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How Dividends Can Help Toward Your College-Savings Goals

Josh Peters, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He's the editor of Morningstar DividendInvestor and also our director of equity-income strategy. A new addition to his family got him thinking about the future of investment returns, and we're here to get his thoughts on that.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Josh, first off, congratulations on your fourth child.

Peters: Yes, thank you. It was back on April 30, a new little baby girl named Abigail Grace, very healthy at 6 1/2 pounds. She's been a really good sleeper compared with the experiences I remember with our older three kids when they were newborns. So, it's been a wonderful addition. But with that, I'm pretty sure we're done. Four should probably be enough.

Glaser: But that did get you thinking a little bit about potentially college costs. You calculated that could cost $1 million to send the four kids through four years of college. How do you think about actually how much money you really need to save to get to that $1 million figure.

Peters: Well, $1 million is an incredibly daunting figure, and that may be too conservative actually or too low. I took just a $30,000 a year, all-in cost per year, which is what some of the public universities here in Illinois are charging. Multiply that by four kids by four years, throw in a 5% inflation rate, which frankly sounds too low, and I did come up with about $1.15 million. But how do investment returns shrink that liability for me out there in the future, and I just did a little more back-of-the-envelope math and figured that, if the market could return 10% a year between now and the time Abby, the youngest, is at her final year of college, then the present value of that liability falls to about $200,000 a year. It's still a tremendous amount of money, but much more manageable to contemplate.

If the markets only returned 5% a year, over these next 20-some years that I'm looking at for planning purposes, then the present value of all these tuition bills and everything else is closer to $500,000. So, there's a huge swing there in the effective cost--meaning how much we're all going to have to save here at my house--depending on how the markets do over this extended period of time.

Glaser: But given that it's such a huge gap, how do you think about if market returns are going to be more in that 10% range or more in the 5% or less range, how do you make that kind of call?

Peters: I'm not terribly optimistic when it comes to the longer-run outlook, which I think it's good to perhaps be conservative, even a little bit skeptical when you're thinking about how fast the economy will grow and how that will translate into investment returns. But we're starting from a period where valuations are, I think, in the fair to perhaps full range. I think valuations are being supported in part by very low interest rates. In turn, the low interest rates means that it's very difficult to try to get adequate returns from long-term bonds, let alone cash or short-term bonds. 

But if interest rates go up in the future, then stock valuations may suffer somewhat, especially for some of the areas that I otherwise like in the market, like utilities and REITs, where these are good businesses for a lot of income investors to own. But, by and large, they're pretty expensive in the low-interest-rate environment. Although I'd like to think that the market can go on to do 10% a year, which you kind of think 9% to 10% is a generic long-run average for stocks, that seems to me like an optimistic appraisal. I'd really like it do that well. Perhaps a lower figure is a better planning assumption, in which case we need to save more.

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Glaser: How do you think about dividends and how they play into that return?

Peters: Here's one thing that I find really valuable, and that is that dividend-paying stocks--in addition to providing more reliable returns because a large portion of that return isn't speculative, it doesn't depend on the market price, it's just cash that's flowing into the account, and providing me with the opportunity to reinvest--dividend-paying stocks, higher-yielding stocks also have a history of outperforming the broad market over long periods of time, not any given day or week or even year, but just in our own experience. The DividendInvestor model portfolios have returned more than 2 percentage points annually better than the S&P 500 over the last nine-plus years. The portfolios did that without trying by the way and never made it an explicit goal to try to beat the S&P. I didn't want to take on that challenge as though it were game to try to play this game and beat the market. It's just finding good, solid dividend yields from companies that are capable of paying and raising those dividends at a good rate over time. And that has added value relative to just being in the generic index fund for example. We've also had less volatility.

But in addition to the likelihood that perhaps we can pick up a little bit of additional performance, we also get the benefit of the opportunity to reinvest the dividends. As the cash comes back to us in the form of those dividends, if stock prices go into a prolonged slump, then I'm buying cheaper stocks with higher yields, generating more income to reinvest and compound the real value of that college-savings program faster.

I would like nothing better actually, just as I'm in the process of starting to save for all of these years of college, to have the market fall apart, then stay at very low valuations, and then just go up at the end. But give me the opportunity to earn higher returns through lower valuations as the money is being set aside and as the dividends are being reinvested. I think it's harder to make a strategy like that work if you don't have the benefit of the dividends that turn low prices into such a direct and contributory advantage to your strategy.

Glaser: Investors would probably then expect maybe lower returns than they've seen historically, but dividends could help kind of shore that up?

Peters: Yes, and I look at it this way. If I'm buying a stock today right now that yields 4%, as long as that dividend doesn't get cut, then I've got that 4% locked in, and it could be cut. No dividend is guaranteed. But you look at everything about the business--its stability, its financial condition, the willingness of management to maintain that payout over time--that 4% provides a nice baseline. Over time, if the dividend is growing, that should encourage capital appreciation. It's not a one-to-one correlation in any period, but if I can find a 4%-yielding stock that can raise its dividend even 4%, 5% a year, now I think I'm looking at 8% to 9% total returns as opposed to maybe only 5%.

A lot of people are talking about mid-single-digit returns from equities over an extended period of time, such as the folks at PIMCO most recently and an even more bearish appraisal from Jeremy Grantham at GMO. I like to think of that big dividend as giving me a baseline for which maybe I can do a little bit better. But in the end, I think the best plan is to keep your expectations for returns conservative. It's better to save too much than too little when those big bills start coming due.

Glaser: Josh, thanks so much for your thoughts today.

Peters: And thank you too, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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