Investing 101: Dividend Reinvestment Plans (DRIP)

In addition to the Stock of the Week and Book of the Week features, I’ve decided to publish at weekly educational article, either on Finance or Investing. This week is DRIPs 101.

What is a DRIP?

First, what heck is a Dividend Reinvestment Plan or DRIP, anyway? Well, the short answer is that a DRIP is a specific type of investment plan, whereby the dividends you would be paid from a given stock (say, Citigroup) are instead automatically reinvested in the company’s stock. Typically you can also buy stock directly from the company (well, through their agent anyway), in varying amounts (very small to somewhat large). And best of all, the fees are typically quite low.

Key Reasons to Invest through a DRIP

So let’s expand on the main reasons to invest using a DRIP.

The ability to start small. In most cases, a single share of stock is all you need to enroll.
Discipline. Since the money is reinvested automatically, you get the benefits of dollar cost averaging. Also the emotion is removed from the equation, so you won’t be tempted put that money into another investment (or worse still, spend it!)
Low or No Fees. Most plans reinvest the money for no fee at all. Many also offer the ability to purchase additional shares (make an additional investment) for little or no fee. Many also offer scheduled investing (via a direct withdrawal) where you can invest very small amounts (say, $50 a month) over time. See also, discipline.
Discounts. Some companies even give you a discount to the current market price for shares, either for new purchases, reinvested dividends or both.
No Brokerage Account Required. While some brokers offer some DRIP services, many do not. But it doesn’t matter, as you don’t need a brokerage account. Which also means you can avoid most or all of the typical brokerage fees.
Diversification. Because you can invest small amounts, you can also afford to own a larger number of companies. Diversification also helps reduce your portfolio risk.

By now you might be thinking, well if these DRIPs are so great, why have I never heard of them before? Well, because companies can’t advertise them (SEC rules) and brokerages don’t advertise them (why encourage you to save money by cutting out the middleman – them?).

Types of Plans

There are really three types of plans, and depending on which one your target company uses will affect how you go about getting the shares and enrolling. The three types of plans are:

Company Run Plans. Some companies run their own plans. These usually require you to own your first share already. Generally calling shareholder or investor services (check their website) will get you in touch with someone who can explain their rules and procedures.
Transfer Agent Plans. Most companies use a transfer agent to handle the plan for them. These are specialized companies that are more cost effective because they are running plans for many companies at once (hundreds of companies in the case of the largest agents).
Brokerage Plans. Some brokerages (like my broker USAA) offer fee free DRIPs in your brokerage account. However, you still have to pay a commission (in most cases) to make additional cash purchases, which is one of the best features of a DRIP. Also, I cannot stress enough… be careful of the fees!

Getting Started with Your DRIP

OK, so you’re convinced. Sounds like a great idea. How do you get started?

First you have to decide what stocks to invest in. Choosing the right stocks, and creating a balanced portfolio is beyond the scope of this article, but here are few key suggestions to keep in mind: Buy what you know, invest for the long term (at least a 10 year time horizon) and try to invest in at least 5-10 different stocks (if you can afford to). There’s a lot more we could talk about (like industry diversification and value versus growth, but let’s stay on topic). You can search the major financial sites for “Dividend Stocks” as a way to get the gears turning. And, of course (shameless plug), you could always browse this site for ideas.

Here are a few places to look for ideas:

Next you need to acquire your first share(s) of the stock, if you don’t already own them. Regardless, you will also need to have those shares registered in your name, not in the “Street Name,” which is typically how shares are held in a brokerage account. Some plans offer “Direct Enrollment” but be careful of the fees. Since you will likely be investing small amounts, at least at first, even a seemly small fee can eat up your returns over time. Most of the best plans have no fees, as in “none”.

Some companies specialize in helping you get your first share and get enrolled. Here are a few of the most trusted names in the business:

You can also go directly to the “Transfer Agent” for your company’s DRIP plan, which is my recommendation. Here are the big names (all service 500 companies or more, I’ve listed a few big names to give you a feel for their client base):

ComputerShare (Bank of America, Pfizer, IBM)
Mellon Investor Services (American Express, Burger King, Caterpillar)
American Stock Transfer and Trust Company (Honeywell, Raytheon)

Final Thoughts

A final note on fees: “How much is too much?” Well, personally, I think if the fees are more than 1.5% in total, you should stay away. Where did I get that number from? Well, the average mutual fund charges an annual fee of, you guessed, 1.5%. So if you can do better than a typical mutual fund, I’d argue you’d be better off just buying low cost index funds and be done with it.

Two more resources, if you want to do more reading on the concept of DRIPs is DRIPinvesting.org. They’ve got tons of great articles and links to other useful resources. Also, here's a great post on the whole process of getting setup with ComputerShare.

I hope you found this helpful. Good luck!