American firms are ratcheting up their dividend payments, drawing attention to this generally dependable income source as an alternative to bonds and other fixed-income holdings that are paying next to nothing. It begs some questions: What is the proper role of dividends in an investor’s portfolio? And, for shareholders, what’s the best use of company profits — dividends, stock buybacks or reinvestment for corporate growth?

Wharton finance professor Jeremy Siegel is a long-time fan of dividends, and thinks they are especially appealing now because fixed-income investments pay so little and could lose money if interest rates rise as expected. Also, January’s fiscal cliff deal in Washington removed a tax cloud that has hovered over dividends since 2003.

“You now have a preferred tax rate [on dividends] for middle-income people that’s as low as 15%,” Siegel notes.

For most taxpayers, the fiscal cliff deal made permanent the 15% rate on dividends and long-term capital gains — for investments longer than a year — that had been temporary since the Bush tax cuts of the early 2000s. Though the recent deal raised those rates to 20% for taxpayers with incomes exceeding $450,000 for filers of joint returns, and $400,000 for single filers, this is still low compared to ordinary income tax rates that apply to interest earnings, salaries and other income. That rate is as high as 35% for taxpayers not in those high brackets, and 39.6% for those who are.

With the “temporary” label removed from dividend and capital gains tax rates, investors can feel more secure about long-term commitments to dividend-paying stocks, Siegel says.

Moreover, some solid dividend payers like Verizon and AT&T now yield in excess of 4%, while the 10-year U.S. Treasury note pays a scant 1.88%. The overall yield of the Standard & Poor’s 500 stock index tops 2%, while the Dow Jones Industrial Average yields nearly 2.5% and the Dow Transportation Index 3.6%.

Stock investors do, of course, risk loss of principal, but bond investors are not immune from that hazard, either. If interest rates rise, the prices of older, stingier bonds fall, as no one will pay full price for a bond yielding 2% if newer ones pay 4%. Falling interest rates have the opposite effect, driving up the prices of older bonds that are more generous than new ones, a trend that has made bonds a very profitable investment for decades. Now, though, interest rates are so low they can’t fall further, and a rise is much more likely, raising the risk for fixed-income investors.

“That is a reason to rely on dividend-paying stocks,” Siegel notes, referring to bonds’ low yields and growing risk.

According to S&P Dow Jones Indices, in the fourth quarter of 2012, U.S. companies announced 1,262 dividend increases, compared to 649 in the same quarter of 2011, a near doubling. For all of 2012, there were 2,883 dividend increases, compared to 1,953 in 2011. Howard Silverblatt, the firm’s senior index analyst, has predicted that “we should see 2013 as setting another record for regular cash dividends.”

Some of those dividend increases were undoubtedly driven by firms’ desire to get cash to shareholders before tax rates were expected to increase in January with the automatic sunset of the Bush-era tax cuts. In addition, firms have been sitting on record amounts of cash, and shareholders have been demanding that they do something with it, especially as low rates mean cash reserves are not even earning decent interest.

The ‘Self-interest’ Component

Dividends are the portion of corporate earnings paid out to shareholders. In 2012, S&P 500 companies paid about 36% of their profits as dividends, a near-historic low. This “payout ratio” was in the mid-40% range from the 1970s through the 1990s, and in the mid- to high-50% range from the 1940s through the 1960s. The low ratio today means companies have plenty of room to raise dividends, Siegel says.

Earnings that are not paid out as dividends can be reinvested in areas including research and development or plant expansion, or they can be spent on stock buybacks — where a firm purchases its own shares on the open market to reduce the number in circulation. In theory, each of the three approaches, if done wisely, benefits shareholders. Dividends put money in shareholders’ pockets, and reinvestment helps the company grow, increasing future profits and share prices.

Proponents say buybacks increase shareholder value by reducing the number of shares in circulation. In theory, notes Wharton accounting professor Stephanie Sikes, “if you repurchase shares, it’s going to increase earnings per share, even if the earnings are the same.”

But in practice it’s not so simple, cautions Wharton accounting professor Wayne Guay. Many buybacks are in fact not designed to reduce shares outstanding but to amass shares the company will distribute as stock options to executives and other employees. Corporate cash spent on this is simply transferred to the options recipients, not to shareholders. Shareholders benefit only if the options program is effective in attracting and retaining employees better than those the firm would have had without that incentive, a result that’s very hard to assess.

Even when the goal is to reduce outstanding shares, the benefits for shareholders can be neutralized by the reduction of cash in the company’s coffers, Guay says. “I think probably one of the biggest misperceptions of share repurchases is that they have some mechanical effect on the stock price,” he says, adding: “There is a flaw in that logic.”

He cites the hypothetical case of a firm with $1 million in assets and one million shares worth a dollar apiece. The firm uses $500,000 to buy back half its shares. Afterward, the firm has $500,000 in assets and 500,000 shares. Each one is worth $1, the same as before the buyback, so the buyback does not increase shareholder value.

Despite this, Guay adds, buybacks do often boost a firm’s share prices because the market views the buyback as a sign that the firm’s executives, who know the company best, believe the shares are undervalued. Other investors then jump on the shares, and the rising demand pushes the price up. (The opposite occurs when a company issues new shares, he notes. Investors assume insiders think the shares are overvalued and can command a premium price, and the issue announcement is followed by a price drop.)

