Advisors know that dividends are never guaranteed; a corporation's board can raise or lower the payments at any time.
Still, companies that regularly increase their dividends build up expectations for a continuation of that policy. Consumer products giant Procter & Gamble has increased its dividend for 57 consecutive years; banking automation company Diebold has a 60-year record. And scores of other U.S. corporations have increased payments to their shareholders annually for a decade or more.
Because corporate boards understand the negative investor reaction to changes in a long-term dividend-increase policy, the practice of regularly boosting dividends can have a stabilizing influence on a company's operations. Essentially, dividend growth is a way to keep the people running the show on the straight and narrow.
Think of it this way: If a company's management and board need to keep more cash in reserve because investors are expecting another dividend increase next year, that company may tend to avoid speculative mergers (remember AOL/Time Warner?) and other costly misguided moves.
But there's a difference between regular dividend increases and the awarding of "extra" or "special" dividends -- a practice that does not restrain management. Such payments are ad hoc and appear to reflect the beneficence of the corporation toward its shareholders.
Although many stockholders look on them favorably, extra payments, by their very nature, are not something that an investor can count on. In fact, when it comes to special dividends, ordinary shareholders are often an afterthought.
Consider what happened when people feared that the preferential taxation of dividends would end at the end of 2012. That year, U.S. corporations paid 1,056 extra dividends on domestic common stock issues, according to data compiled by S&P Dow Jones Indices -- representing a 129.6% increase over the number of extra dividends distributed to shareholders in 2011.
Did corporate boards fear that their shareholders would be hit by higher taxes if they didn't distribute extra cash before the year ended? Were these acts of goodwill toward investors? In some cases, certainly. But often it was insider self-interest.
John Mackey, a co-founder and co-CEO of natural foods retailer Whole Foods Market is famous for accepting a salary of only $1 a year. In December 2012, Whole Foods paid shareholders a special dividend of $2 a share. According to SEC filings, Mr. Mackey owned 828,516 shares; that extra dividend gave him a year-end payment of $1,657,032.
The Buckle, a denim-focused retailer for the under-30 set, paid a special dividend of $4.50 a share in December 2012. Daniel J. Hirschfeld, the company's chairman, owns 1.6 million shares or 33.5% of the company. That dividend was worth $72.9 million to him.
Similarly, casino operator Wynn Resorts paid shareholders a special dividend of $7.50 a share that November. CEO Steve Wynn held more than 10 million shares of the company's stock at the time, while his ex-wife, Elaine Wynn, a director, owned 9.7 million shares. Their combined take in extra dividends that year was more than $148 million.
There are many other examples, but you get the point. If those insiders had taken the same payments as bonuses, they would have paid 35% in federal taxes; instead, everyone paid the then-applicable tax rate of 15% on dividend income.
Years ago, when dividends were taxed at ordinary income rates, numerous tax shelter schemes allowed people to reclassify dividend income as capital gains. Now, the lower dividend tax rate allows corporate insiders to pay less on what might appear to be part of their compensation.
As a result, expect to see "special" dividends for years to come.
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