DRIP-ping Your Way to Wealth(?)
One of the reasons why people love dividends, especially in the accumulation stage, is that they like the idea of being paid from their investments and using those investments to buy more of the same securities. This can be done in an automated matter by enrolling your account in a DRIP, a Dividend Re-Investment Plan.
What is a DRIP?
Companies issue dividends to shareholders from their earnings. These dividends can come in the form of new shares of the company, often known as stock dividends, or as cash dividends. In the case of a Dividend Re-Investment Plan or DRIP, this refers to the process of automatically reinvesting the cash dividends that are paid to a shareholder.
While shares can be held directly under the administration of a company’s transfer agent, in which case dividends can be reinvested down to 3 or 4 decimal places, most often shares are held at an investment firm. When held in that manner, typically the dividend paid has to be at least equal to the value of one full share for DRIP enrollment to be effective.
For example, let’s imagine you held 100 shares of a stock with a price of $25 per share. The stock paid $0.75 per unit over a year, evenly split into four quarterly distributions, which works out to $0.1875 per quarter per unit. At the current price of $25, that works out to a 3% distribution. Each quarter, you would receive $18.75. Unfortunately, $18.75 is not enough to purchase even one share as it is less than $25.
If you are determined to set up an effective DRIP, then you need to buy more shares so that your dividends are larger, buy a stock that pays a higher dividend, or hope that the price of the stock that you own goes down(!) so that your dividends are worth more relative to the share price.
Why would you want to enroll in a DRIP?
The idea behind DRIP plans is to build up your investment portfolio. If you are accumulating stock, this means you can buy more shares without actually spending more of your own money. Or so it seems. More on that later.
Most investors start small. You don’t have a lot of spare money when you are young and in your lower-earning years. There may also be significant demands on your money from, for example, a mortgage or children. Anything that helps you add more shares/units to the stocks or funds that you own seems like a good thing.
Should you enroll all account types in a DRIP?
Adding a DRIP to your investment strategy makes sense in your accumulation years. It may make less sense when you are withdrawing from your financial assets.
Registered Retirement Savings Plan (RRSP)
An RRSP is a good place to set up a DRIP program since this account is specifically for the accumulation of assets for retirement. You don’t need the cash to spend now. It makes sense to reinvest it.
Registered Retirement Income Fund (RRIF)
The RRIF may be a less likely account to set up for DRIP. It depends on how much you have to withdraw in a given year. If you were 65 years old at the turn of the year, you would have to withdraw a minimum of 4%. If your account balance was $500,000, you would have to withdraw a minimum of $20,000 that year. Dividends may contribute substantially to your mandatory withdrawals. Why bother to reinvest them if you are only going to have to withdraw them anyway?
On the other hand, if using uninvested dividends to cover your withdrawals leads to a distortion in your asset allocation, you may wish to reinvest them and then withdraw from your RRIF with an eye toward the proper balance.
Tax-Free Savings Account (TFSA)
Whether to enroll the stocks and funds in your TFSA in DRIP depends on how you plan to use the account. You may want to use the dividends as a regular source of income. And since withdrawals from a TFSA are tax-free, you can have a regular tax-free source of income. In other words, this depends on your personal needs and preferences.
Unlike dividends in registered accounts or TFSAs, dividends paid into a non-registered account have tax consequences that year. The taxable income for eligible dividends may be quite small, but that doesn’t mean the consequences should be ignored.
The more important element of a DRIP in a non-registered account, though, is keeping track of the Adjusted Cost Base (ACB) of the stock or ETF in question. Each time you reinvest your dividends you are changing the cost base.
Let’s go back to the example from earlier in this blog post. You own 100 shares of a stock with a price of $25 per share. Let’s change it so that the stock now pays $1.20 per share over a year in four quarterly distributions of $0.30. That is a 4.8% dividend yield on a $25 share price. When the stock pays out its $0.30 dividend you get $30. Let’s assume that at the time the dividend was paid, the stock was up to $26 per share. You buy one share for $26. (The remaining $4 is left in your account as cash.) Let’s assume that you had originally bought your 100 shares for a total cost, including commission, of $2,500. You now have 101 shares with a total ACB of $2,526. That works out to an ACB of $25.01 per share. As the DRIP continues each quarter, the ACB will adjust, and you will need to keep track of it to determine your capital gain (or loss) when you sell it one day.
