State Pension: if you’re buying shares to boost it, here’s what you need to know

Buy dividend stocks if you want to live on more than the £175.20 a week State Pension when you retire. Just be wary of these red flags, says Paul Summers.

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The new State Pension pays out just £175.20 per week. To make matters worse, many will now need to wait until 66 before being able to collect the cash.

One way of boosting a meagre State Pension would be to own shares in dividend-paying companies. These regularly return a percentage of their profits to their owners, allowing the latter to enjoy their golden years in a bit more comfort.

Unfortunately, not all such stocks are created equal. Today, I’ll highlight a few things that investors need to look out for. 

1. A very high yield

Big dividend stocks understandably appeal to those wanting to top-up the State Pension. The bigger the yield, the more money they’ll receive, right? Not necessarily.

A seriously-high yield — found by dividing the predicted total dividend by the share price and then multiplying by 100 — is usually a red flag. More often than not, it’s due to a fall in a company’s valuation. The yield is high because the dividend is now larger, at least relative to the share price. 

Generally speaking, it’s best to start asking questions of any company/share paying over, say, 5%. A lot more than this and it’s usually just a matter of time before management announces a cut.

The lesson here is clear — always look under the company’s bonnet first. Is trading poor? If so, are dividends likely to be paid while it turns itself around? If not, steer clear.

2. No growth

A lack of growth in the amount of cash returned to shareholders over the years is another potential red flag. After all, a rising dividend implies rising profits and confidence on the part of management; a stagnant dividend suggests a company is treading water. Even a long period of hikes is worth investigating further if these barely cover inflation and do little to supplement your State Pension.

This is not to say investors should panic if dividends don’t rise every year. Sometimes, a firm may simply want to invest spare money back into the business, perhaps to capitalise on a new growth opportunity.

A metric worth following over time is the extent to which a company’s dividend is covered by profits (otherwise known as ‘dividend cover’). Anything less than 1x cover for too long is a warning sign. Dividends covered twice by profits is ideal.  

3. Shaky finances

The coronavirus pandemic has served to remind investors that buying shares in highly indebted companies can be a risky strategy. This is particularly the case for those seeking to top up their State Pension via dividends. The latter are often the first thing to be sacrificed in troubled times as firms try to preserve cash.

Any debt-heavy company showering its shareholders with money should be avoided like the plague, in my opinion. The only exception might be if earnings are very predictable, such as those of a utility or pharmaceutical giant. Which brings me nicely to my final point for anyone looking to top-up a State Pension.

One final thing worth checking is just how cyclical a business is. Does it do well in times of economic prosperity and poorly in periods when people are tightening their belts? Clearly, any income from companies in this category is vulnerable, even if they look financially sound for now. Spread your money around or avoid them completely.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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