FP Answers: How can I maximize dividend income and CPP and OAS?

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In an increasingly complex world, the Financial Post should be the first place you look for answers. Our FP Answers initiative puts readers in the driver’s seat: you submit questions and our reporters find answers not just for you, but for all our readers. Today, we answer a question from Ralph about how to maximize dividend income needed to supplement CPP and OAS.

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By Julie Cazzin with Allan Norman

Q. How can seniors maximize dividend income needed to supplement Canada Pension Plan (CPP) and Old Age Security (OAS) during retirement? — Ralph

FP Answers: Ralph, these are two coincidental questions for me, as I am currently working with someone transitioning from a dividend paying portfolio to a portfolio focusing on capital gains. Why? For two reasons. He wants better control over his income and tax situation, and his dividend income is robbing him of his OAS.

This client is earning about $92,000 a year in dividends on top of his other income. The $92,000 dividend income is reported as $127,000 on his tax return after being grossed up by the required 38 per cent, and it is the grossed-up amount of $127,000 that is used to determine the OAS clawback — not the actual amount received of $92,000. The dividend tax credit isn’t applied until after the OAS clawback threshold is applied. This is one reason for switching to a capital gains or total growth portfolio.

The other thing that has happened is that this client’s annual dividend income has grown over time. In his early retirement he was spending most of his income. But now, at age 82, he is not spending like he used to, but he is receiving taxable quarterly dividends, and he can’t shut them off.

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A portfolio focused on capital gains has many advantages. For instance, it gives you more control over the timing that income is received by allowing you to sell investments only when needed. As well, it may provide a reduction in tax because capital gains are more tax efficient than dividends. It may also reduce the OAS clawback, and may increase after-tax investment return. These are all great things.

Now, I am not knocking dividend investing because there are a lot of successful dividend investors. Dividend investing is a great entry point to learning about investing, and Ralph, there are some simple methods you and other do-it-yourself (DIY) investors can use to build a dividend portfolio. Probably the most familiar method was presented by Michael O’Higgins, in his 1991 book, Dogs of the Dow, which attempts to beat the Dow Jones Industrial Average by buying the 10 highest-paying dividend stocks available from each year. Canadian David Stanley went on to create the Beating the TSX approach, which also aims to invest equal amounts in the 10 highest yielding stocks by dividend yield, and his work is still being carried on at DividendStrategy.ca

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Dividend investing is simply a stock picking strategy. If you are a big believer in dividends, then a dividend strategy may be the right strategy for you because you are likely to stick with it when the going gets tough. Dividend investing is not superior to all other investment strategies and dividends are not freebies and shouldn’t be considered as a substitute for Guaranteed Investment Certificates (GICs). And remember Ralph, just like non-dividend-paying stocks, dividend stocks can also go to zero.

I remember working with a client a few years ago who held shares of a dividend-paying stock with a share price that was slowly falling. During our meetings she would remind me that even though the share price was dropping, she was still getting a dividend. Eventually, the share price went to zero and so did her dividend. So, when you purchase a dividend-paying stock, remember that it was issued by a company and that company faces the same business risks as any other company. There is no guarantee.

Sometimes there is a misconception that dividends are extra or free. The thinking is that, rather than owning a stock that only appreciates in value, why not invest in a dividend-paying stock and get both appreciation, and dividend income?

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Dividends are paid through company profits and companies can use those profits to reinvest back into the company to hopefully grow and increase share value. They can purchase outstanding shares, which may push up share prices, or they may pay a dividend. When a dividend is paid you should expect the share price to drop by roughly the amount of the dividend. This is because the capital value of the company has decreased by the amount of the dividends paid. This is evidenced by a Dimensional Fund Advisors LP study looking at the 10 largest companies in the S&P 500 from Dec. 3, 2018, to Oct. 31, 2023, which found that for every US$1.00 of dividend paid, the share price dropped by US$1.15.

If you accept the evidence that share values drop by roughly the amount of the dividends paid, then what is the difference between taking a dividend or selling a portion of your portfolio and creating your own so-called dividend? On paper there is no difference between the two but the good news is that there are potential tax benefits and higher expected after-tax returns.

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Ralph, if you want to maximize your dividend income to supplement your CPP and OAS, consider instead maximizing your investment growth within your tolerance and sell your investments, on your schedule, to supplement your income. You can do this confidently when you focus on your investments over time and incorporate your spending rates. This will also allow you to enjoy more of what your money can bring you today rather than tomorrow.

Allan Norman, M.Sc., CFP, CIM, provides fee-only certified financial planning services and insurance products through Atlantis Financial Inc. and provides investment advisory services through Aligned Capital Partners Inc., which is regulated by the Canadian Investment Regulatory Organization. He can be reached at alnorman@atlantisfinancial.ca.

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