Why it’s risky to rely solely on dividend income

Holding dividend-paying defensive stocks in your portfolio is a sound investment strategy. But beware. Dividends may not be as safe as you think. Merryn Somerset Webb explains the risks.

In my editor's letterin this week's issue of MoneyWeek magazine, I wrote that we should keep an eye on the risks involved in holding our favourite dividend-paying defensive stocks.

One of these risks, I said, is the fact that the huge cash piles sitting on these companies' balance sheets must look very attractive to our broke government.

Right now, the government seems most keen to bring down the tax it takes from the corporate sector. But that doesn't mean it won't change its mind, or bring in a tax aimed just at large companies with particularly big cash piles.

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I mentioned the thought to a few people. Most pointed out that it wouldn't matter much.

It might they said even be good for shareholders. It would bump directors into distributing the cash to shareholders, rather than have it taxed. Hello special dividend.

But history suggests that they might be being too complacent.

Governments have frozen dividends in the past

It's easy to shrug off the idea of a special' tax on corporate cash piles as something that companies could get around easily.

But you only need to read John Littlewood's excellent financial history book, The Stock Market, as far as page 40 to realise that a focused government would be well on top of this.

How? Dividend controls. In 1945, the new Labour chancellor, Hugh Dalton, showed something of an antagonism towards dividends: "I do hope that the increase in the net profits of companies will be spent on new and up-to-date plant, and will not go straight into shareholder's pockets. In the national interest, capital development must stand in front of higher dividends."

This isn't quite what happened. Instead, to make up for the lack of dividends during the war, most companies increased dividends. Many announced special bonuses too.

So in 1947, Dalton decided to have a go at discouraging this unpatriotic behavior. He separated the existing tax on profits into two tiers: those not paid out to shareholders were to be taxed at 5%, those paid out at 12.5%. In his next budget still unhappy with the "continuing custom on the part of many companies of declaring increased dividends" - he raised the latter to 25%.

Then in 1948, a White Paper came out. In it, was one sentence that sent "shivers through the stock market," says Littlewood. It went like this: "there is no justification at the present time for any rise in incomes from profits, rents or any like sources."

This reflected the fact that large number of ministers appeared to be convinced that high dividend payouts were somehow contributing to inflation.

Later that year, the rather feeble-sounding Federation of British Industries (now the CBI) capitulated. They proposed a voluntary policy of dividend control at the levels of the time.

The chancellor (by then Sir Stafford Cripps) said he would "gladly accept" the offer. But he made it clear that the policy, while notionally voluntary, could be enforced at anytime.

And that was that. Corporate Britain had lost control of its own cash.

The policy was to last for two-and-a-half years. That sounds bad. But it could easily have been much, much worse. In 1950, a Dividend Control Bill was introduced which was to legally control payments for three years and allow each company to pay out only the average of its previous three-year dividends.

This never happened Clement Attlee called a surprise general election and, after eight budgets, almost all of which deliberately discriminated against shareholders, a Labour majority of five turned into a Conservative majority of 18.

It's not all that long ago that dividend controls were in place

But, much as you might think this would be the end of the story, it was not.

By 1966, Labour was back and a 'voluntary' freeze on dividends was demanded once again. This time, the 'strict watch' on dividends lasted until 1969, at which point shareholders were given a brief respite from government bullying.

Then came 1972, when inflation pushed Ted Heath's government to yet another 'freeze' on dividend payments, something that didn't quite match the promises on which it had been elected ("have you taken leave of your senses?" asked Enoch Powell).

If you want to know more detail on all this you can find it here from page 8 onwards. But one thing to note is that controls were not entirely abolished until 1979. Which is not really very long ago.

Littlewood has a lesson to offer from all this: sell all your shares as soon as there is any announcement of dividend limitation or control.

Why? Because they tend to last a long time. And if they "last for a number of years, equities assume the character of a fixed-interest investment but without any guarantees." In other words, all the downsides of a bond with none of the benefits.

Conversely, you should buy as soon as you expect controls to end. "Companies like to restore long-term dividend trends, and are more likely to regard the effect of controls as a postponement of increases to a later date, rather than a forfeit."

I suspect you think this is advice you will never need. But I wouldn't be too quick to say 'never' at the moment. The well-off aren't popular, and the government is broke. That's a dangerous combination.

I'd also note that dividend payouts in the UK rose by 18% in the second quarter (the highest rise on record). This hasn't gone unnoted. I wonder just how many government ministers raised an eyebrow at The Times headline of Monday 23 July. "Who cares about recession?" it said. "It's the City's Great Giveaway."

I'm not really suggesting that anyone sells their high dividend-paying stocks (yet). But you might want to take a tiny precaution and think about diversifying your sources of yield, if you are very dependent on rising dividend payments.

Our cover story in the magazine last week suggested several great options. And in this week's magazine I suggest another in my letter.(If you're not already a subscriber, subscribe to MoneyWeek magazine.)

P.S. One more warning from the behaviour of Sir Stafford. In his budget of April 1948, Cripps introduced a one-off tax (effectively a wealth tax) on all investment income 10% on the first £500 and 50% on anything over £5,000.

One-off taxes are supposed to be more palatable than regular taxes. Those in doubt that this kind of thing might ever happen again, might like to remember that the 50% top rate of income tax that we still suffer today was sold, if not as a one off, at least as "temporary".

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.