The ultimate aim of all this investing business is being able to survive once we stop earning an income. For some, that’s retirement at 65. For others, it’s financial independence at 37. When we stop earning an income, we have to sell some of our investments to replace the income we earned before we reached financial independence.
The 4% rule is a rule-of-thumb to help us determine how many assets we have to sell to maintain our living standard. For example, if you have R1m invested in ETFs, you can sell R40,000 worth of ETFs in a year. The money you have left over will continue to grow above inflation and you won’t run out of money – or so the theory goes. During periods of under-performance or market corrections, however, even selling 4% of your assets could do some damage to your long-term financial health.
Holding on to your assets as long as possible is ideal since you won’t be earning any more income to buy more assets. In a perfect world, you want your assets to cover your living expenses without having to sell any. Income earned from dividends and interest reduces the amount of assets you have to sell to live off your investment.
While ordinary ETFs pay out dividends, dividend-centric smart beta ETFs, listed property ETFs, bond ETFs and our single preference share ETF contend for top honours in the income space. Bonds and preference shares offer a less volatile income option, providing you don’t invest in a total return index tracker, which reinvests income on your behalf. Choosing the best options for your portfolio will require good decision-making on your part.
This week we feature three dividend-centric ETFs. The CoreShares Dividend Aristocrats range uses dividend payments as a filter to determine which companies are worthy. These ETFs look at past dividend payments as a filter. The Satrix Dividend Plus ETF, on the other hand, looks into the future. The ETF is comprised of the 30 companies expected to pay the best dividends in the forthcoming year.
Factors to consider when choosing an income ETF
As you near the end of your investment term, you’ll have to make important decisions about protecting your portfolio against volatility. The easiest way to do this is to reduce your exposure to ordinary shares and diversify into other asset classes. The right mix of ordinary shares, property, bonds and cash will protect your assets while paying you an income.
You also have to consider the tax implications of your income investments. Dividend income on ordinary shares is taxed at a 20% dividend withholding rate, unless the investment is within a tax-free wrapper. Income earned from property ETFs is added to your ordinary income for the year and taxed at your marginal tax rate. Depending on how much money you earn, that can be a great deal higher than 20%. For that reason, some investors prefer buying property ETFs within the tax-free space. If most of your income comes from bonds, you are taxed on the interest. The first R23 800 interest earned every year is tax-free. Interest earned over the exempt amount is charged at your marginal tax rate.
When you are financially independent, less tax means more money in your pocket. Being mindful of the tax implications of your choices can make a significant difference to your living standard.
Tip: Our friend Stealthy Wealth developed a calculator to help you work out which of these options is best for you from a tax perspective.
Dividends as a quality indicator
The CoreShares Dividend Aristocrat range includes two ETFs – one local and one global. While the word “dividend” might make it seem like you can expect great income from these two ETFs, dividend payments actually help the index provider find quality companies. Some ordinary ETFs might have a higher dividend yield.
The CoreShares S&P SA Dividend Aristocrats ETF (DIVTRX) invests in South African listed companies that have paid a dividend seven years in a row. If one of the companies don’t pay a dividend, it gets booted out of the index and has to pay dividends for seven consecutive years before it can get back in. Only including companies that have consistently paid dividends automatically filters out companies that haven’t consistently had profits to share. It also excludes companies that haven’t been listed long enough. Investors end up with 30 stable, mature companies that provide not only income, but stability. The dividends from this ETF won’t blow your hair back, but holding this ETF will help you ease up on the volatility in your portfolio.
The global take on this strategy is the CoreShares S&P Global Dividend Aristocrats ETF (GLODIV). This ETF is comprised of Dividend Aristocrat indices from various regions, all with different entry criteria. If you think the seven-year rule is strict for local companies, consider this: for US-listed companies to be included in the index, they need to show dividend payments for over 25 years! Since US companies take up little over half of this ETF, you end up with a group of established, stable companies capable of withstanding market ups and downs. This ETF is one of only five local ETFs that offer access to emerging economies too. Unlike the Ashburton 1200, however, the companies included need to have a proven dividend history. Once again, stability is the name of the game here.
Dividends that look into the future
Compared to the CoreShares dividend range, the Satrix Dividend Plus ETF (STXDIV) is a real cowboy. This ETF invests in 30 JSE-listed companies that have paid a healthy dividend in the past. The hope is that these companies will continue their dividend streak, thus insuring a high dividend yield in the future. The ETF pays out dividends four times per year, but since companies aren’t required by law to pay dividends every year, a constituent might decide against paying one in the year that you hold this ETF. In other words, this ETF includes companies that aren’t opposed to the idea of paying dividends, since they’ve done so in the past. Whether that’s an investment strategy is up to you.
The tax situation
All income earned from these ETFs are taxed at a flat dividend withholding rate of 20%. The tax is deducted from the dividend before the money hits your account. The only admin required on your end is reinvesting this income. Remember, compounding only works if you don’t spend the money until you absolutely have to.