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Beware the hidden costs of DRPs

10 Nov 2012 SYDNEY MORNING HERALD - JOHN KAVANAGH



Dividend reinvestment plans are popular, but investors must remain vigilant, writes John Kavanagh.

Like many large companies, ANZ operates a dividend reinvestment plan. Investors can choose to take their dividends in the form of new shares in the company, rather than cash. The scheme has been reasonably generous, offering to issue the new shares at a 1.5 per cent discount to the market price.

ANZ shareholders like this deal, which can be seen in the fact that the participation rate has been about 40 per cent in recent years.

But all good things come to an end and last month the company announced it would be dropping the discount from its DRP. The scheme will still have some appeal - it gives shareholders a mechanism for acquiring shares without having to pay brokerage - but the decision should prompt ANZ shareholders to review their use of the plan.

ANZ's decision is a reminder that DRPs are not set in stone. Companies may adjust or withdraw a discount on the issue price, or they may suspend or withdraw a plan altogether. Playing around with DRP arrangements is part of what chief financial officers call capital management.

Telstra, which is popular with investors looking for dividends, suspended its DRP in 2008 and has not reintroduced it.

Some companies, such as the energy company Woodside, announce whether they will offer a discount with the DRP when they declare dividends. Woodside is currently not offering a discount.

Just as companies reassess their DRPs from time to time, investors should overcome their tendency to set and forget. They should include a review of their participation in these schemes as part of their regular investment planning.

One of our great shortcomings as share investors is that we often sit on our hands, despite changing circumstances.

Almost half of all adult Australians own shares - that's more than 7 million people, according to an Australian Securities Exchange survey. However, the research company Investment Trends estimates that fewer than 1 million of us are active, meaning that we have traded shares in the past 12 months.

Most people buy some shares and maybe sign up for the DRP, and then leave them in the bottom drawer for years. Some are happy with the portfolio they have put together and are content to leave things as they are. But many sit on their holdings because they feel they don't have the skills to make decisions.

There is plenty of debate about whether it makes sense to use a DRP. The appeal is that the new shares are usually issued free of brokerage and often come at a discount to the market price.

Another attraction of DRPs is that they are a form of dollar cost averaging. By electing to receive additional shares instead of a cash payment, the shareholder is acquiring new lots of shares regularly. By "averaging in" in this way, the investor removes timing risk from the investment decision.

However, there is one unappealing aspect to using DRPs. Each time investors acquire new shares, they establish a new cost base. Over time, the holding in a stock might include a number of parcels, acquired at different times and with different cost bases and tax outcomes.

When stock is sold, the accounting of such a holding for capital gains tax will be complicated and may involve additional cost. What is gained at one point of the transaction might be lost at the other.

If an investor takes part in a DRP, the Australian Taxation Office treats the arrangement as if the investor had received a dividend and then used the cash to buy additional shares. On the income tax front, the dividend is taxable income, whether paid in cash or issued as new shares. Some investors receiving substantial dividends might need the cash to pay their income tax, and this may limit their ability to participate in DRPs.

On the CGT front, each parcel of shares acquired in a DRP has a cost base for calculating CGT - the price paid for the shares and any costs involved in the acquisition.

Some financial planners recommend that their clients avoid DRPs, regardless of the tax complications. They prefer to see them accumulate dividends in a cash account and then buy new stock after making a review of the performance of their portfolio and reassessing their investment goals.

Most private investors hold only a small number of stocks.

Another argument planners use against DRPs is that they perpetuate small portfolio holdings, whereas most private investors should be aiming for a higher level of diversification.

One reason DRPs are subject to change is that institutional shareholders don't like them. They rarely participate in them and see the issue of new shares to private investors as diluting their return on equity. Companies have to balance the competing demands of big and small investors.

Another reason DRPs change is that balances in company franking accounts change. As companies pay their tax they are given franking credits, which go into a franking account until they can be distributed with dividends.

Companies have to manage their franking accounts those credits are of no value to the company and must be released to shareholders through the payment of dividends so their value can be realised.

What companies do is set high dividend payout ratios and offer a DRP, assuming that a lot of the dividends they have paid out will flow back.

Last week, Westpac revealed that the interim and final dividend it declared during its 2012 financial year, adding up to $1.66 a share, was equivalent to 74 per cent of its profit. With a DRP take-up of about 20 per cent, the dividend payout comes back to about 63 per cent.

When Westpac was challenged about its dividend payout and DRP policies at an investor briefing last year, the bank's chief financial officer, Phil Coffey, said: "One of the factors that we have as part of our overall capital base is a very strong franking surplus and what we have elected to do over the last few halves is keep the dividend up a little higher to return those franking credits at a faster pace than would otherwise happen.

"That's the balance that we have been trying to achieve.

"We look to make sure we don't offer the DRP with a discount, so it's not as if we are disadvantaging shareholders by selling the shares cheaper."

To the extent that high dividend payout ratios help companies distribute franking credits, shareholders are better off.

The DRP allows them to choose whether to reinvest or take the cash.