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The Cash Flow or Nest Egg Debate

February 14th, 2006 · 4 Comments

With the RRSP season in full swing, Frugal Focus is debating whether to focus on building a large nest egg or the passive income or cash flow that is generated by a portfolio. In retirement, of course, generating enough cash flow to cover living expenses without depleting capital is the preferable strategy.

During the asset accumulation phase, if assets are held in a tax-deferred account like a RRSP, the debate mostly boils down to six of one or half a dozen of the other. However, focussing on cash flow is not a winning strategy for taxable portfolios.

To see why, let us pretend that we are invested in an imaginary company that makes a nice profit selling some widgets. With its after-tax profits, the company has three options: (1) reinvest in its business, (2) pay a dividend or (3) buy back its shares. Ideally, management should choose an option (or a combination of options) that provides the highest rate of return for shareholders.

From a tax perspective, option #2 is the least attractive as the income stream is taxed on an ongoing basis. A superior business that is able to earn high rates of return on its reinvested profits allows true compounding to work its magic and would choose option #1. Option #3 is a tax-efficient way of rewarding shareholders. In taxable accounts, investors should prefer to buy businesses that mostly reward its shareholders through options #1 and #3, which would mean focussing on the size of the nest egg.

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4 responses so far ↓

  • 1 anonymous // Feb 14, 2006 at 8:07 pm

    I like option 2 best.

    Why? Option 1 gives management a chance to waste money. Option 3 is acceptable, but I still prefer option 2.

    Option 2 lets me decide how best to spend that money.

  • 2 Humble Investor // Feb 14, 2006 at 8:37 pm

    Interesting twist CC, and I think your post probes the discussion even further than I dared tread (given my raltively junior blogging tenure).

    While I certainly don’t claim to have all the answers (as I’m openly still studying this myself) I do have a couple thougths though on your example:

    1. In terms of all the types of income, dividend income is presenly the most tax-advantaged (i.e. comparied to employment income, interest income or capital gains). Many have argued, as a result, that one should consider keeping less tax-advantaged invetsments inside an RRSP, and if one does keep a taxable portfolio, from a tax standpoint, this would be the preferable place to keep dividend paying equities. As many have pointed out, when registered savings withdrawls are eventually made, its all at the your marginal rate, without any consideration for how the gains were made while being accumulated.

    2. Many companies do all three (or 2 out of three) – issue a dividend, reinvest in their business and buy back shares (TSX:RUS comes to mind). As to the first two, when the dividend payout ratio is less than 100% (which it sure better be), the balance is in the ‘reinvestment’ bucket.

    3. The other challenge I have with the model you provide is if our sample investor sold shares (to realize some of the value gained by #1 and #3) in order to materially increase the size of his/her nest egg, he/she would be subject to tax on the capital gains. We would need something of a spreadsheet and a few more underlying assumptions filled in in order to truly evaluate tax-related benefits.

    In my mind, I’m comparing the example you provided to one where we invest (taxable portfolio) in a company that issues a dividend, buys back shares and re-invests a portion of growth back into its business. The dividend for this company has increased consistently for at least 10 years.an the investor reinvests dividends year after year, and naturallly has to pay tax, each year along the way. The investor hopes to never sell.

    Each time I run these models in my head, this is about where I need to break out Excel. Like I said, I don’t have all the answers, I’m weighing this considerably, and at present, I’m not convinced of the superiority of one model over the other.

    Thanks for keeping the discussion alive.

  • 3 Canadian Capitalist // Feb 15, 2006 at 7:27 am

    Anon: Good point. I am talking here about superior businesses run by good management, not ones that engage in corporate empire building, acquiring unrelated businesses or even corporate art collections.

    If a company is able to earn 15% on its capital, I want that company to reinvest profits and grow the business and I likely cannot earn a better return elsewhere.

    HI: Personally, I hold all income producing (Canadian dividend stocks, US dividend stocks) investments inside my RRSP. I prefer value stocks that don’t pay a dividend (a small dividend is ok) for my taxable accounts. The reason is I don’t want to be paying even a small tax on an ongoing basis. Untaxed capital gains are like a free loan from Revenue Canada. Note though that when the business outlook is unfavourable it is better to sell a position and pay the tax.

  • 4 Canadian Capitalist » More Reasons to Love Dividends? // May 30, 2006 at 7:30 pm

    [...] While I love dividend-growth investing and follow the strategy in our retirement accounts, I prefer non-dividend payers in our taxable accounts (discussed in an earlier post). The main reason behind the idea is a preference for businesses that can reinvest earnings and earn a better return than is possible on my own. A secondary reason is to avoid losing a portion of dividends to taxes every year. [...]

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