Could you live off dividends for the rest of your life?

The first question to ask is how much income can come from dividends. Once you have this figure, you can then calculate how large your stock portfolio should be to generate such dividends. The dividend yield metric can help you calculate this. Dividend yield is dividend per share divided by current price per share. Hence, if you have a portfolio of ₹1 crore, a dividend yield of 2% means you should expect to receive income from dividends of ₹2 lakh per annum. If this is your expected income, then you need a portfolio of ₹1 crore.

Note that companies only pay a part of their earnings in dividends and hence you also get returns from price appreciation of your shares, even in a dividend-oriented portfolio. The second question to answer is how to construct a high dividend yield portfolio. One simple option could be to replicate the Nifty Dividend Opportunities 50 Index. This index has 50 stocks selected on the basis of dividend yield from amongst the 300 largest companies which have reported a net profit in their latest results. The index is rebalanced once a year.

As per the latest fact sheet of this index (December 2021), the Nifty Dividend Opportunities Index has a dividend yield of 3.17%. It has also delivered a price return of 12.06% over the past 5 years. To put it simply, the index gave you a part of your returns as income in the form of dividend and another (much larger part) as capital gains in the form of price appreciation. Did it underperform the broader Nifty? To an extent, yes. The Nifty 50 delivered a total return (including price and dividends reinvested) of 17.67% over the same 5 years. High dividend companies tend to be mature and slow-growing businesses and then can lag behind fast-growing young companies that are reinvesting the cash they generate into the business.

However, an investor looking for income may not find a 3% dividend yield sufficiently attractive. Bank fixed deposit rates are close to 5% at present. Note that Bank FDs are very different from dividends in both risk and reward, but they offer an alternative income stream for retirees.

Anish Teli, founder, QED Capital, looked at an equally-weighted portfolio of the top 25 companies in the Nifty Dividend Opportunities 50 Index ranked by dividend yield since 2016. Such a portfolio had an average dividend yield of 4.75% over the next 5 years. This portfolio delivered a CAGR (compound annual growth rate) of 12% over the next 5 years. Adding up dividend yield, the portfolio return of 16.75% also lagged the Nifty 50 return of 17.67% but not by a very large margin.

For the Nifty Dividend Opportunities 50, when stock prices tanked during the onset of covid-19 in India, the absolute amount of dividend paid out did fall by around 30%. However, for an equally weighted portfolio of the top 25 dividend payers in this index, the dividend payout actually rose. According to Teli, companies that are committed to dividend payments such as utilities, PSUs (public sector undertaking) or mature companies that do not have opportunities to deploy cash do not easily cut dividend payments, even in times of distress.

There are certain caveats to dividend investing. The past five years have been exceptionally good for equities in general, including dividend yield stocks. However, dividends may not hold up well in a prolonged bear market. A 100% dividend yield strategy is thus highly risky. It must ideally be paired with a debt allocation that can provide income at times when dividends are reduced or not declared at all.

A dividend yield strategy is also tax inefficient. Equity dividends which were earlier tax-free, were made taxable above ₹10 lakh per annum in the 2016 budget. The 2018 budget made them taxable at slab rate and imposed a TDS (tax deducted at source) of 10% on them. When the same income is obtained by selling stocks instead of relying on dividends, the tax outgo comes down to 10% long term capital gains tax above ₹1 lakh on stocks or mutual funds sold after a 1 year holding period. Also, a more tax efficient method to adopt the dividend yield strategy is to invest in dividend yield funds. These mutual funds invest in companies with high dividend yields and the dividends are tax-free in the hands of the fund.

However, do not choose the dividend option of such funds (now called Income distribution cum Capital withdrawal) since mutual dividends are also taxable at slab rate. If you choose the ‘growth’ option of such funds, you end up paying the favourable 10% LTCG (long-term capital gains) when you sell units in the fund after 1 year.

Selling units worth a fixed amount every year can replicate the cash-flows you would get from dividends and bring more flexibility and certainty to getting the cash flows. Dividend yield funds have delivered a return of 17.07% CAGR over the past 5 years (as of 14 January 2021), slightly below the Nifty return of 18.10% over the same period.