Investors who rely on their investments to maintain their standard of living throughout their retirement years often create “homemade dividends” by periodically selling shares. However, it is often difficult to know how many shares to sell to match future consumption levels, as consumption needs can change. Even with this challenge, dividends are an important factor when considering how to maintain a certain standard of living.

Consumption smoothing is a term used to describe achieving a balance between spending and saving during the different phases of one’s life. When income is significantly decreased in retirement, individuals need to rely on savings more—often by selling investments to fund withdrawals. This can create a concern for retirees.

A survey of nearly 900 Dutch households that owned investment funds or stocks demonstrated this. When asked if participants “worry about depleting your assets,” 44.5% answered not at all and 7.9% answered very much. Conversely, when asked if they “avoid (avoided) selling stocks to fund consumption because I want (wanted) to avoid depleting my assets,” 40.0% said they agreed with the statement.

Dividends help investors avoid selling stocks to fund retirement by providing a stream of income. In addition, dividends act as a way for investors to understand a firm’s future cash flows. A company enters into an implicit contract with investors to maintain or raise that level of dividend payments for the foreseeable future. This reassurance allows investors to spend their dividends without depleting the underlying assets.

Another factor explored in the study is the idea of long-term holding periods. The study found that when adjusted for volatility, firm size, stock price and other variables, turnover is strongly negatively related to the dividend yield. Stocks of companies that have a record of increasing and or paying a dividend are likely to be associated with a lower portfolio turnover ratio when compared with other assets. For individual investors, the consistent payout of dividends helps to avoid the need to sell assets in order to maintain a certain standard of living. Those who utilize dividend-paying stocks are less likely to make trades as frequently as those who do not.

Source: “Why Dividends Matter,” by Paul Schultz; University of Notre Dame, January 2023.

Related

Portfolio Strategies

Strategies for Determining How Much You Can Spend in Retirement

Dispatches

How Retirees Handle Portfolio Allocation, Income and Spending

Retired Investor

Many Retirees Limit Withdrawals to the RMD Amount