficiary of the income, that suggests we should walk back our system? What nonsense.

Brian Polkinghorne

Perhaps Michael Ryan would like tp explain why it is proposed by the shadow treasurer Bowen that some people retain their imputed credits and others don't according to which super fund they have used for their retirement. I would point our that imputed credits are not a cost to the tax payer, they are the profits of companies of which the investor owns a small part. Brian Polkinghorne

Michael Ryan

@ Alex Jones I was referring to any earned income by a company or business should have tax levied on it, not on any earned income whatsoever in any entity. I think there definitely will need to be a return to tax on pensions at some stage given the growth of the superannuation sector and the ageing population. Again it's just not something Australia will be able to continue to afford unless there are other tax revenues made elsewhere. I know to date the system has been set up to ensure the dividends are effectively taxed at the end shareholder's marginal tax rate, but I'm suggesting that the system is not necessarily wrong but is unaffordable. I raised that it remains unique in OECD countries to make the point it is not necessarily a core or structural part of a first-world tax system and therefore by getting rid of the refundable credits we aren't being all that radical, in fact the opposite. Looks, its crap people are gonna miss out on benefits they are receiving, but tax reform through policies like this I think are necessary to implement sooner rather than later to ensure Australia can continue to maintain social infrastructure or provide tax relief where it's really needed. Some people are always going to be worse off when it comes to tax policy changes, as the status quo can't be maintained with changing economic and social conditions. I'm looking beyond the short term pain of the few to the long term benefits for the many - I imagine an unpopular opinion on a forum such as this, but is my opinion nonetheless and I write this in the hope of at least helping some people see this in a different light. @ Brian Polkinghorne Yes as the policy stands, some retail and industry funds may in fact still allow pension accounts to have the full benefit of franking passed to them and I agree it doesn't seem fair that others including SMSF's would miss out. I am not cynical enough to say that it was deliberate on Labor to have that effect but more of a quirk of the system where those large funds pool benefits and tax outcomes together. Ideally, the legislation would include something to stop that from happening, but that might not be possible, I'm not an expert. To your other point, I would say while profits can go to the shareholders, and the company is ultimately owned by shareholders, the profit is still earned by the company not the shareholder and therefore tax should be levied on that profit at the appropriate tax rate, even if that profit is paid out as a dividend.

Bill Edlinger

@ Michael Ryan I have heard this type of response from the Labor party spin doctors; shameful misrepresentation of the facts when cherry picking outcomes to suit your narrative. Mr Oliver," But don’t dividends crimp capex?" Agree with your comments, but you left out that it is the management decisions by the CEO that crimp/destroy capex, not dividends. Cue, NAB, BHP, etc. etc. We need a new chart rating the CEO's ; not holding my breath.

Shane Oliver

Hi Peter. I would assume that would be the case..but would need to see what a new ALP Gov says if they win. Regards Shane

Shane Oliver

Hi Brian. Sorry I can’t comment on the AMP share price. Regards Shane

Shane Oliver

Hi Lyn. In terms of the 8% ...I am not a tax expert but for most taxpayers their franking credits would be well below their taxable income so for a fund with a lot of accumulators franking credits will still be received in full as now. Regards Shane

Shane Oliver

Hi Michael. Thanks for your comment. Regards Shane

Shane Oliver

Hi Bill. Thanks for your comments but actually I did refer to that in the first point regarding dividends in relation to “poor hubris driven investments”. Regards Shane