Everything Investors Need to Know About DRIPs
Dividends do not always have to result in regular cash payments. Many companies offer DRIPs (Dividend ReInvestment Programs) that use the funds from dividends to automatically purchase more shares of stock, at little to no cost to the investor.
Sure, investors can do the reinvestment themselves in their brokerage accounts after receiving cash dividends, but the transaction fees associated with share purchases can be a drag on one's returns. That's why companies have created DRIP plans: to make reinvestment much cheaper and simpler.
As you probably know by now, DRIP is an acronym for Dividend ReInvestment Plan. This means that an investor's dividend is reinvested in the company with the purchase of additional shares of stock, rather than receiving a cash dividend payout. So instead of receiving a quarterly or monthly dividend payment, the party running the DRIP (the company, transfer agent, or brokerage firm) uses the money to buy additional stock in the name of the investor.
How DRIPs Work
Many companies operate their own dividend reinvestment plans. Rather than purchase stock on a secondary market, such as the New York Stock Exchange or NASDAQ, common stock is bought directly from a company's share reserve. Once the direct stock is purchased investors then have the option to enroll in the dividend reinvestment plan with the company to build up a holding of more shares. Companies do this directly or, more commonly, through a third party called a transfer agent that handles investor relations. Companies like Coca Cola ( KO ), Kellogg ( K ), Colgate-Palmolive ( CL ), Microsoft ( MSFT ), and Johnson & Johnson ( JNJ ) participate in direct purchasing and dividend reinvestment plans with transfer agents.
Usually these direct purchase and reinvestment programs allow investors to buy partial stock in a company with their dividend. For instance, if a $10 stock that pays a $1 dividend is in a DRIP then that $1 will be reinvested to purchase one tenth of a share. This is a convenient way for an investor to start off with a limited number of shares that can build up over a long term period. Also, many companies' DRIPs allow for an additional cash purchase of more shares directly from the company at discounted rates.
Not all companies have direct DRIP programs, however many brokerage firms fill this void by also offering their own DRIPs through purchase of stock in the secondary markets. The brokerage run DRIPs operate much like company and transfer agent programs, sometimes with little to no brokerage commission fees for the transactions of buying the shares with the reinvested dividends. However, investors do not have the advantage of optional cash purchases and partial share purchase in brokerage-run DRIPs. Brokerages may also charge higher fees than company-run DRIPs, so be sure to ask your broker before enrolling.
Since the purchases within DRIPs are done automatically, the price paid for the shares through the dividend reinvestment is determined by an average costs of the share price over the given time period of ownership of stock. This system is in place so an investor does not pay for the stock at its highest or lowest prices.
DRIPs are very beneficial to help build up wealth if the company has substantial gains over time. For example if you had $2,000 invested in Pepsi in 1980, that would be worth more than $150,000 by the end of 2004. You would have started with 80 shares, but by reinvesting dividends, you'd now have 2,800 shares. The opposite is also true, if a company goes under then an investor will lose the money reinvested, never seeing the benefits of the dividend payouts. This is the risk and reward basis of investing. Investors need to always keep the pulse of the company that they are invested in to make sure they come out on top.
Other Issues with DRIPs
There are a few issues that need to be considered when thinking about investing in a DRIP. If an investor does not need the cash dividend a company pays immediately, then a DRIP is acceptable alternative to traditional dividends. However, if a steady dividend payment is needed as a source of income, then a DRIP is not an efficient way to manage dividends. DRIPs are a way to build up additional shares over time for a potential payoff in higher capital gains. Investors also need to be aware that the dividends that are reinvested are still seen as a source of income and therefore taxable. That's right - just because you decide to automatically reinvest the dividends, never receiving any cash, Uncle Sam still gets his cut.
Also, depending on what kinds of DRIPs an investor is involved with, it can be hard to track all of the transactions and purchases that have occurred over the years. The DRIP information could be spread out over several companies,transfer agents, or brokers, rather than in a single online brokerage account file. Extensive records need to be kept by an investor to maintain the proper information to help with income and tax related questions that might come about down the road. Keeping track of these records can be time consuming, or costly if done by an outside source such as an accountant. More problems could arise if the DRIP is with a company that is merged, sold, or involved in restructuring that can bring uncertainty to investors.
Shares bought in DRIPs are usually not easy to liquidate. Many times investors can not immediately sell at market price. It is not as easy as just calling a broker or hitting a button. Investors need to take into consideration the time it might take to sell off shares and at the price at which the sale will take place.
The Bottom Line
DRIPs are a nice alternative to the traditional dividend cash payout. However, an investor needs to be ready to put in the research and work to determine if a DRIP is the optimal investment strategy. DRIP investing can bring a change of pace and potential diversification to a portfolio, but it can result confusion and high costs if not properly managed. An investor just needs to take into account their needs and expectations of their investments to determine if a dividend reinvestment plan is right for them.