There are different opinions on whether dividend income is essential for retirement or not. One side presents the case that holding a widely diversified portfolio filled with index funds is the way to success. The other side feels that owning high dividend paying companies is the key to ensuring they will enjoy plentiful cash flow through their silver years. This is not forgetting the fact that some business owners will be able to sell their business to someone else and live on the proceeds of the sale; however, they still must invest the proceeds somewhere and make them last.

Let’s look at investing in the stock market via index funds vs investing in high dividend payers.

Tax-efficient Diversified Investing

For people looking for the highest long-term return and using a structure like a 401(k) plan, then investing for capital gains instead of mainly for dividend income makes sense. Avoiding paying tax or reducing the tax burden later holds the most appeal here.

Groups like “the Bogleheads,” who following the teachings of Jack Bogle of Vanguard fame, consider a widely diversified portfolio of index funds to be the way forward. The benefits of tax-efficiency, some capital gains, and a modest amount of dividend income (usually 2% or lower from equities) get them through. They run Monte Carlo computerized simulations to confirm based on a randomized historical record what the minimum safe withdrawal would have been for a given asset allocation over a fixed number of years and that’s the percentage they take out annually from a portfolio, adjusted yearly for inflation.

Dividend Income Investing

The dividend income route is an investing style where the investor mainly lives off the dividends and does not rely on the sale of part of the portfolio every year to survive in retirement. Instead of planning to sell 2% of the portfolio value annually, a dividend investor lives off their dividends alone.

When a dividend portfolio income reaches 4% per year, the income investor is free to leave the portfolio untouched and simply live off the stream of dividends. They also do not have to worry about sharp market declines because as long as the underlying economics of the companies they’ve invested in remain strong, the dividend income won’t be majorly affected. As discussed regularly on the Dividend Mantra website, even during steep market falls, dividends tend to hold up much better.

Which is Better?

While the tax-efficient nature of index investing in a total market index fund is attractive, the sub 2% income after fees is not. Being forced to sell a stake in the index fund every year to cover living expenses even in a down year – or a 5-10-year period where the market is below the pre-retirement portfolio valuation – leaves diversified low-income investors constantly worrying about selling off shares to live. Will the portfolio run down to zero too soon?

By contrast, when an income investor owns pipelines, real estate investment trusts, utilities, financial companies, and other attractive investments that pay 4% or greater as a dependable diversified income stream, there’s very little to worry about. There’s no forced sale of portfolio assets to pay for the essential expenses of a retiree every year. The income investor can buy and hold, enjoy their livable income and their retirement too.

There are many different approaches to investing. Investors must be self-educated to make the most of their money.