Summary: Australia’s big banks could place more emphasis on dividend reinvestment plans in the future in order to manage their capital position. This allows investors to take advantage of compound interest. But the downside is a lack of control, meaning investors could miss out on opportunities to spend dividends on cheap stocks during market downturns.
Key take out: Dividend reinvestment plans have their uses and banks may soon start discounting again, but organised investors can be just as efficient with dividend income outside the programs.
Key beneficiaries: General investors. Category: Bank stocks.
Australian companies are among the biggest dividend payers in the world - a report earlier this week from Henderson Global showed our largest stocks among the biggest dividend payers in the world in dollar terms. In fact Westpac came in as the world's fourth largest divided payer with ANZ squeezing into the top ten at ninth.
Now with the distinct threat that banks may have to seek more capital from shareholders as new capital adequacy requirements loom, the issue of Dividend Reinvestment Plans at the banks is back on the agenda. There is every chance that bank stocks may start or indeed enhance existing discounts to their DRP programs in the months ahead.
What's more, ANZ, NAB and Westpac are all set to pay annual dividends in the near future, so it's a good time to take a look at banks and their dividend proposals to retail shareholders.
The basics of a dividend reinvestment plan are simple – rather than receiving a cash dividend, investors receive an allocation of shares. Investors still have to pay tax on the dividend as though it were received as a cash dividend, regardless of whether or not they participate in the dividend reinvestment plan.
The following table sets out the dividend reinvestment program for the big four banks:
Dividend Reinvestment Available
Discount in Most Recent Dividend
National Australia Bank
There are a number of benefits that an investor might experience from investing through the dividend re-investment plan. The first of these is that additional shares are purchased without brokerage – although in the age of low-cost brokerage this is probably not a big factor for most investors. Shares may also be issued at a discount to their market price, providing a little more bang for your investment buck. Dividend reinvesting also sees the investor taking advantage of the “miracle” of compound interest, which Albert Einstein is reported to have described as the “eighth wonder of the world”.
Compound interest comes about through the reinvestment of investment income, so that in following years there is investment income earned on both the initial investment and the re-invested income. This seems to be a particularly attractive feature of dividend reinvestment plans for investors with a shareholding that offers diversification – for example a listed investment company like Argo Investments. In 2014 its dividend reinvestment plan ran at a 2% discount to the market price of the shares. Investors in Argo could use the dividend reinvestment plan to increase their exposure to the company over time, picking up extra shares at a slight discount, a particularly good strategy for young investors starting to build their investment portfolio.
Now while the benefits of DRPs are strong, there are downsides to using a dividend reinvestment plan. Chief among these is a lack of control – by taking your dividends as shares you are giving up the ability to build cash in your portfolio that you might then use to purchase any shares at any time. The recent market downturn provided some good opportunities to purchase shares, and investors who had chosen to take recent dividends as shares through dividend reinvestment programs may not have had cash at hand to take advantage of any buying opportunities that they may have seen.
The compounding effect of “dividend reinvestment”, where an investor uses the cash dividends from a portfolio to buy more assets, is just as powerful as a formal “dividend reinvestment program” from a company – it is just that the investor who reinvests cash dividends takes greater control over the timing of purchases, and the identification of which assets they wish to purchase. This also presumes the investor is organised and disciplined.
Dividend reinvestment plans have also provided many headaches for investors in calculating their capital gains tax position – the automatic addition of (usually) two parcels of shares a year provides a vast array of cost bases that have to be tracked to understand the capital gains tax position of a holding – however with greater automation of portfolio record keeping, this should be less of a problem. Even the online records held by the share registries are helpful in keeping on top of the various parcels of shares purchased through dividend reinvestment plans.
One somewhat more minor downside of a dividend reinvestment plan comes with the “leftover” money. Consider a dividend of $395 with a dividend reinvestment price of $80 per share. The investor will usually receive 4 shares ($320), with the remaining $75 being added to the next dividend to be paid – without any interest being earned over the six months. Commonwealth Bank explain the process this way in their dividend reinvestment plan rules:
“Commonwealth Bank will … carry forward any residual cash balance to the participant's DRP account for the next dividend. No interest will accrue or be paid in respect of residual balances in a participant's DRP account.”
All up DRPs have their uses, and better still banks may soon start discounting again - indeed NAB already has - but if you are organised you can be just as efficient with your dividend income outside the programs. In fact, it may be more lucrative.
Scott Francis is a personal finance commentator, and previously worked as an independent financial adviser. The comments published are not financial product recommendations and may not represent the views of Eureka Report. To the extent that it contains general advice it has been prepared without taking into account your objectives, financial situation or needs. Before acting on it you should consider its appropriateness, having regard to your objectives, financial situation and needs.