What A Dividend Reinvestment Plan (DRIP) Is - And Isn't

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Includes: CL, JNJ, KO, MCD, MMM, XOM
by: The Struggling Millennial

Summary

With so many different investment strategies available, different investment vehicles can have a profound impact on your returns over time if you choose a vehicle poorly suited to your strategy.

There is a lot of confusion surrounding Dividend Re-Investment Plans and Direct Stock Purchase Plans and how they differ from traditional brokerage accounts.

The differences are profound and I will explain them below.

For those Seeking Alpha readers that follow me, you know that I am a huge fan of Dividend Re-Investment Plans [DRIP], and their slightly more flexible brother, the Direct Stock Purchase Plan [DSPP]. The DRIP and DSPP are two of the greatest investment tools for individuals - especially Average Joes - to use to build wealth throughout their lifetime. Sadly, the overwhelming majority of people are unaware these plans even exist.

Even more in-the-know investors are confused by these plans, misunderstanding their strengths and weaknesses. This was made very clear to me in a recent article I wrote, titled 5 Reasons Why I Continue To Buy Johnson & Johnson. For those who do not follow me, the Johnson & Johnson (NYSE:JNJ) Dividend Re-Investment Plan is one of my cornerstone investments - I have committed to this contribution day-in, day-out, through good times and bad times. Most readers were acutely aware of the power of an investment in Johnson & Johnson over time, but sometimes, just as important as the investment itself is the vehicle the investment travels in and there was a bit of a breakdown in the understanding of how a Dividend Re-Investment Plan functions versus a standard brokerage account. I would like to take this time to break down the differences because in this case, an investment in the same company will have a tremendous difference in performance over time given the investment vehicle used.

Dividend Re-Investment Plans (DRIPs) Versus Direct Stock Purchase Plans (DSPPs)

In a traditional brokerage account, when you purchase shares of a company, those shares are held in the name of the brokerage firm. For example, if you purchase 100 shares of McDonald's Corporation (NYSE:MCD) through a Scottrade account, those shares are not registered in your name. They are registered in whatever name Scottrade's holding corporation is. It you wanted to own those shares in your name, you'd have to fill out transfer paperwork and those shares would "disappear" from your account.

With Dividend Re-Investment Plans and Direct Stock Purchase Plans, you are directly purchasing stock from the company and registering it under your social security number. You're the owner - you'll get physical letters in the mail to vote on issues and select board members and all that cool stuff!

Further breaking it down, Dividend Re-Investment Plans and Direct Stock Purchase Plans differ slightly in their initial stages. To enroll in a Direct Stock Purchase Plan (DSPP), you do not need to be a current shareholder of record. You can simply navigate to the plan on their website, it'll re-direct you to their broker (the biggest player is Computershare) and you can instantly sign up as a shareholder of record once you hurdle a minimum initial contribution amount.

With a Dividend Re-Investment Plan, you must first be a shareholder of record to enroll in their plan. When I set up my JNJ DRIP, I purchased one single share through Scottrade, filled out their transfer paperwork and faxed it to my local branch (they transferred the share to me for free). The single share disappeared from my Scottrade brokerage account entirely. Then I went to Computershare's site and signed up - my Social Security Number was recognized as a current shareholder of record and the rest was history.

After initial setup, DSPPs and DRIPs function the same, so for the purposes of this article, we are going to stick to the DRIP acronym to carry us through.

DRIPs Versus Traditional Brokerage Accounts

The real confusion seems to lie when it comes to the function of DRIPs versus a standard brokerage account. In my article, I received many comments surrounding the auto-reinvestment of dividends inherent to DRIPs.

JNJ is an Excellent stock pick TSM, but why pay $1 per month to DRIP? At Schwab, it's free. Just click on the "reinvest" dividends box.

ETrade DRIPs are also free....really convenient.

Likewise Fidelity. I'm not sure what the minimum balances are, but the same miracle of compounding that makes the DRIP so mighty also applies to the fees.

Drips are free at Vanguard too.

Drips are free in TD Ameritrade as well as Wells Fargo.

This is all true - most brokerage accounts will automatically re-invest dividends without cost when a company does make a distribution. However, the limitations in traditional brokerage accounts are far more profound than what we can expect out of DRIPs, and this ignores the #1 reason to own a DRIP entirely.

DRIP Pros

  1. The #1 reason to own a DRIP is the Ongoing Automatic Reinvestment feature. This is the set-it-and-forget-it tool that will help the Average Joe investor build wealth beyond their wildest dreams and weather any economic storm given enough time. The cornerstone feature of these plans is that they will automatically deduct a predetermined amount of your choosing from your checking or savings account every single month on a predetermined date (or next closest business day). Most plans have a minimum ongoing reinvestment amount of $50 with a ceiling in the thousands, allowing people of any income class to participate. Traditional brokerage account fees cannot compete with the fee schedule of DRIPs. In fact, some DRIPs are completely free on the buy-side.

    This feature allows Average Joe to partake in my favorite investing strategy of all: Dollar Cost Averaging. Participating in the Ongoing Automatic Reinvestment option gives the investor 12 different buy-in points each year. Over the course of 30 years, that's 360 individual buys. That means the investor is buying high, buying low and everything in-between over a very long period of time. Over the decades, your purchase price will be the true fair value of the company with no short-term risk of a value trap. You will not have to worry about valuation - your only job as an investor is to pick excellent companies that will stand the test of time, a much simpler task when we're dealing with behemoths like Johnson & Johnson, Exxon Mobil (NYSE:XOM), 3M (NYSE:MMM), Coca-Cola (NYSE:KO), Colgate-Palmolive (NYSE:CL) and so much more.

