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

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 alltogether. High yielding funds were forced to cut their payouts, which had a devastating effect on their investors' income.

This year, the seven largest companies in the UK stock market are all predicting very little or zero dividend growth. In some cases their dividends are not covered by earnings and companies are having to take on debt to meet the payments. Income investors should be very wary of funds which hold stocks which are at risk of dividend cuts.

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.  

By James Yardley, senior research analyst, Chelsea

*source: FE Analytics 01/05/15

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.
Published on 18/06/2015