Reinvesting the coming dividend bonanza a sure way to build long-term wealth

Long-term returns provide compelling evidence you can’t beat a dividend reinvestment plan.

Long-term returns provide compelling evidence you can’t beat a dividend reinvestment plan. Picture: NCA NewsWire / Gaye Gerard

Shareholders have been rewarded with a record payload of dividends from the 2020-21 financial year of more than $35bn.

It’s a stark turnaround from this time last year, when payouts to investors slumped as many companies chose to stockpile cash rather than spend it.

Moreover, many companies are keen to reduce the amount of cash held on their balance sheets.

Consequently, as well as ­declaring higher dividends, some companies have also announced they will be paying a “special dividend” to return excess cash to shareholders.

Investors with direct exposures to companies can expect distributions to start flowing from this month as dividend payments from 2020-21 are made.

Exchange-traded funds and managed funds will also be receiving company dividend payments, which will then be aggregated and paid out as distributions to their unitholders.

As always, the decision for investors is whether to keep those dividends or reinvest them back into the market.

For many investors, especially people in pension phase reliant on regular income streams, company dividends and fund distributions are an important element of cashflow to pay for everyday living costs.

Investors in pre-retirement (accumulation) phase may not need additional cash income.

But there’s compelling evidence that reinvesting distributions will produce significantly higher investment returns over the longer term.

Shares fare best when you look at the average annual return of six different asset types over a 30-year period from July 1, 1991 – Australian shares, US shares, international shares, Australian bonds, listed property, and cash.

Of course, when these long-term returns are calculated total return numbers are rounded up and it is assumed all the income received from distributions along the way was reinvested back into the same asset. Also, they don’t include any buying costs or taxes.

What’s clear is that the ­average annual returns from higher-risk assets such as shares have been consistently stronger over the past 30 years than lower-risk assets such as fixed income and cash.

Anyone who invested $10,000 across the whole Australian sharemarket three decades ago would have achieved a total return per annum of 9.7 per cent, assuming all distributions had been reinvested.

By June 30, 2021 their initial investment, combined with distributions, would have compounded to $160,498.

Alternatively, a $10,000 investment into the US sharemarket in June 1991 would have grown to $217,642 by 2021 if all income received had been reinvested back into the market. That’s based on the 10.8 per cent average annual return from the broad US market over 30 years.

 Investing $10,000 in cash over 30 years would have achieved a total return per annum of 4.6 per cent and grown to $38,938.

The lesson here is that reinvesting distributions over time, regardless of the asset class, will achieve long-term compound growth.

Taking distributions such as share dividends in cash will invariably erode the benefits of those compounding returns, especially over the longer term.

Reinvesting company dividends or distributions from shares, ETFs or managed funds is relatively easy. Many listed companies offer dividend reinvestment plans (DRPs) that allow investors to have the cash value of their distributions converted into additional shares. This conversion is generally done at the market price on the day the company pays out its dividend.

DRPs can usually be selected through the share registry company used by the listed company to manage its customer records, including changes in share ownership and dividend payments.

The advantages of selecting a DRP option are that there are no additional brokerage fees involved when shares are added to an existing shareholding, and the overall process is automatic.

Likewise, ETFs and managed funds usually provide reinvestment options either as an automatic or opt-in investment feature.

Where automatic reinvestment plans are not available, fund investors can readily redirect cash received from distributions straight back into their investments by purchasing additional shares or units.

Either way, choosing to reinvest distributions is a proven strategy for building long-term wealth.

Tony Kaye is senior personal finance writer with Vanguard.

www.vanguard.com.au