What is a dividend reinvestment plan?

Dividends are a nice little bonus that comes with owning shares, but if you think you’d be better off if the cash were reinvested, then you may want to learn more about dividend reinvestment plans.

What is a dividend?

To understand what a dividend reinvestment plan is and how it works, you’ll first need a strong understanding of dividends.

When a publicly held company makes a profit the board of directors have to decide where the funds will go. Either the company retains the profits to invest back into the business or the decision is made to pay out dividends to shareholders. Sometimes, it can be a mixture of both. When ASX-listed companies decide to pay out dividends they generally do so bi-annually. And this cash payment is usually a percentage of the profits relative to the number of shares you own in the company.

For example, let’s say that company XYZ makes a $10 million profit. The board decides to pay out 70% ($7 million) of the earnings and retain the remaining 30% ($3 million) for business expansion. The company has 1 million shares on issue. Therefore, each shareholder is entitled to receive a dividend payment of $7/share.

If a company has had a particularly profitable year dividends may even be increased. Generally, dividends are sent to shareholders either via a cheque or transferred by direct credit.

Related article: Should you reinvest your dividends or take the cash?

How does a dividend reinvestment plan work?

Some companies allow shareholders to automatically reinvest all or part of their dividends to buy new shares in the company, this is known as a dividend reinvestment plan (DRP). When using a DRP, sometimes shareholders will receive the new shares at a discount compared to market price and can avoid paying brokerage fees. If you don’t want to reinvest all your dividends you will have the option to select a percentage to be reinvested, e.g. 70%.

Investors who like to take the ‘set and forget’ approach may find DRP appealing as it is all automatic and they won’t need to intervene. In contrast, investors who are looking for an additional income stream from their investments will likely not benefit from a DRP.

It’s important to note that not all companies offer dividend reinvestment plans and even if they do, there is no guarantee that they will continue to do so.

How can you set up a dividend reinvestment plan?

Probably the simplest way to set up a reinvestment plan is through a share registry like ComputerShares and Link Market Services. A share registry is the liaison between investors and companies. Share registries will act on behalf of companies and contact investors on all shareholder matters, including the payment of dividends.

To set up a dividend reinvestment plan through ComputerShares simply go to ‘my profile’, then ‘reinvestment plans’, select the company and decide if you want all or part of your dividends to be reinvested.

With Link Market Service you will need to click on the ‘view details’ of the company of interest and update it in the payments and tax section.

Who offers a dividend reinvestment plan?

At the time of writing, there are a number of companies that have DRPs including:

• Commonwealth Bank
• Rio Tinto
• BHP Group
• Wesfamers LTD
• Suncorp Group
• Fortescue Metals Group Ltd
• Platinum Asset Management
• Qantas

Some ETF providers also offer DRPs, including Betashares. Much like with shares you can set up an DRP for your ETF/s through a share registry.

Pros of dividend reinvestment plan

There are a number of benefits of DRPs including:

Avoiding brokerage fees

When you reinvest your dividends you can avoid brokerage fees as there is no broker involved. This can be a very cost effective way to obtain new shares, especially for small trades.

Dollar cost averaging

Dollar cost averaging is a popular method of buying shares. Instead of investing all of your capital in one go, the idea is that you invest smaller, fixed amounts on a regular basis over an extended period of time. The price of the asset you’re buying may go up and down over that period, but you always invest the same amount.

What happens is that you end up buying more of the asset when the price falls in any given month, and fewer units if the price is higher. DRPs incorporate a similar idea to dollar cost averaging, with your money being regularly reinvested back into the same company, and gradually growing your investments .

Compounding growth

From a purely mathematical perspective reinvesting dividends generally has the advantage over taking your dividends as cash, because of the power of compounding.

Discount on the market price

Some DRPs offer new shares at a discounted price to the market price. And these discounts can range from 1-5%.

Franking credits

Despite your dividend being reinvested through a DRP, generally investors will still receive a franking credit.

Cons of dividend reinvestment plan

There are a few drawback as well, including:

Not ideal for all investors

As mentioned, DRPs are not ideal for income investors who are investing with the goal of creating an income stream. DRPs also don’t typically suit short-term investors, as obtaining shares on the market is much faster than through a DRP. Especially, considering most dividends are paid bi-annually. Short term investors may prefer to take the cash instead of reinvesting.

Unbalances your portfolio

When you invest you should devise an investment strategy that suits your investment style and this should be reflected in your portfolio’s asset allocation. However, with a DRP automatically issuing new shares in a particular company, this may throw off your ideal asset allocation and reduce your diversification.

Tax implications

Despite choosing to reinvest your dividends, for tax purposes you will need to treat the transaction as though you had received the cash. Therefore, you should declare the dividend as income in your tax return and the additional shares are subject to capital gains tax. To learn more, visit the ATO website.

Is a dividend reinvestment plan right for you?

When deciding if a DRP is worth doing, you should consider your investment goals and strategy. If ever in doubt seek the advice of a professional financial adviser.

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