In some respects, Guay adds, a share repurchase accomplishes the same thing as a dividend payment: It puts cash into shareholders’ pockets. Why, then, would a firm choose a buyback over a dividend increase, or vice versa?

In some cases, a buyback is preferred because it is more flexible, he explains. The firm announces it will spend a given sum to buy back shares over a period of months, but makes the purchases only when conditions are favorable, such as when the price is down. If conditions aren’t good, the buyback can be cancelled. Each buyback, moreover, is a one-time event that does not have to be repeated.

A dividend increase, in contrast, must be made on the promised date. And once a dividend is raised, a firm is typically very reluctant to reduce it, as that creates an aura of failure. “Dividends tend to be a stronger commitment to paying out cash,” Guay notes.

Tax incentives also play into the decision. Dividends are taxed in the year they are received, while capital gains tax is not levied until the stock is sold, allowing the investor to postpone tax for years, even decades. Hence, many investors prefer to receive their returns from share price increases rather than dividends. That favors buybacks and reinvestment of cash to grow the company. This is one reason companies have in recent years paid out less of their earnings as dividends than in earlier decades, though tax incentives change, of course, as tax rates are altered.

The tax interests of large investors tend to dominate firms’ decisions, says Sikes, because big investors, though fewer in number than small ones, have a disproportionately large share of holdings, and thus more voting power. “It’s the people at the top that kind of dictate what the payout policies are,” Sikes states.

The fiscal cliff resolution, increasing dividend and capital gains tax rates for wealthy investors to 20% from 15%, will make stocks slightly less profitable for the wealthy. But since dividends and capital gains are taxed the same, the new rates do not change the relative merits of each. That would not have been so if Congress had, as some advocated, allowed dividends to be taxed at the much higher income tax rate — as high as 39.6% — while leaving capital gains rates lower. There have been periods when dividends were taxed as income, as well as periods when capital gains rates were much higher than they are today.

John C. Bogle, founder of The Vanguard Group, the mutual fund giant, notes that the increasing use of stock options as an incentive for executives and employees has also caused firms to minimize dividend payouts. That’s because the value of a stock option does not rise if the dividend does. Those who hold options would thus prefer to see cash used for reinvestment and buybacks, because those are expected to raise the share price, making options more valuable. “There’s a self-interest component to this” downplaying of dividend increases in recent years, he says.

Shareholders’ Choice

Given all these considerations, which of the three options should shareholders prefer — dividends, buybacks or reinvestment? There is no simple answer. Experts say it depends on the situation of the investor and the company.

Bogle favors dividends. Most small investors, he notes, have the lion’s share of their holdings in 401(k)s, IRAs and similar tax-favored retirement accounts. For them, the various tax issues are irrelevant, as all gains in traditional tax-favored accounts are taxed as ordinary income regardless of whether they come from dividends, capital gains or interest.

 “I’m skeptical about buybacks, as a generalization,” Bogle says, arguing that they often fail to drive up the share price.

With a dividend, he notes, the investor has a known amount of cash in hand. If the shareholder likes the stock, the cash can be reinvested in more shares. If not, the cash can be used for another investment. Or it can be spent. The ultimate effect of a buyback or reinvestment on the share price is, by comparison, uncertain, he says.

Reinvestment of cash can be crucial to a company’s growth, driving stock price gains, which is why young, small companies typically do not pay dividends, according to Siegel. But as firms get larger, growth is harder to achieve, often making dividend hikes and share repurchases a better option than reinvestment. “I definitely like returning the cash” to investors with dividends or buybacks, Siegel says. “I think, unfortunately, a lot of firms spend money on plants and equipment. That isn’t necessarily as productive.”

Obviously, he adds, the relative merits of each option for cash vary from company to company.

Another issue, says Sikes, is the “agency problem,” when executives sitting on large amounts of cash find inappropriate uses for it, like giving themselves raises and bonuses they don’t deserve. Using cash for dividends or buybacks removes that temptation, she points out.

Over the long term, dividends are a major contributor to stock returns, which are a combination of share price gains and any dividends paid. Returns reported for stocks always assume that dividends are reinvested in more shares, and as the years pass this means that a growing portion of the shares in the portfolio can be traced to dividend payments. This snowballing effect makes dividends very valuable.

Today, though, dividends have a special appeal to investors like retirees who, rather than reinvesting them, will use the income for ordinary living expenses. Is this too risky?

Relying on dividend income is definitely riskier than counting on interest earnings from bank savings, experts warn. But fixed-income investors also face the risk of earning too little, and today’s federally insured bank holdings pay next to nothing. Siegel believes dividends are a good alternative for a portion of the typical investor’s fixed-income holdings. Investors can find generous dividend-paying stocks and mutual funds, and Siegel suggests that the risks of stock losses are acceptable, as the average S&P 500 or Dow stock is trading at a relatively low price relative to earnings.

“If you buy for dividends, you should not worry so much about day-to-day fluctuations in the stock market,” Siegel states.

Bogle concurs, noting that long-term investors should not fixate on the ups and downs of their stock prices, but should instead focus on the dependability — or lack of volatility — of dividend payments. Because firms are loathe to cut dividends, he adds, that income stream is quite reliable — suitable for part of the holdings investors might otherwise keep in bonds.

“I like dividends,” Bogle says. “If you’re talking about a fairly assured [income] stream, I think they’re a reasonable option.”