Dividend reinvestment plans, often called DRIPs, have long been a not-so-secret way to build wealth efficiently over time. These plans allow shareholders in dividend-yielding stocks to have their quarterly payouts reinvested to buy more of the same stock. And the long-term results can be lucrative.
One of the best known examples is that of Grace Groner, a retired worker at Abbott Laboratories in Illinois who purchased about $180 (U.S.) of the company's stock in 1935. She never touched the investment, allowing its dividends to be reinvested over decades.
When she died in 2010, she willed the account – then worth $7-million – to her alma mater, Lake Forest College.
While not all investors are familiar with that particular story, hopefully they are aware of the power of DRIPs.
"It's a disciplined investment strategy that takes emotions and timing out of investing," says Darren Quiring, an investment adviser with Edward Jones in Winnipeg.
As dividends are automatically reinvested, investors are benefiting from what is essentially a long-term buy-and-hold strategy.
"That's important because historically, the dividend from your stocks can represent over time 50 per cent of your total return," Mr. Quiring says.
Investors have plenty of choice, too. More than 1,000 stocks and exchange traded funds traded on the Canadian and U.S. markets offer DRIPs. All full service and discount brokerages offer automatic dividend reinvestment with no commissions on non-registered and registered accounts such as registered retirement savings plans (RRSPs).
"About 60 per cent of our clients use it for their accounts, including people in their early 20s to late 80s," says Michael MacDonald, vice-president of strategy for RBC Direct Investing.
Yet one of the problems with using DRIPs through a brokerage account is that the earnings can purchase only full shares, leaving excess dividend income in cash sitting in the account, says Bob Gibb, a frequent contributing editor with DRIPinvesting.org and the magazine Canadian MoneySaver.
"So if $100 in dividends is paid to you, and the stock is worth $70, your broker would buy you one share and the rest of the money would sit in cash," Mr. Gibb says.
Mr. Gibb refers to these plans as "synthetic DRIPs" because a true one reinvests all the money by purchasing fractional shares. The only way to doing this is by enrolling directly in a DRIP with the company paying the dividend.
To get started in Canada, investors must request that their broker send them an ownership certificate for at least one share. In fact, investors must purchase the share because technically it's the brokerage that owns the shares, which facilitates quick buying and selling on behalf of investors, Mr. Gibb says.
The certificate is required so investors can prove they are shareholders to take advantage of the company's shareholder benefits plan, which includes access to its DRIP. The process also usually involves a fee for transfer of the stock – about $50 – as well as commission for purchasing the share.
Beyond the added benefit of having the entire dividend reinvested, many companies also offer a small discount on their share price. "The usual discount is somewhere between 3 to 5 per cent," he says.
Yet signing up for a DRIP directly is only worthwhile if the company also offers a stock purchase plan (SPP), also called a unit purchase plan for trusts. "If a company doesn't offer a stock purchase plan, it doesn't make any sense to sign up for a DRIP because you're only going to be reinvesting dividends from the one share you originally requested."
But together a DRIP and SPP help small investors maximize their money. Not only are all of the dividends reinvested, but investors can buy more shares without paying a commission because no broker is involved in the transaction.
Still, DRIPs are not for everyone. For one, using them in combination with an SPP works only for non-registered accounts because RRSPs and tax-free savings accounts (TFSAs) have to be set up through a financial institution, which inevitably will involve commissions.
Work-around solutions exist, Mr. Gibb says. Among them is transferring stocks purchased directly from the company at the end of the year to a TFSA or RRSP, but this can trigger taxable capital gains.
Other investors do not like the fact that DRIPs automatically reinvest in the same company. Among them is Tom Connolly, who blogs about dividend investing on his website dividendgrowth.ca.
"If you want to keep buying a stock of a company, DRIPs are great," Mr. Connolly says. "But now that commissions to trade equities are so low, it might make more sense to use the dividends to buy other stocks that are better priced at any given time."
Moreover, DRIPs held in non-registered accounts can complicate an investor's tax situation. Although reinvested dividends in non-registered accounts are taxed at a lower rate than most other income, making them tax efficient, problems can arise when the shares are sold. Because these plans involve regularly buying small amounts of stock over time, investors can have difficulty determining capital gains when selling. To figure out the capital gain, investors need to calculate their average cost per share.
While software is available to do this automatically, Mr. Gibb says investors can do it "quite easily" on their own by dividing the total amount of money invested over time by the number of shares.
Yet in many cases the main reason a lot of investors – often retirees – have no interest in DRIPs is they want the dividends as income, Mr. Quiring says. "But for clients who need their money to grow still, a DRIP is a very good way to do it over the long term."