DRIP, is an acronym for a Dividend Reinvestment Plan. It is a system of automatically reinvesting dividends in additional shares of the same stock in lieu of receiving cash dividends thereby increasing one’s equity in a position over time. It comes in two forms – an authentic DRIP sponsored by the issuing company and a pseudo-DRIP where a brokerage automatically reinvests dividends according to the instructions provided by the investor. This can be an efficient form of commission-free dollar cost averaging using a fixed dollar amount (the dividend) to purchase fewer shares at higher market prices and more shares at lower market prices. For those situations where the goal is to build additional equity and forgo cash dividends, it is a great strategy for traditional equities. However, there are two types of investments where this system is not advisable.
First, employing a DRIP strategy for Master Limited Partnerships (MLPs) is almost always not a good idea and is not a tax efficient strategy for investors that depend on MLP distributions to supplement their income in retirement. Unlike traditional equities, MLP distributions, with few exceptions, are not dividends, but in fact, Return of Capital. When selling traditional dividend paying equities with dividends reinvested in a DRIP, the tax liability will be treated simply as a short term or long term capital gain or loss, computed by the net difference between the purchase price and the selling price. Prior dividends were already taxed in the year that they were received. With MLPs, it’s not that simple.
Due to the treatment of Return of Capital, the cost basis of MLP sales must be reduced by the earlier distributions received for the lots being sold. This will result in an increase in the taxable capital gain at sale beyond the simple difference between the purchase price and selling price. This additional tax liability for sales of MLP units often comes as a surprise to many uninformed investors, thereby wiping out much of the deferred tax benefit enjoyed in earlier years. If the intent of using an MLP DRIP strategy is solely for the benefit of heirs and not for income, then it becomes a reasonable strategy, as the cost basis will be stepped up for them upon the original investor’s death.
Notwithstanding the benefit of a stepped-up basis for heirs, tax efficient MLP cash distributions should, at some point, be spendable and should therefore be taken as cash rather than additional shares. Further, to receive the maximum tax benefit, MLPs should be held in a taxable account as opposed to an IRA or 401K. One risk worth noting is the potential conversion of an MLP to a C-Corp. This conversion will result in a tax trap causing the MLP units to be sold as they are converted to common shares.
The second form of investment that I do not recommend DRIP purchases is preferred shares. Although qualified DRIP plans for preferred shares are not directly available directly from the companies themselves, the process can still be implemented through the reinvestment of dividends per the instructions issued to your broker. Preferred shares are typically issued at a Par value, usually $25.00 with a fixed coupon rate. Most often, they give the issuer the right, but not the obligation, to buy them back at a future specified call date at par. In a stable or declining interest rate environment, the universe of Preferred stocks tend to rise in value, and conversely decline as prevailing interest rates rise. Because the issuer has no obligation to redeem the shares at the call date, they will most likely not do so if rates have risen causing the market price of the issues to fall. On the other hand, if rates decline, causing market prices to rise, there is a good chance that the issuer will exercise its right to redeem preferred shares at par and reissue new shares at lower coupon rates than those redeemed.
The DRIP problem with preferred stocks is this. As shares climb above par in value because rates are rising, then dividends will be reinvested at the higher market prices, not par. By purchasing shares above par value as a result of DRIP instructions, the investor is in effect granting a no cost call option to the issuer to purchase those shares at below their original issuing price, locking in the probability of a principal loss to the investor.
Another factor to consider for any purchase of preferred stocks above par value is the Yield to Call (YTC) of those shares if the company chooses to exercise its redemption option. The coupon rate remains the same at the “when issued” price causing the effective yield on the investor’s purchase of shares above par to decline. For example, consider xyz preferred issued at $25.00 with a $1.50 dividend yielding 6%. If market conditions cause the same shares to rise in value to $28.00 and are purchased at that price either outright or through dividend reinvestment, the $1.50 annual dividend remains the same, but will now have a nominal yield of 5.4% based on the $28.00 purchase price. While a 5.4% yield may be deemed acceptable to the investor, there is a trap looming. If the call date is three years out and the shares are redeemed at par ($25.00), the effective “yield to call” on those shares will be 1.89%, not 6% or 5.4%. Even though a total of $4.50 in dividends were received during the three year period, a principal loss of $3.00 will be incurred as a result of the company’s redemption at par.