Businesses exist to make money for their owners. So why is it such big news that Apple, the most valuable company in the world at the moment, has announced plans to resume paying dividends – and how could Apple get away with not paying dividends for the previous 15 years?
The short answer is that corporate managers and shareholders alike have disdained dividends for the past quarter-century. There were a lot of economic and tax reasons for this, but the bottom line is that everyone became fixated on stock prices. Senior executives were paid to get the price as high as possible. If they failed, shareholders suffered. If they succeeded just long enough to convert their incentive packages into shares or cash, shareholders suffered. If the stock rose and fell with the market tides, shareholders suffered, since the market indexes still have not recaptured the highs they set more than a decade ago.
The only shareholders who did not suffer were those who sold their shares when the prices were high. Investing for long-term capital growth is fine, and often wise, but it is misses the original purpose for which most businesses are started. The idea is, or at least used to be, to generate a steady stream of income for owners, not to force them to hold their shares for an indefinite period and then sell in order to reap the accumulated benefits of a company’s success.
My colleagues and I have taught clients to focus on total expected return – dividend income plus capital growth – because this is what matters most, especially in a world where dividends are a second-tier consideration for corporate managers. This is still good advice, but retirement planning would be a lot easier if companies would share more of their profits with their owners. A larger and steadier cash flow from investments would help everyone stop obsessing about short-term stock price movements, which are irrelevant for long-term financial planning.
There are signs that the pendulum is finally swinging back. Apple’s dividend, which will tap into a portion of the $100 billion in cash the company has accumulated, is one such sign. Apple joins a growing list of technology companies, also including Microsoft and Cisco, that have instituted dividends despite the stereotype that tech companies should plow their cash into the business in search of ever-higher share prices. That cash was, in reality, mainly piling up in corporate treasuries, where it was a target for regulators and other litigants and a temptation to engage in loosely budgeted acquisitions and business initiatives.
Apple’s dividend works out to an annual rate of about 1.8 per cent, based on its recent share price. That’s below the average for dividend-paying S&P 500 companies, which is around 2.5 per cent. (The overall S&P average, including companies that pay no dividends, is a bit over 2 per cent.) Back in the 1980s and 1990s, such yields would have been disregarded by investors, who could have earned more simply by parking their cash in money market funds. Today, however, corporate stocks have become one of the few places an investor can receive a fair current rate of return without taking on undue risk. Money market funds pay almost nothing at all, and are virtually guaranteed losers after taxes and inflation.
Recent dividend boosts in the financial sector are pushing the S&P 500 dividend yield closer to 3 per cent. Many stocks in the index, such as Pfizer and Waste Management Inc., already pay more than 4 per cent. Overall, about four-fifths of the S&P 500 companies pay dividends right now.
Returning excess cash to shareholders is one reason companies are instituting or boosting dividends. Another is the current U.S. tax law, in which most dividends from public companies are taxed at the long-term capital gains rate of 15 per cent. Though this still represents a double tax when added to the corporate income tax, it at least makes paying dividends a reasonable option. If the Bush-era tax legislation expires at the end of 2012 as scheduled, dividends paid to higher-income individuals will be taxed at more than 43 per cent at the federal level (thanks to a newly expanded Medicare tax), and at more than 50 per cent overall for shareholders who reside in some states. At those levels, shareholders will not want companies to pay dividends, and the payout trend may be nipped in the bud.
That would be a wasted opportunity for our ageing society. One of the biggest financial perils we face is the cost of providing for increasing numbers of elderly people, who will live for many years after they stop bringing home a paycheck. Many private pension plans are under-funded; public pension plans are typically in even worse shape; and Social Security holds nothing at all except IOUs issued by the U.S. Treasury, which is already $15 trillion in debt. This vast federal debt puts intense pressure on central bankers to keep interest rates as low as possible for as long as possible – so savers cannot get a fair return on their capital from banks or government borrowers.
Corporate dividends could step into the breach. If future retirees hold substantial and well-diversified portfolios of dividend-paying stocks, they will be in a better position to ride out market downturns without panicking or having to liquidate shares at fire-sale prices in order to meet living expenses. While holding retirement accounts in stocks sounds risky to a lot of people (and it is risky unless those accounts are diversified), it is actually a lot safer than betting on bank CDs or government bonds to provide a reasonable income stream and some defence against inflation.
Former President George W. Bush was on the right track when he suggested keeping the current Social Security structure for Americans near or past retirement age, while allowing younger workers to accumulate shares in what his critics called “privatized” accounts. Governments at all levels will eventually have to renege on their unfunded promises, and the best way to prepare for that is to give citizens the opportunity and the means to provide for themselves.
A wise tax policy would allow corporations to deduct dividend payments for income tax purposes, just as they now deduct interest. The government would not lose much money, if any, since individual dividend recipients would pay tax on what they received, and there would no longer be reason to offer dividends a preferential tax rate. Companies also would have no reason to favour debt over equity as a source of capital; this would reduce corporate exposure to bankruptcy during business downturns. Any reduction in government revenues would ultimately be offset by a reduction in the need to fund future benefits to retirees.
A return to higher dividends would also restore a healthier balance between the corporate goals of producing long-term growth along with current income for company owners. Stock prices will always matter, but people will be less obsessed with the day-to-day fluctuations in their portfolios if they know that their companies will continue to earn profits and distribute cash. This should reduce stock price volatility, which would be a welcome relief after the wild swings of the 21st century so far.
When I was much younger, a client who was a senior corporate executive remarked to me that you can always substitute capital for labour. That simple lesson has stuck with me. As we age, we lose our ability to generate income from our labour, but a lifetime of thrift can compensate by giving us capital to substitute. A wise society will take advantage of this, encouraging its citizens to save and invest for their own futures and to pass capital to their heirs. It’s the best way to create an income stream that can support us through ever-lengthening life spans.