Stock Market: Use DRIPs to Build Your Nest Egg
Financial expert Gordon Pape offers a quick primer on Dividend Reinvestment Plans (DRIPs) and how they can provide stable growth. Photo: Peathegee Inc/Getty Images
If my correspondence is any indication, investors seem to be more interested than ever before in Dividend Reinvestment Plans, more commonly referred to by the rather unflattering acronym DRIPs.
I’ve been asked questions about whether they are recommended for RRSPs, how they’re taxed, who offers them, what advantages they confer, and more. So, it seems like an opportune time for a quick primer on DRIPs and how they work.
DRIPs give investors the option of receiving their dividends in the form of shares rather than cash. Although most DRIPs are offered by corporations, some ETFs, mutual funds, and trusts like REITs also have them.
DRIP shares are issued from the company’s treasury and no commission is charged for the purchase. Not only are the shares commission-free, but some companies offer them at a discount to the market value. These discounts can range from 1 per cent to 10 per cent (one company only). Most are in the 2-5 per cent range. Some of the 5 per cent discounters are well known companies like gold miner Agnico Eagle (AEM-T), Crescent Point Energy (CPG-T), and Pembina Pipeline (PPL-T). You can find a list of Canadian DRIPs here.
Why do companies offer these plans? DRIP sales bring in new cash. When stocks trade in the market, the company receives no money. The cash passes between the buyers and sellers of the shares. In the case of DRIPs, the dividend flow directly back to the company’s treasury, to be used for new investments, debt repayment, operating expenses, or however else management chooses.
DRIPs offer the opportunity to make use of two investing principles: long-term compounding and dollar cost averaging. By adding to your position in a stock each quarter, your portfolio steadily grows over time, assuming the stock you’ve chosen isn’t a dog. And your cost averages out over the years, smoothing the peaks and valleys of market movements.
For example, suppose you buy 100 shares of Bank of Montreal (BMO-T) and enrol in its DRIP program. That allows you to use your dividends to buy more shares of the stock each quarter at a 2 per cent discount to the market price. The stock pays a dividend of $1.39 per quarter, so you’ll receive $139 every three months to put towards new shares. At the current price, that will buy you about one share per quarter. That may not seem like much but, assuming the dividends and the share price maintain roughly the same relationship over time, at the end of five years you will have added about 20 new shares to your total – a 20 per cent increase in your position. While that was happening, both the dividend and the share price presumably moved higher.
There’s more. Some (but not all) companies also offer a Share Purchase Plan (SPP). These allow investors to buy additional shares directly from the treasury with no commissions or brokerage fees. BMO is one of the companies with an SPP program. Some others include Scotiabank (BNS-T), BCE (BCE-T), CIBC (CM-T), Emera (EMA-T), Enbridge (ENB-T), Fortis (FTS-T), Imperial Oil (IMO-T), Manulife (MFC-T), National Bank (NA-T), Suncor Energy (SU-T), and Telus (T-T).
Seems like a good deal. Any drawbacks? Yes, a couple.
For starters, taxes. Even though they are received as shares, your dividends will be taxed as if they were cash if the security is in a non-registered account. You’ll get the benefit of the dividend tax credit, but you’ll still have to pay.
The second concern is keeping track of the cost of all the DRIP shares you purchase over time. That could turn into a nightmare because the cost base will change with every purchase. Your broker may do this for you but check first.
The way around these problems is to confine your DRIP programs to registered accounts – RRSPs, RRIFs, TFSAs, RESPs and the like. The tax sheltering these plans provide mean you never have to worry about paying taxes on new purchases or calculating cost bases.
DRIPs are an excellent way to build your registered portfolios. Keep them out of non-registered accounts and avoid the headaches.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.