Why dividend growth is the most important thing if you want long-term income

James Yardley 18/06/2015 in Income investing

Interest rates are at all-time lows and investing for income has never been harder. It wasn’t so long ago that you could achieve 6 or 7% in a cash ISA. Today you’ll be lucky to get 1.5%.

Lower interest rates have forced many income seekers into the stock market. Many fund dividend yields have fallen as a result. Even those with large savings pots are struggling to generate a good income. £200,000 at a 4% yield would only give you an annual income of £8,000 a year.

In the current environment it’s tempting to look for the funds with the highest yields. However, this is often a mistake. Whilst a high yielding fund may provide you with a good income for one or two years, it will often do this at the expense of dividend growth.

The dangers of high yield investing

The highest yielding funds will also hold the highest yielding stocks and this can be dangerous. High yielding stocks can disappoint and are often pricing in future dividend cuts. Already in 2015, Centrica, Tullow Oil, Severn Trent, Sainsbury’s and Morrisons, all top 100 companies, have cut their dividends and it was a similar story with Tesco last year.

Back in 2007, the banks had some of the highest dividend yields, but that yield was a warning of the trouble to come. All those companies were forced to cut their dividends and some disappeared altogether. High yielding funds were forced to cut their payouts, which had a devastating effect on their investors’ income.

Looking for a high standard of living

If you’re looking to generate an income for yourself over the long term it is vital that you look for funds which can grow their distribution over time. It could make a huge difference to your standard of living in 10 or 15 years time.

One manager who has done this very successfully is Thomas Moore, manager of the Elite Rated Standard Life UK Equity Income Unconstrained fund. Thomas believes that dividend growth is the key to providing the best overall returns for investors. A £10,000 investment in Thomas’s fund would have generated £370 of income in 2010 but the dividends have subsequently grown and the same investment would have generated £714 of income in 2014. In five years the fund grew its distribution 93%*. The dividend growth means that the initial investment is now yielding over 7% a year and, if the dividends can continue to grow, this will only increase further.

Back in 2010 there were many other funds which yielded a lot more than 3.7%, but most of these have shown very little if any dividend growth and some have even been forced to cut their payouts. One large well known fund has cut its payout 35% since 2010. After years of cuts the fund was forced to abandon its high yield dividend strategy. A new manager with a more manageable dividend policy has subsequently taken over, but that is scant consolation to investors who have seen a big drop in the income they were relying on. This fund is not alone, many funds now have a lower dividend payout than they did five years ago.

The chart above shows the dividend growth in some Elite Rated funds versus over some other anonymous funds in the IA UK Equity Income Sector.

Other Elite Rated funds in the UK Equity Income sector which consistently grew their dividends every year were Evenlode Income and JOHCM UK Equity Income.

Keeping up with inflation

Dividend growth is also important because it allows your income to keep up with inflation. Fortunately inflation has been very low recently. This means if you can invest in a fund providing meaningful dividend growth your spending power, and therefore standard of living, should increase in the future.

Another great thing about dividend growth is that it will almost always lead to capital growth. All the funds above comfortably outperformed their benchmark over the past five years. So, dividend growth investing is also a great strategy for those seeking capital growth. Rather than taking an income you can re-invest your dividends instead allowing them to compound over time. The benefits of dividend growth investing are clear. I would like to thank Chelsea Financial Services client Jeff Newton who gave me the idea for this blog.

Source: FE Analytics 01/05/15

This article is provided for information only. The views of the author and any people quoted are their own and do not constitute financial advice. The content is not intended to be a personal recommendation to buy or sell any fund or trust, or to adopt a particular investment strategy. However, the knowledge that professional analysts have analysed a fund or trust in depth before assigning them a rating can be a valuable additional filter for anyone looking to make their own decisions.Past performance is not a reliable guide to future returns. Market and exchange-rate movements may cause the value of investments to go down as well as up. Yields will fluctuate and so income from investments is variable and not guaranteed. You may not get back the amount originally invested. Tax treatment depends of your individual circumstances and may be subject to change in the future. If you are unsure about the suitability of any investment you should seek professional advice.Whilst FundCalibre provides product information, guidance and fund research we cannot know which of these products or funds, if any, are suitable for your particular circumstances and must leave that judgement to you. Before you make any investment decision, make sure you’re comfortable and fully understand the risks. Further information can be found on Elite Rated funds by simply clicking on the name highlighted in the article.