Investment firms are supposed to be doing a better job of accurately tracking your ACB recently, so you may be able to rely on them but they don’t always get it right. Another option is a website called Adjusted Cost Base.ca, a free service to help you track your ACB. You can also track it yourself using spreadsheet software. Finally, you can choose not to enroll assets in a non-registered account in DRIP.
Does using a DRIP build wealth for investors more quickly?
There is this frequent misconception that dividends are free money. Rather, dividends come out of earnings. I have written this before, but if you have ever seen how a stock price is impacted on the ex-dividend date, that is, the date that a purchase of that stock no longer gives you the right to the upcoming dividend, you will recognize that the value of the stock drops by precisely the amount of the dividend. The reason is that the dividends payable are now a liability of the company and reduce its value by the amount of the dividend. Having said that, most companies do not distribute the entirety of their earnings to their shareholders, so the company should grow in value and as you own more shares you will gain a greater proportion of ownership in the company’s earnings.
However, all else equal, a company that had the same earnings, reinvested those earnings in productive ways, but did not pay a dividend, should have shares that grow at the same pace as the value of the dividend-paying stock plus the dividend-paying stocks’ trading price. A company may also choose to buy back shares, which reduces the shares outstanding and leads to the shareholder owning a greater proportion of the company, which again leads to growth in the value of the shares without actually having had to buy more shares.
What are the pros and cons of using a DRIP?
In this section, I am limiting the discussion to so-called “synthetic” DRIPs, those available through an investment firm, rather than the arrangements available at a transfer agent.
Accumulation of shares
The name of the game in investing, especially early on, is to grow your assets. Rather than spending your dividends, reinvesting them helps you to do that. You might liken this to a tax refund following a contribution to an RRSP. The contribution will generate a tax refund, but to benefit from the money that came back to you, you should use the refund to put more into your RRSP, put it into a TFSA, or pay down debt. Simply spending the refund will do you little good. Likewise with a dividend that is simply spent.
One of the appealing aspects of DRIPs is that you buy more shares without paying a commission. These days, there are discount investment services that waive commissions altogether, more often on ETFs than individual shares. DRIPs offer this commission-free advantage to individual stock purchasers, too, though only to the extent of allowing investors to buy a few shares periodically when the dividend gets paid out.
Tendency to favour dividend-paying stocks
This is more of a behavioural concern, I suppose. The opportunity to buy more shares will tempt many investors to favour dividend payers, which will inevitably narrow the degree of diversification in the investors’ accounts.
Excess growth of certain holdings in your portfolio
An investor in higher dividend payers may find that those stocks grow faster than others as they will find it easier to accumulate more shares. This may distort the balance in their accounts. High dividend payments may also be a sign of a decline in the share price, which could undermine the net value you receive. More shares of a stock that is going down in value is seldom a net positive.
Need to rebalance
Related to the two points above, participation in a DRIP could cause certain parts of your portfolio to become disproportionately large, requiring an investor to rebalance more frequently. If that’s the case, then needing to sell the shares that were added to the account via DRIP is contrary to the goal you were seeking to achieve. In that case, it is better to let the dividends flow into your account as cash and redistribute the money as appropriate for your risk profile.
Possible tax implications
If you use DRIP in a non-registered account, it doesn’t matter whether they are reinvested in the same stock or paid out in cash. You will still need to account for the income in your tax return.
Buying shares regardless of your intentions
Maybe you are content with the number of shares you have in a certain stock or fund, but you’d rather put new money into something else. Unless you unenroll from the DRIP, that is not going to happen. This is a rather small thing to resolve, but inertia prevents many people from doing the things they should.
What should you do?
DRIP can be useful, especially in tax-sheltered accounts. A great place to use DRIP is with one of the asset-allocation ETFs. Assuming you have found an ETF that matches your target allocation, the accumulated units will be completely diversified and continue to match the balance you are seeking. I am not a big fan of using DRIPs in individual stocks, mostly because I am not a big fan of investing in individual stocks. You are opening yourself up to avoidable risks, and DRIP only multiplies the risk. By all means, use DRIP where it makes sense but avoid the opportunity if it leads you to add more risk than appropriate.
This is the 181st blog post for Russ Writes, first published on 2023-01-23.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.