When investing pays dividends

Investments team
June 2021

For more than a decade now, the shares of many companies around the world have been rising. Some have risen much more than others. Household names, such as Facebook, Amazon, Apple, Netflix and Google - often referred to as the ‘FAANGs’ - have led the way, along with other companies whose products and services are transforming the world.

There has been a lot of focus on the share prices of these companies, in both newspapers and online forums. Many people have wanted to get ‘a slice of the pie’ and the good news is that for those with pension savings and other types of investments, such as a Stocks & Shares ISAs, they will have benefited from rising share prices.

However, investing in stock markets isn’t all about the price of shares – there is another benefit, and that is the dividends paid by companies. Not all companies pay dividends but many do, particularly well-established ones that have been around for a long time. When you buy shares in a company, you become a shareholder, which means that you actually own part of the company. Because of this you are due a share of the profits and this is what the dividend is. Dividends are usually paid four times a year.

UK companies as a whole actually pay some of the highest dividends in the world. Dividends are often expressed as a proportion of the share price – called the dividend yield. So if the share price is £100 and the dividend is £2 then the dividend yield is 2%. Share prices regularly move up and down and so the dividend yield will move too. The yield on the FTSE All Share (which includes all of the UK’s publicly traded companies) has been between around 4% and 4.5% per year over the last few years.

Investors have two choices as to what they can do with their dividends – they can take them immediately or they can choose for them to be used to buy more shares. This process is made easy; if you want to receive the dividends as income then you buy income shares in the first place. If you want the dividends to be reinvested into more shares then you buy accumulation shares.

If you’re in a pension, you will typically be invested in a fund that holds shares, and saving for the long term. For this reason, with many pension funds, dividends are usually accumulated back into your pension. That allows them to build up over time for a potentially greater reward at retirement. There are other types of pensions that can treat dividends differently, and pay them out as income, so it so it’s best to speak to your financial adviser or employer, if you’re not sure.

Why are many pensions invested in “accumulation” shares? As we mentioned, you can build up value from dividends over time. An often underappreciated aspect of investing in stock markets is how beneficial it can be to keep reinvesting your dividends. It’s due to something called compounding – the value that comes from getting returns on returns on returns and so on, year after year. Albert Einstein reputedly referred to compounding as ‘the 8th wonder of the world’.

In investing, one of the easiest ways to appreciate this benefit is to imagine being invested in all the companies that are in a particular stock market index, which is exactly what ‘index tracker’ funds do. Then compare the difference between what you would get if you were to take the dividends (what happens with income shares) and the return if you were to reinvest the dividends (what happens with accumulation shares). The difference is pretty big and gets more so the longer the period of time.

Take, for example, the FTSE All Share index, which has risen by 43% over the past 20 years. With dividends reinvested, the total return from the FTSE All Share index is 186% over the same period - more than four times higher because of the compounding effect of reinvesting dividends.

Over 40 years - about the maximum amount of time over which someone pays into a pension – the MSCI World index (which includes a large number of global companies) has risen by 2690%, but has returned 5912% with dividends reinvested. That’s more than double the amount.

So in an environment where it may be tempting to chase the next ‘big thing’, whether it’s a new tech company or a cryptocurrency, the compounded value of dividends reinvested really is worth remembering.

Pensions are a long-term investment. The retirement benefit(s) you receive from your pension will depend on a number of factors including the value of your plan when you decide to take your benefit(s) which isn’t guaranteed and can go down as well as up. The value of your plan could fall below the amount(s) paid in.

Every care has been taken to ensure that this information is correct and in accordance with our understanding of the law and HM Revenue & Customs practice, which may change. However, independent confirmation should be obtained before acting or refraining from acting in reliance upon the information given.