There’s more than one way to set up a dividend reinvestment plan

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Is there a significant advantage to enrolling directly in a dividend reinvestment plan (DRIP) with a company instead of enrolling in a DRIP offered by a brokerage? I currently have the latter but only because it's much easier to set up. If the former is better, do you have any statistics about what the compounding difference can be over time?

Broker-operated or "synthetic" DRIPs are definitely easier to set up – all it takes is a call to your broker. Another plus is that these plans are available for both non-registered and registered accounts. The main drawback is that you can only acquire whole shares. For example, if you receive $40 in dividends from company XYZ and its shares trade at $25, you'll get one additional share but the remaining $15 will sit in cash. If you have a small account, your dividend might not be sufficient to buy even a single share.

With a "true" DRIP operated by the company's transfer agent, on the other hand, you'll be able to purchase fractions of shares, which means every penny of your dividend will be reinvested. In the above example, the $40 dividend would purchase 1.6 shares and no cash would be left over, so all of your money would be put to work. Even if you have a small position, a true DRIP lets you harness the full benefits of compounding.

True DRIPS have a couple of other advantages. Some offer optional share purchase plans (SPPs) that let you acquire additional shares with no brokerage commissions. This is great for people who want to make regular contributions. However, with many discount brokers now charging less than $10 a trade – down from about $30 many years ago – the commission savings aren't as dramatic as they used to be.

Another benefit of true DRIPs is that some companies offer discounts of 2 per cent to 5 per cent on shares acquired through the DRIP. (For a list of DRIPs, SPPs and discounts, see http://www.dripprimer.ca/ and be sure to verify the information, as DRIP terms can change.)

True DRIPs do have a few downsides, however. There is usually a cost of $50 or more to register the shares in your name so you can enroll them in the plan. That's over and above the commission for buying the shares initially (although you can also acquire your first share[s] with a private transfer, as explained in dripprimer.ca). Another drawback is that true DRIPs aren't available for stocks held in a registered retirement savings plan, tax-free savings account or other registered plans.

Is one DRIP better than the other? If you want minimal effort, a synthetic DRIP is the way to go. If you don't mind spending some additional time and a few bucks on initial fees so that all of your dividends get reinvested, a true DRIP may be the better choice.

There are other ways to reinvest your dividends that don't require enrolling in a DRIP at all. I used to have several true DRIPs and, while they worked out well financially, I eventually transferred my shares to my discount broker because I like to have all of my stocks under one roof. Now, instead of using a DRIP I wait until a chunk of cash builds up and then purchase whatever stock looks most attractive. This gives me more control over the reinvesting process. It also reduces the paperwork required to track all those small DRIP purchases – something DRIP investors must do in order to calculate their adjusted cost base and capital gain when they sell a stock in a taxable account.

Another easy way to reinvest dividends – and a method I also use – is to purchase a low-cost mutual fund to periodically "soak up" dividends. When enough cash accumulates to meet the fund's minimum investment threshold, I buy some additional units. To keep my costs down, I periodically sell a chunk of the fund and put the money into a stock.

I don't have any data on the returns of stocks held in a synthetic versus a true DRIP, but the difference will depend on all sorts of factors including what percentage of the dividend gets reinvested, how long the residual cash sits idle and the price appreciation of the stock. With a synthetic DRIP, the size of your position also matters; if you are acquiring a large number of shares every quarter, missing out on a fraction of a share will have less relative influence on your return than if you have a small position that acquires only one or two shares at a time.

There are many ways to reinvest your dividends. The important thing is to pick a strategy – or a mix of strategies – that works for you. By putting the power of compounding in your corner, you'll greatly enhance your chances of long-term investing success.