What are Dividend Reinvestment Plans (DRIPs) – the Complete Guide?
By: NED PIPLOVIC
Investors typically use dividend-paying stocks as a source of income but the payments can be reinvested through corporate Dividend Reinvestment Plans (DRIPs) – also called dividend reinvestment programs– to boost returns.
Of course, investors always had the option to cash their dividend checks and then buy stocks in the open market. But fees and commissions can diminish the total value of the purchased stocks. Therefore, formalized programs like DRIPs make this process easy and – once the plans is established – happen automatically without any active investor involvement and with minimal monitoring.
In some cases, individual companies set up their own reinvestment plans for their shareholders and some entities offer the shares at a discount of up to 10% of the market price. Additionally, most brokers offer their own version of DRIPs.
Shares purchased through a DRIP usually come from a company’s own reserve of stock. Therefore, these shares must be redeemed through the company and cannot be traded on the exchanges. It is important to note that while an investor does not receive the actual dividend payment, the total dividend amount must be reported as taxable income
Types of DRIPs
While all types of DRIPs operate on the same basic principles, the entity that manages the program defines the DRIP type. Reinvestment plans can be managed by:
- The company
- A transfer agent
- A brokerage
Many companies establish and manage their own DRIPs. While most companies require that investors own at least one share of the company’s stock before being eligible to enroll in the reinvestment plan, some companies allow investors to buy into the DRIP without the prior share ownership requirement. In most cases, the company has a department designated to manage the DRIP. Depending on the size of the reinvestment plan and the company’s available resources, the department’s sole function could be managing the reinvestment program.
Transfer agent-managed DRIPs
Management of dividend reinvestment plans is becoming more onerous because of increasing financial regulations. Therefore, some companies are choosing to outsource management of their DRIPs to third-party companies. These companies – called transfer agents – specialize in providing management services for DRIPs. The transfer agents can offer reinvestment plan management services efficiently to multiple public companies.
Some brokerages provide dividend reinvestment plans to their clients as well. Most of these plans let investors reinvest dividends of any stock in the client’s account, even if that particular company does not have its own DRIP.
While the first two plans are essentially identical, save for who administers the program, brokerage-managed plans have one major disadvantage. Investors in brokerage-managed DRIPs can reinvest only dividend distributions. Unlike the first two DRIP types, the brokerage-managed plans do not allow any additional cash purchases of shares. Optional Cash Purchase (OCP) plans are big draws for investors because they allow additional assets to be invested above the mere dividend distributions.
Enrolling in Dividend Reinvestment Plans
Investors who already own shares in one of the more than 1,100 companies and closed-end-funds offering DRIPs can enroll in the reinvestment plan by simply filing out a form. Most companies have all the information and details easily accessible in the Investor Relations portion of their website and prospectuses that they regularly mail to their investors. Alternatively, transfer agents will readily assist in the enrollment process, and often without any fees.
Investors who do not own any shares in a company simply can purchase the required minimum number of shares to join a DRIP – usually a single share will meet the minimum requirement – and then follow the same process as existing shareholders.
Once the investor is enrolled in the DRIP, the cash dividend distribution checks or direct deposits to the investor’s brokerage account will cease. Instead, the investor will receive additional shares equivalent to the value of the declared dividend distribution. The same process will happen every subsequent time that the company distributes a dividend.
DRIPs Advantages for Investors
In most instances, investors can buy fractions of shares, which they cannot do in the open market. Additionally, shares purchased through a company’s reinvestment plan are usually not subject to fees or commissions. Some companies have exclusive offers for investors to purchase shares at discounted prices. These discounts can reach 10% or more. Shares purchased at a discount generate instantaneous paper gains for investors that can help offset any fees and commissions associated with the DRIPs purchases.
While not specifically an advantage, DRIPs can help investors impose a more disciplined approach to investing. Unlike investing in open markets, which requires investors to take on an active role to increase their invested capital, reinvestment plans’ automatic setup forces investors to invest small amounts and grow their assets on a regular basis.
Additionally, some companies offer a special version of a reinvestment plan called the Optional Cash Purchase Plan (OCP). Investors enrolled in an OCP can use their own cash to purchase additional shares beyond the ones bought with dividend distributions.
While some of these advantages might seem small, the combined effect of all these pluses allows investors to accumulate larger amounts of shares, which could add up to significant capital growth when compounded over extended periods
DRIPs Advantages for Companies
While investor advantages of DRIPs are easily identified, companies offer the plan to gain some advantages for themselves. DRIPs help companies reduce sell-offs during bear markets and diminish capital flight, as well as increase the prospect that investors will keep their money invested in the company over a longer term.
Since the shares purchased through a corporate reinvestment plan must be redeemed through the company, investors are less likely to sell their shares at every trend reversal of the overall market. Even in cases of bear market indicators, participants in a company’s DRIP may hold their shares longer than they would if they purchased their stock in the open market.
Also, companies get to capture some of the capital that otherwise would be lost through cash dividend distributions. Investors who take their dividends as cash have multiple investment options for those funds and only a fraction is reinvested back into the company through share purchases in the open market.
However, the company captures 100% of dividends distributed through a reinvestment plan, which has the same effect as raising capital through the exchanges. The issuing company can use this additional capital to support its growth initiatives and daily operations. Additionally, participants in reinvestment plan are more likely to be long-term growth investors. Therefore, the interests of those investors might be better aligned with the company’s own long-term growth initiatives, allowing management to prioritize executing long-range growth plans rather than single-mindedly meeting quarterly financial expectations.
Dividend Reinvesting Abroad
Like U.S. companies, many foreign companies offer dividend reinvestment plans. While investing in overseas markets used to be reserved almost exclusively for institutional investors, American Depositary Receipts (ADRs) enable individual U.S. investors to access foreign markets with relative ease.
ADRs are negotiable securities that represent one or more shares of stock in foreign companies which trade on one of the U.S. exchanges. Just like shares of stock, ADRs can be traded on the exchanges. These depository receipts are denominated and pay dividends in U.S. dollars.
Commissions on ADRs are lower than commissions on the equivalent value of equity purchased directly in the foreign stock markets. Additionally, investors can trade ADRs without the need for any currency exchange transactions
While there is no need for currency exchange transactions, currency fluctuations do impact ADRs. A local currency that is appreciating against the U.S. Dollar will enhance total return on investment. However, a depreciating local currency can diminish or completely wipe out any gains.
Dividend Reinvestment Plans are an effective way for long-term investors to accelerate capital growth in stock they intend to hold for a long time through an automatic and disciplined program. However, as with any other investment vehicle, the individual shareholder must perform due diligence and determine whether a DRIP is a good fit with the investor’s overall strategy.
For instance, DRIPs probably are not the optimal choice for investors seeking high levels of cash income or investors designing their portfolio with a short-term horizon. Conversely, DRIPS are well suited for investors with a long-term outlook or those looking to invest small amounts in frequent intervals, while avoiding most fees and taking advantage of discounted share prices.
While most DRIPs require minimal involvement once they are established, the investor must monitor and review any changes to the plan. Companies can decide to implement or raise fees, enact eligibility requirements or cap optional cash payments. Additionally, companies might change or eliminate the share price discounts or any other factor crucial to the plan.
The key to taking advantage of DRIPs is for investors to be diligent in determining whether that investment instrument fits their personal strategies and to continuously evaluate any changes to make sure that a company’s reinvestment program remains a good choice to enhance total return for the desired time horizon.
Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.