    This is the feature that really sets DRIPs apart from traditional brokerage accounts and can really propel Average Joes that don't understand how to value a company to great success. The overwhelming majority of people don't understand how to value a company, but they DO know a great company when they see one, and this type of strategy can have a tremendous effect on wealth for a general public notorious for panic-selling when they should be buying the dip instead.

  2. DRIPs are the ultimate re-investing tool. While most traditional brokerage accounts do offer free dividend reinvestment, many limit the investor to whole shares only. DRIPs reinvest the entire portion, and track fractional shares to 4-5 decimal places or more. While there are occasionally fees for dividend reinvestment - most plans are free - it typically amounts to pennies. Individuals who enroll in automatic dividend reinvestment within a brokerage account but only own a few thousand dollars' worth of a position or less often cannot take advantage of the reinvestment feature each quarter because the dividend does not amount to a full share. This is never a concern in a DRIP.
  3. As mentioned above, the fee schedules are typically low. While DRIP fee schedules vary per plan - some are much lower than others, and some completely free on the buy-side - all are lower than setting up a similar dollar cost averaging strategy through a traditional broker.

DRIP Cons

While it is important to know what a DRIP is, it's just as important to know what a DRIP isn't.

  1. A DRIP is not a brokerage account for trading. If you initiate a manual buy or sell order through a DRIP account, it typically takes days to process. This is not the type of account to make a single large lump sum purchase to sit on and ignore for decades because you probably won't get the price you want. If this is your strategy, it is better to open up a traditional brokerage account that offers free automatic dividend reinvestment with partial shares, set up your limit orders accordingly and fall asleep behind the wheel. DRIPs excel when you don't have a lot of money and can only afford to contribute a few dollars here and there each month and slowly build a massive position over time.
  2. DRIPs typically have very high sale fees. It is a slow and costly process to liquidate a position. This is actually a pro to an investor like me. DRIPs are geared toward the income investor - accumulate a position over time with the intent to never sell and live off the dividend income. You can use this potential drawback to your advantage because if you commit to never selling your shares, you won't make the mistake overreacting and panic-liquidating your assets during an economic downturn. That is my personal goal with my DRIPs - accumulate a massive position over decades, never sell the principle, live off the dividend income later in life and leave what remains to my grandchildren in a trust with a stipulation that they can never sell the shares, only collect the dividend. It's sort of my own little Social Security policy.
  3. DRIPs have very low liquidity. It can takes days, sometimes more than a week, to sell a position no matter how large or small. Again, I consider this a pro for the typical investor because the limitations help keep hands out of the cookie jar. When you know you can't instantly get your money, you'll be less likely to sell. The #1 mistake most investors make is selling low, and the low liquidity nature of DRIPs help promote the strategy of buying and holding and never selling.

Tying It All Together

Now that we've gotten all the details out of the way, I would like to give you a real-world example of my Johnson & Johnson DRIP versus if I were to adopt the same strategy with a traditional brokerage account. The fee schedule for the DRIP is below:

Johnson & Johnson (click here for plan details)
a) Minimum purchase OR $25.00
b) Minimum ongoing automatic investment $25.00
Minimum shares required to enroll for existing accounts 1
Maximum Purchase $50,000.00 Per Year
PLAN FEES
Initial Setup Fee $0.00
Cash Purchase Fee $0.00
Ongoing Automatic Investment Fee $1.00
Purchase Processing Fee (per share) $0.00
Dividend Reinvestment Fee Company Paid
Batch Sale Fee $15.00
Batch Sale Processing Fee (per share) $0.12
Batch Maximum Sales Fee N/A
Market Order Sale Fee $25.00
Market Order Processing Fee (per share) $0.12
Market Order Maximum Sales Fee N/A

Since inception, I have been contributing $100/month to this plan. To date, I have made exactly individual 18 buys, which has amounted to a total of $18 in transaction fees (excluding the initial 1-share buy thru Scottrade). Since inception, this $18 in total fees has amounted to 0.839% of total asset value.

If I were to adopt this same strategy in my Scottrade traditional brokerage account, I would have accumulated $126 in fees to date (excluding the initial single share purchase), or 5.887% total fees.

The fees in my Scottrade account would have eaten away half of my returns, while the fees in the JNJ DRIP are relatively negligible by comparison. But the problems don't stop, there. Because Scottrade does not allow free dividend reinvestment with partial shares, I still would not have accumulated enough dividend income to purchase a single share of Johnson & Johnson stock at current market price. To date, I have had six separate FREE dividend reinvestments in my JNJ DRIP.

There are many different investment strategies out there, and depending on your strategy, different investment vehicles can have a tremendous impact on your returns. If you are like me and you don't have a lot of money for single purchases but have spare income every month and a lot of time on your hands, dollar cost averaging yourself a large position over time in a fantastic company is a tough strategy to beat. If this sounds like the kind of strategy you want to adopt, a DRIP is probably the best way to do it - it is certainly leaps and bounds above a traditional brokerage account.

Disclosure: I am/we are long JNJ, XOM, CVX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All information found herein, including any ideas, opinions, views, predictions, commentaries, forecasts, suggestions or stock picks, expressed or implied, are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. I am not a licensed investment adviser.