While not all mutual funds or subaccounts held in a 401(k) pay dividends, many do. And the value of dividends should not be underestimated. Dividends are another way to boost the accumulation of shares. Over time, dividend compounding can be quite meaningful. Dividend reinvestment is a way to participate in an effective strategy to help build retirement savings. But many participants in a 401(k) either don’t understand or underestimate the value of dividends or how they impact shares. And with the recent market volatility, now is probably a good time to better understand dividends.
The term dividend is derived from the Latin term that means “thing to be divided.” As you may know, with dividends, companies divide their profits among shareholders. This is not a new phenomenon. In fact, companies have been paying dividends for over four hundred years. In the early 1600s, the Dutch East India Company was the first company on record to ever pay a dividend1. Do dividends matter? You bet! Since 1929, dividends have accounted for over 40 percent of the S&P 500’s total return2.
If a mutual fund pays a dividend, it is normally paid out either monthly or quarterly. Of course, because of the diversification in a mutual fund, dividends paid within a 401(k) investment options are typically the result of the collective dividends received by the stocks held in the portfolio or the result of interest earned on bonds. Within a 401(k), dividends are automatically reinvested so participants who invest in funds that pay dividends automatically build up their retirement accounts through increased shares; something many participants may overlook yet which could be very meaningful over the long-term.
A dividend distribution is paid based on the number of shares held at the time the dividend is declared. In other words, how much you get depends upon how many shares you hold. For example, suppose XYZ fund declares a 0.20 dividend this quarter. This means for every share you own of XYZ fund, you will receive twenty cents. If you own one thousand shares, you would get a $200 dividend. If you own ten thousand shares, you would get a $2,000 dividend. So, clearly, the more shares you have, the more dividends you receive.
Over time, dividends really do make a difference. Keep in mind that even if the price per share fluctuates (or even falls), dividends generally continue to pay. Thus, with dividend-paying funds, there is the potential for return even in down markets. Indeed, over time the dividend reward increases with reinvestment. For instance, if you start with one thousand shares of a fund paying a quarterly dividend of $0.35 per share (1.4%), in thirty years if the dividend stayed the same, you will have a dividend yield of 6.97%. I think you would agree that could provide a very attractive income benefit for retirement. Because as your shares increase with every reinvestment, so does the dividend payment. That is the potential power of dividend compounding over a long period of time.
Dividends Don’t Discriminate
In 2014, Warren Buffett’s Berkshire Hathaway fund indicated it owned four hundred million shares of Coca-Cola stock at a cost of $1.299 billion. Today, each share of Coca-Cola pays $1.56 annual dividends which suggests Berkshire Hathaway would get $624 million in dividend payment from Coca-Cola - which translates as an annual yield of 48%. Imagine that. Buffett acquired shares of Coca-Cola in 1988, and at the time he wrote, “We expect to hold these securities for a long time. In fact, when we own portions of outstanding businesses with outstanding management, our favorite holding period is forever.” Although past performance does not assure future results, Warren Buffett understands the value of dividend compounding. Furthermore, dividends don’t discriminate. If you had purchased Coca-Cola at the same time and reinvested your dividends all these years, your dividend yield would also be 48%.
Of course, all stocks are still subject to market risk. For instance, Coca-Cola shares fell from $29 to $18 during the 2008 financial crisis, although the company did continue to pay rising quarterly dividends throughout the crisis. Actually, you may be surprised to know that even during the 2008 financial crisis, most companies continued to pay dividends. In 2008, 236 out of the 500 companies in the S&P 500 index actually raised their dividends, and in 2009, 151 companies increased their dividends. Only 11 companies in the S&P 500 reduced their dividend during the major economic crises.3 If that comes as a surprise to you, I encourage you pay more attention to dividends. The media would have left investors to believe all companies were forced to halt dividends during the Great Recession of 2008. Certainly, the news did not paint the picture that companies would have been increasing them. If participants focused on dividend trends, they might not be so inclined to panic during market drops. Many flagship large-cap companies have not only paid dividends consistently for many decades but also have consistently increased dividend payouts.
Because the dividend payment is independent of the price, it isn’t the price that matters but the number of shares. As already noted, accumulating more shares translates into greater compounding. Dividends are not guaranteed, but companies who pay them are typically determined to continue paying them because they understand their importance to shareholders. In many cases, such companies not only try to pay steady dividends but also seek to increase the dividend payout. Since it is in the best interests of a company to retain its shareholders, maintaining a steady dividend is a strong focus of many blue-chip companies.
How Dividends Work
Dividends are an important part of investing; therefore, it’s important that investors understand how they work. When a dividend is paid, the stock (or mutual fund) trades on what is called the ex-dividend date. The ex-dividend date often confuses investors because they see their share price drop. Suppose, for instance, you own 1,000 shares of XYZ fund, currently priced at $10.42. Your market value at the end of the day is $10,420, but tomorrow, the fund is trading ex-dividend because it will be paying out a 0.12 quarterly dividend. This means the share price will be adjusted by the distribution, down to $10.30. On the payment date you will see a cash dividend posted to your account in the amount of $120.
In your 401(k), this dividend will automatically reinvest and buy additional shares. A participant will not generally see the cash but rather, in the above example, all else being equal, would have 11.65 shares added to his or her account. By the end of the day, he or she now has 1,011.65 shares priced at $10.30 per share, for a market value of $10,420. But wait, you say, in the end the account value is unchanged! Indeed, it is. But you have more shares. With that said, let’s look out a little longer.
In the next quarter, let’s suppose the dividend is paid again at a rate of 0.12, but this time the participant has 1,011.65 shares (11.65 more shares than last quarter), so the dividend paid for this quarter is $121.40. All things being equal, he or she will get 11.78 additional shares. As this continues, the dividend increases with every quarterly payment because of compounding. As the dividend continues to increase, the number of shares increases, thus compounding the dividends with each dividend payment.
Furthermore, the dividend payout is absorbed through the share price because the price of a stock is presumably equal to the value of the assets of a company divided by the number of shareholders. Of course, there is more that influences share prices, such as management, market sentiment, outlook, innovation, and debt, among other variable factors. However, in many cases it does take between a few days to a few weeks for the stock price to recover from a dividend payout, and it could certainly take longer if the company or market fundamentals deteriorate. In 2011, for example, the market overall was rather lackluster, and on average it took about eight days for Coca-Cola’s share price to recover from the dividend payout. In 2017, the market rallied strong, and it took only about four trading days on average for Coca-Cola’s price to recover from the dividend payout.
The added benefit within a 401(k) are the regular or systematic monthly contributions which increases shares with each deposit. This approach, called Dollar Cost Averaging, is another way to accumulate more shares and that, compounded with dividends, offers the potential to boost account value over the long-term. Too many investors discount the value of dividends, but history has demonstrated they matter, especially over time.
Dividends play an important role in a retirement plan, whether in the form of compounding or eventual income payments. It is important for 401(K) participants to understand how dividends work, why they are important, and how to utilize dividends as a part of a retirement investment and income strategy. If you haven’t provided them with a sound education program, now may be a time to revisit your 401(k) and think differently about your employee education plan.
This information was developed as a general guide to educate plan sponsors, but it is not intended as authoritative guidance or tax or legal advice.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Investing in stock includes numerous specific risks including; the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Investing in mutual funds involves risk, including possible loss of principal.
Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.
Investing involves risk, including loss of principal. No strategy assures success or protects against loss.
Data Sources: 1 The Economist; 2 Ned Davis Research, 3 S&P Dow Jones Indices, A Division of S&P Global