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How dividend reinvestment plans super charge returns

DRIPs make a lot of sense for investors especially in a weak market if you don’t need cash dividends for living expenses.

Just before the end of the year, two of Canada’s big banks sweetened the pot for investors who prefer to take their quarterly dividends in shares rather than cash.

Royal Bank of Canada (TSX:RY) tweaked its Dividend Reinvestment Plan (DRIP) to offer a 2-per-cent discount to the market price for shares taken as dividends. A week later, CIBC (TSX:CM) announced the same 2-per-cent-off deal.

The move was good for the banks and their shareholders. By creating an added incentive for investors to participate in their DRIP programs, the banks conserve capital. RBC expects to save about $2 billion annually which helps finance its $13.5-billion acquisition of HSBC Bank Canada. For CIBC, the announcement came a day after the federal banking regulator increased the capital reserves banks must keep on hand.

DRIPs make a lot of sense for investors if they don’t need cash dividends to live on. The purchases are fee-free and the compounding effect adds up. A primer by Globe and Mail personal finance columnist Rob Carrick offers a step-by-step guide, describing DRIPs as a “get rich eventually scheme.”

Coreen Sol, a senior portfolio manager with CIBC Wealth in Vancouver, says in a weak market the purchases have more impact. The shares are acquired at a depressed price, so the long-term benefit is magnified as conditions improve. This is particularly good for investors with long horizons holding the shares in tax-protected vehicles such as Registered Retirement Savings Plans (RRSPs) and Tax Free Savings Accounts (TFSAs).

Ms. Sol is the author of the Unbiased Investor: Reduce Financial Stress & Keep More of Your Money.  The book offers strategies to help investors guard against common errors in judgment, one of which is behavioral bias.

 “Categorically, I would recommend a DRIP if it’s an investment that you’re holding for a long period of time,” she says, adding that the “set-it-and-forget-it” element of the plans is a big plus. It lets the compounding power of the reinvested shares go to work.

 “Investors shouldn’t discount how valuable that is,” she says. “The fewer times you intervene in your financial choices, the better. So set-it-and-forget-it is quite brilliant, in lots of ways. A DRIP is one more aspect of that.”

DRIP plans are easy to set up via an online broker, your bank, or your investment advisor and most large Canadian companies offer them. A list on the RBC Direct Investing web site has almost 1,000 companies with plans.

Tim Johal, vice president and portfolio manager at Mackenzie Investments in Winnipeg, says he doesn’t typically participate in DRIP programs. Mr. Johal is lead manager for the Mackenzie Canadian Dividend Fund with most of the companies in it offering dividend reinvestment.

“We would rather take cash dividends and redeploy as we see opportunities,” he says, adding that on occasion he will participate in a program if a company offers a significant discount to market price.

Tim Johal is a vice president and portfolio manager based in Winnipeg with Mackenzie Investments. Credit: Supplied photo

He says the programs can be beneficial for companies that have growth strategies or have made acquisitions and need equity capital. A dividend reinvestment is typically a less dilutive and inexpensive way to issue shares compared to an equity offering to the market which involves fees to underwriters.

 Ian Tam, director of research in Canada for Morningstar Research Inc., says the fee-free aspect of DRIPs adds to the compounding power. This would have been a bigger deal in the past, but the advantage has fallen by the wayside given that trading costs have fallen and are free for retail investors via discount brokerages.

While DRIPs are one reason to consider an investment, given that dividends are taxed at a higher rate than capital gains it can make more sense to own non-dividend paying stocks in a non-sheltered account. This is especially so if the investor has a longer investment time horizon and doesn’t need income.  

 A related consideration relates to the notion of dollar-cost averaging. Dividends tend to be paid quarterly which means the shares are purchased at different times of the year at different prices. Mr. Tam says that gives psychological comfort to investors who feel better about stretching out their purchases to get an average price. However, research shows that one lump sum purchase is a better choice most of the time.

“But if  investors feel more comfortable averaging in over time, that’s a better outcome than not investing at all or ‘waiting’ to invest. A DRIP would be an extension of this.”  

 The tax treatment of dividends as shares is the same as cash dividends, so the choice comes down to investment goals and strategy. If a company is a poor investment, its dividend yield will rise as its share price falls.  The DRIP will deliver more shares but it is still a bad investment.

“The key is in which companies you have DRIPs,” says Ms. Sol.  “And whether they’re still valuable investments and meet your objectives.”

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This article appeared in the Globe Advisor section of the Globe & Mail’s Report on Business on Mar. 13, 2023. For reprint information please view this page.

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