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Investing basics: pros and cons of dividend reinvestment plans

Nicki Bourlioufas  |  20 Aug 2021Text size  Decrease  Increase  |  
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Dividend reinvestment plans (DRPs) allow shareholders to reinvest their dividends in a company, often at a discount to the market price. They can be an affordable and effective way to for shareholders to boost their investment in a company. Yet there are pros and cons in deciding whether to participate.

What are DRPs and how can investors participate?

Companies that offer dividend reinvestment plans (DRPs) allow shareholders to reinvest some or all of their dividends in new shares, which may be issued at a discount to their market price at the time a dividend is declared.

Likewise, exchange traded funds (ETFs) and listed property trusts may offer unit holders the chance to participate in distribution reinvestment plans by using their cash distributions to buy additional units in the fund or trust.

To participate, a person must be hold shares in a company and they must elect to participate in the DRP through the company’s share registry. Shareholders may elect to participate in the DRP as either full participation, whereby all dividends payable for the shares held by the investor at the dividend payment date are treated as participating shares and are reinvested in the company.

The number of new shares allotted under the DRP depends on the value of the dividend declared and the market price of the shares, rounded down to the nearest whole number of shares. Any leftover cash dividend is carried forward for future dividend payments.

Partial participation allows shareholders to elect only a specific number of shares to participate in the DRP and receive the rest as a cash payment. For the specified number of shares not participating in the DRP, cash dividends will be paid to the shareholder.

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Any new shares issued under the DRP will be listed on the stock exchange like the shareholder’s existing holdings. Companies may modify or suspend DRPs at any time and shareholders can opt out of a DRP at any time too. Participation in any plan does not restrict shareholders from selling any of their shares at any point. So they are a flexible reinvestment tool.

According to Scott Keeley, senior financial adviser with Wakefield Partners, DRPs offer several benefits. 

Shareholders are usually not charged a commission or additional brokerage costs when buying shares and they are often issued at a discount to the market price. In addition, participating in a DRP ensures you do not purchase all your shares when the price is high.

“The ability to obtain more shares at no cost, and perhaps at a discount, is an excellent way of compounding your returns and steadily growing your portfolio,” says Keeley.

“It is essentially another form of regularly investing into the share market, which often provides excellent outcomes for long term investors.”

Discounts not always on offer

Whether a company offers a discount in the DRP on the current market price of the company's shares may depend on its size and how much its focus in on growth.

“Companies that are perhaps in a more growth-focused phase and would therefore like to retain capital often offer DRP at a discount as a small incentive for the investor to leave their dividend with the business, taking additional shares instead,” says Keeley.  “More mature, stable businesses (such as banks) which perhaps do not need the capital are less likely to offer a discount.”

According to HLB Mann Judd wealth management partner, Jonathan Philpot, even if a discount is offered, the size of the discount shouldn't be the decisive consideration in deciding to participate. Instead, investors “should be more based on their own individual needs and their personal share portfolio.”

As for the big banks, given they generally have significant surplus capital, discounts aren’t likely to be offered on shares under a bank DRP, says Nathan Zaia, Morningstar’s bank analyst.

“I wouldn’t expect banks to introduce a discount on the DRP any time soon. You usually only see a discount offered when the bank (or any company) is trying to encourage a shareholder to participate in the DRP, because they want to retain a little more capital than they otherwise would if the shareholder takes the cash payment,” says Zaia.  

Weighing the pros and cons of DRPs

HLB Mann Judd’s Philpot says DRPs are a great savings tool, particularly for investors who do not need the income for living purposes. 

“Often it suits those who are building up their wealth. Given that dividends form a large part of the overall return from Australian shares, if the dividends are then being reinvested into purchasing more shares, the value of the share portfolio will build much more quickly than those who do not participate in DRP’s and spend the dividend income,” he says.

“Also, with good companies, the share prices tend to rise over the long term, so often participating in the DRP of that business has meant good share purchasing along the journey; you build up more wealth in good businesses.”

The biggest downside of DRPs is investing in a stock that falls in price over time. “If the company’s price falls, say 50 per cent, all those DRPs now look like a poor investment. It is why you should regularly review your portfolio and make sure it is well-diversified and not too heavy in one particular stock or sector,” says Philpot.

Another downside is that administration and record-keeping is more complicated where DRPs are used; each parcel has its own cost base which can make the CGT calculations more complex if the shares are eventually sold, says Keeley. According to the ATO, if you participate in a DRP, you are treated as if you had received a cash dividend and then used the cash to buy additional shares for capital gains tax (CGT) purposes. 

is a Morningstar contributor.

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