Reinvesting dividends is one of the surest ways to build wealth. But as Dave Hook discovered, it's not as easy as it sounds.
Some stocks and exchange-traded funds that qualify for dividend reinvestment plans (DRIPs) at one discount broker don't qualify at another, as he found out when he opened an account at one of the big bank-owned firms.
What's more, because most broker-operated DRIPs only allow reinvestment in whole shares – not partial shares – some cash invariably builds up in his accounts. Not only does the orphaned cash sit idle for months – defeating the purpose of a DRIP – but he has to pay a commission if he decides to reinvest it.
"I'd like [reinvestment] to be automatic. I'd like to invest in partial shares," says the retired Barrie, Ont., resident. "That would make it so much easier."
To be sure, Mr. Hook's situation is more complex than most: He and his wife have 11 accounts at four different financial institutions – some chosen specifically for their DRIP policies. But his frustrations are shared by plenty of other dividend investors.
Here's a rundown of the advantages and disadvantages of some common dividend reinvestment strategies:
The "true" DRIP
- How to set it up: You need to buy at least one share through a broker, and then have the share(s) registered in your name and the certificate be mailed to you at a cost of about $50. Alternatively, you can avoid fees by purchasing a share in a private exchange (more information at dripprimer.ca). You then enroll in the DRIP administered by the company’s transfer agent.
- Advantages: Allows for partial share purchases, so every penny of your dividend is reinvested. Some DRIPs also permit subsequent share purchases with no commissions.
- Disadvantages: Not available for shares in registered accounts. For tax purposes investors must track the adjusted cost base (ACB), which changes with each reinvestment. No control over reinvestment price.
The "synthetic" DRIP
- How to set it up: Check the list of stocks and ETFs that are eligible for your broker’s “synthetic” DRIP. Call your broker to enroll your shares.
- Advantages: Easy to set up. Most brokers will track the ACB for you. Available for shares in registered and non-registered accounts.
- Disadvantages: No partial shares. No control over reinvestment price. If dividend is not sufficient to purchase at least one share, no money will be reinvested. This can be a problem with monthly-pay ETFs because the dividend amounts are small. On the plus side, some brokers – including Scotia iTrade, Virtual Brokers, QTrade and Questrade – offer commission-free ETF trades, with certain restrictions.
The mutual fund DRIP
- How to set it up: When you purchase a mutual fund, request to have the distributions reinvested instead of received in cash.
- Advantages: Simple. Allows for full reinvestment, including partial units. Plenty of funds to choose from. Can be used in registered and non-registered accounts. No commissions to buy or sell.
- Disadvantages: Mutual fund management expense ratios (MERs) are typically higher than ETFs and can exert a drag on returns. To keep costs down, consider index mutual funds.
The hybrid DRIP
- How to set it up: Purchase a small amount of a mutual fund and use it to “soak up” dividends from stocks and ETFs when enough cash accumulates to meet the fund’s minimum purchase level.
- Advantages: Keeps costs low because the mutual fund is only a small portion of portfolio. Can control timing of reinvestment. No commissions to buy or sell fund units.
- Disadvantages: Depending on the fund and account size, it might take a while to build up enough cash for the fund’s minimum purchase. High MERs of some funds.
The DIY DRIP
- How to set it up: In a portfolio of stocks and/or ETFs, simply let cash accumulate until you decide to add to a position or invest in a new security.
- Advantages: Gives you complete control over reinvestment timing and price. Can be used in any account.
- Disadvantages: Not automatic. Commissions to buy and sell stocks and ETFs (unless you use a broker that offers free ETF trades).
There is no single best strategy for reinvesting dividends. The important thing, if you don't need to spend the cash and want to maximize the benefits of compounding, is to redeploy your dividends so that they, in turn, can generate more dividends.
"A perfect solution will always be elusive," Mr. Hook says. But whatever method you use, reinvesting "is absolutely essential to a dividend strategy."
Got a creative dividend reinvestment strategy? Tell me about it. E-mail email@example.com