Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.
The importance of reinvesting dividends and why costs matter
Reinvesting dividend income is fundamental to making the most of your investments and getting the full benefit from the effect of compounding.
To give an idea of the advantage let’s look at how £100 invested over the last 121 years would have theoretically grown with and without reinvesting dividend income.
The annual Barclays Equity-Gilt study shows that over the last 121 years UK equities as represented by the FTSE All-Share index have delivered a CAGR (compound annual growth rate) of 8.9% a year, including reinvested income, which would have turned £100 into £2.9 million.
Without reinvesting the income, the CAGR drops by over half to 4.2% a year. That is a big drop in return but looking at the data this way isn’t as illuminating as seeing the difference in actual money terms.
What might surprise you is that the same £100 invested would have in theory only turned into £15,179 over the last 121 years, a staggering loss in potential value of £2,897,759.
That might seem like an extreme example, after all almost no one could live long enough to invest over such a period, but the principle still holds, so it makes a lot of sense to reinvest dividend income that you don’t need for other purposes.
MIND THE COST GAP
In this section, we look at the cost of reinvesting dividends and look at ways to optimise the process.
Most investment platforms will offer an automated reinvestment service where they will do the work for you. Alternatively, you could place an order to purchase more shares in the company that paid out the dividend.
In most cases it is better to choose the automated reinvestment option because it is cheaper and more convenient. However, as we explain below, sometimes reinvesting small amounts isn’t cost effective.
Let’s look at some hypothetical examples to illustrate the different costs of reinvesting dividend income.
If you choose the dealing option, you will incur a charge which is usually a fixed price.
Using some ballpark numbers, let’s say your platform charges you £12.50 to deal in shares online and charges 1% of the value of each dividend with a minimum payment of £1.50 and a maximum of £9.95.
Because the maximum reinvestment charge is below the dealing charge, it’s clearly cheaper to make use of the automated reinvestment service.
UNDERSTANDING THE PRICING STRUCTURE
The pricing structure means that higher value dividends have the lowest proportional cost to reinvest. For example, if you were fortunate enough to have a £5,000 dividend payment, the maximum charge to reinvest it would be 0.2% (£9.95 divided by £5,000).
However, that implies an underlying stock position of around £160,000 assuming the stock paid a typical 3.1% yield. Given the need for a diversified portfolio of at least 30 stocks, this implies a portfolio value of £4.8 million, beyond the reach of most retail investors.
The 1% charge and minimum £1.50 threshold converge at dividends worth £150 because 1% of £150 is £1.50.
However, that implies an underlying stock value of £4,839, assuming a 3.1% yield. (£150 divided by 0.031) A well-diversified portfolio comprising of at least 30 equally weighted holdings implies a portfolio value of around £150,000.
Data provided by Platforum suggest that a more typical retail portfolio value is around £55,000. Assuming a similarly diversified portfolio and 3.1% yield implies a stock position size of £1,800 paying a dividend of £56.
Reinvesting £56 would incur the minimum charge of £1.50.
REINVESTING REMAINS KEY
As we explained earlier, reinvesting dividends is the key to building wealth in the stock market, so any lost income via dealing costs should be considered very carefully.
Additionally, most UK companies pay dividends twice a year in a rough ratio of one-third-to-two thirds with the final dividend being the larger. This means in the example above the first half dividend would be worth around £18.65.
The minimum £1.50 charge represents just over 8% of the value of the dividend (£1.50 divided by £18.65).
With smaller portfolios the costs can become prohibitive, for example, if your average stock position is £200 paying an annual dividend of £6.20, the first half dividend would be around £2 and paying the minimum fee would wipe out 75% of the dividend. (£1.50 divided by £2).
An alternative to immediately reinvesting income is to allow multiple dividends to accrue over time and reinvest at the point where the cost of reinvestment is say, below 2% or whatever threshold you consider reasonable.
Putting it into practice
On 4 November telecoms giant BT (BT.A) announced a first half dividend of 2.31p per share. Based on a share price of 161p an investor with £500 worth of shares would receive a dividend of around £7.16. If they chose to reinvest this, the typical platform minimum platform charge of £1.50 would amount to more than 20% of the total value of the dividend.
There isn’t a perfect solution unfortunately, it’s more of a trade-off between getting the money to work as quickly and efficiently as possible while also keeping costs to a minimum.