# The Pros And Cons Of Hedging Inflation With Dividends

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by: Doug Carey

It is generally well known that dividend payments from most stocks tend to move up and down with the rate of inflation. Many investors choose dividend stocks just for this reason, and this can be a good strategy for hedging against inflation. Unlike with fixed income, companies can change the dividend payment at any time and we would expect that if nominal revenues are increasing due to inflation, then the dollar dividend payout should increase as well.

But there is a problem with some of the analysis out there when it comes to just how much one can hedge using dividends. It turns out that in a taxable account, if inflation is high enough, investors are very likely going to lose money over time.

Let’s look at an example of a stock that has a dividend yield that is 3% while the inflation rate is running at 2%. The dividends are taxed at 15% each year, all dividend payments are reinvested back into the stock and the investor holds onto this stock for 10 years. For the sake of simplifying the example, we will also assume the stock price doesn’t move during this time. Using my publicly available calculator called Total Returns- Dividends vs. Price Appreciation, along with some calculations in a spreadsheet, I came up with the following outputs below:

 Year Div Payment Dollars Taxes Net Dollars After Taxes Total Return After Taxes Total Return 10 Yrs Cumulative Inflation Real TR Over 10 Years 0 - 10,000 1 300 10,255 45 10,255 2.6% x 2% x 2 308 10,517 46 10,517 2.6% x 4% x 3 315 10,785 47 10,785 2.6% x 6% x 4 324 11,060 49 11,060 2.6% x 8% x 5 332 11,342 50 11,342 2.6% x 10% x 6 340 11,631 51 11,631 2.6% x 13% x 7 349 11,928 52 11,928 2.6% x 15% x 8 358 12,232 54 12,232 2.5% x 17% x 9 367 12,544 55 12,544 2.6% x 20% x 10 376 12,863 56 12,863 2.5% 29% 22% 7%
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Over 10 years, the investor has achieved a total return of 29%. But after taking into account inflation over this time period, his real total cumulative return is only 7% (barely 0.5% per year). In other words, half of the real return expected due to the dividend yield being 1% point higher than inflation is taken by taxes.

The situation becomes much worse as inflation increases. In fact, once inflation hits 6%, the investor will actually lose money over a 10 year time frame in real terms if we assume the dividend yield will always be 1% point higher than the inflation rate.

 Year Div Payment Dollars Taxes Net Dollars After Taxes Total Return After Taxes Total Return 10 Yrs Cumulative Inflation Real TR Over 10 Years 0 - 10,000 1 700 10,595 105 10,595 6.0% x 6% x 2 742 11,225 111 11,225 6.0% x 12% x 3 786 11,893 118 11,893 5.9% x 19% x 4 833 12,601 125 12,601 5.9% x 26% x 5 882 13,351 132 13,351 5.9% x 34% x 6 935 14,145 140 14,145 6.0% x 42% x 7 990 14,987 149 14,987 6.0% x 50% x 8 1,049 15,878 157 15,878 5.9% x 59% x 9 1,111 16,823 167 16,823 5.9% x 69% x 10 1,178 17,824 177 17,824 5.9% 78% 79% -1%
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Why is it that the real return declines as inflation goes up? The reason is that more and more of the gains due to the dividend payment are going to pay taxes. That is the insidious nature of taxes on gains due to inflation. They eat into real returns: the higher the rate of inflation, the more that is lopped off of the real total return.

This is one more reason that gains that are generated every year and taxed every year should be in a tax-deferred account if possible. Holdings that generate mostly capital gains that can be deferred until the stocks are sold should generally be held in a taxable account. I’ve written previously on the topic of choosing between taxable and tax-deferred accounts.

Let’s look at the same example above where this stock is in a tax-deferred account and the rate of inflation is once again 6%.

 Year Div Payment Dollars Taxes Net Dollars After Taxes Total Return After Taxes Total Return 10 Yrs Cumulative Inflation Real TR Over 10 Years 0 - 10,000 1 700 10,700 - 10,700 7.0% x 6% x 2 749 11,449 - 11,449 7.0% x 12% x 3 801 12,250 - 12,250 7.0% x 19% x 4 858 13,108 - 13,108 7.0% x 26% x 5 918 14,026 - 14,026 7.0% x 34% x 6 982 15,007 - 15,007 7.0% x 42% x 7 1,051 16,058 - 16,058 7.0% x 50% x 8 1,124 17,182 - 17,182 7.0% x 59% x 9 1,203 18,385 - 18,385 7.0% x 69% x 10 1,287 19,672 - 19,672 7.0% 97% 79% 18%
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That is much better. The real return is 18% over the 10 year time period. Now I’m sure many people are saying the same thing: I already max out the amount I can put in my tax-deferred accounts and still have dividend paying stocks in my taxable account. What else can be done?

For some, the capital losses that have been experienced in the stock market over the past four years could actually benefit them. There is a strategy that I have used myself whereby I take my stocks with the highest dividend yields and I buy them on the ex-dividend date and sell them the day before the next ex-dividend date. This way I get all of the price increase due to dividends, but in the form of capital gains. Because I sell on the ex-dividend date, I receive no dividends at all. At the end of the year I can offset these capital gains with capital losses I incurred years ago and effectively pay no income tax on my gains. I have used this strategy with Annaly Capital Management (NYSE:NLY), which pays a hefty dividend yield of 15.1% today. Over a 10 year period, the difference in the real compounded return for NLY using this strategy (assuming the dividend yield and inflation rate stay the same) would be 73%.

I don’t recommend trying this strategy with multiple stocks at once. It would end up being a lot of work and the trading fees will add up. But you could use this for a select few individual stocks or a strong dividend paying ETF such as the Dow Jones Select Dividend ETF (NYSEARCA:DVY), which has a dividend yield of 3.5%. For more ideas on how to beat inflation over time, see my previous article on this topic here.

Disclosure: I am long NLY.