Long time Simply Safe Dividend readers will know that we’re big fans of Dividend Reinvestment Plans (DRIPs).
That’s because anything that helps automate investing and keeps you focused on the long-term is great for helping you maximize the compounding power of successful dividend growth investing.
However, there is an even better option out there, for customers of Scottrade, that has the potential to improve your long-term total returns even more.
Find out why a Flexible Reinvestment Program (FRIP) may be a superior choice, but also what limitations it has.
What Is a Flexible Reinvestment Program (FRIP)?
Scottrade (the only discount broker to offer a FRIP) lets you use the power of automated, commission-free dividend reinvestment, but in a more focused and targeted manner.
Specifically, you can select most stocks or ETFs to divert the dividends into a shared pool. Then you can select up to five stocks or ETFs into which to reinvest those pooled dividends commission free.
Why is this a potentially better option than a traditional DRIP? The answer lies in the differences between these two types of programs.
FRIP vs. DRIP Comparison
As you can see below, there are several important differences between the DRIPs offered by most discount brokers and Scottrade’s FRIP.
By far the most important is the mechanics of the FRIP program compared to a standard DRIP.
For example, in a DRIP a stock’s, ETF’s, or mutual fund’s dividends will be automatically reinvested into additional shares or units of that same holding, via a market order on the pay date of the dividend. Note that optional dividends (when a company is bought out and offers to pay investors in shares or cash) and special dividends generally are not eligible for DRIP plans.
Most DRIPS also allow fractional shares, which means that if an investment’s dividend isn’t large enough to buy an entire share, you still benefit from having all of the income working for you and compounding your long-term wealth and income.
Scottrade’s FRIP on the other hand is a bit different, in ways that are both better and worse depending on your needs.
The program works by letting you select any eligible stock or ETF (mutual funds are not eligible) and the dividends from these investments are put into a non-interest bearing account.
You can then select up to five stocks or ETFs into which to reinvest these dividends, in whole shares (no fractional shares), in any percentage you wish. The selection of which five securities you reinvest the dividends can be changed at any time, either online or by calling a Scottrade office.
So, with the limitations of the FRIP plan, including: only five securities at once, no mutual fund eligibility, and no fractional shares, why is the FRIP potentially better than a DRIP?
Simply put, a DRIP plan is a great, automated way to dollar cost average, meaning add to a position each quarter, regardless of price. This is a powerful tool because it helps you keep a long-term focus on investing rather than fall into the trap of short-term speculating or market timing.
However, the downside to a DRIP is that this form of capital allocation, while better than market timing, isn’t optimal. For example, say you own shares of Caterpillar (CAT), which has strongly outperformed the S&P 500 over the last year.
The reason for this strong rally is the hope that the Trump administration’s promise of huge tax reform, and up to $1 trillion in new infrastructure spending will create a major demand boom for the company’s industrial machinery.
However, this is a somewhat speculative rally, not backed up by the company’s continued weak fundamentals (sales, earnings, and cash flow have been declining for years due to a global mining recession).
This means that shares of Caterpillar could be overvalued today, and thus if you DRIP its shares you are potentially buying at a poor margin of safety (i.e. discount to intrinsic value).
Instead, Scottrade’s FRIP allows you to channel all your dividends to your most undervalued names, and even lets you schedule when you will buy them on a monthly or quarterly basis.
This means that your dividend capital allocation can be optimized to maximize your long-term wealth and income compounding, creating potential for your portfolio’s value to increase more substantially over time.
Limitations of FRIP
FRIP’s flexibility also means it’s not for everyone.
For example, because you can’t buy fractional shares, to maximize the benefit of quarterly dividend reinvestment you will need to have a large enough portfolio that you’ll generate significant dividend income. Otherwise your dividends will sit in your FRIP pool until they have accumulated enough funds to buy full shares of your selected, undervalued stocks.
In addition, to fully take advantage of FRIP you will need to devote some time and effort into following your stocks, in order to know which are the most undervalued at any given time. That’s because the limit of just five securities that can be bought via the dividend reinvestment pool means that you have to be selective about where you reinvest your dividends.
Because most people have busy lives and many don’t have the interest in tracking companies frequently (on a quarterly basis), a DRIP plan’s “set it and forget it” approach can be an easier and less time-intensive approach to building your wealth and income.
Finally, because Scottrade is the only discount broker to offer a FRIP, keep in mind that if you want to go with this option, you’ll have to open an account with that broker. That means paying $7 per trade in commission in order to buy your securities.
While that’s not a high cost, it’s also not the lowest that you can find compared to other brokers (many that offer DRIPs) but charge as little as $4 per commission.
Other FRIP Details to Know
If FRIP sounds like a good fit for you then you’ll need to open an account, either regular taxable or an IRA, with Scottrade.
After funding your account through five options, including electronic transfer (ACH is free), electronic stock transfer from another broker, mailed check, wire transfer, or stock certificate deposit, you can set up your FRIP online or by phone with your nearest branch office.
Finally, be aware that, just as with DRIPs, your dividends may be exposed to foreign tax withholding (unless in an IRA) for shares in companies incorporated overseas. The amount withheld can vary between 10% and 35%, depending on the country.
In order to recover these withheld dividends you’ll need to file an IRS form 1040 to get a foreign tax credit, or the more complex and time consuming form 1116 (for which the instructions alone are 24 pages long) to fully recover the withheld payout.
In addition, just like DRIPs, FRIP dividends held in a taxable account will be liable for the same tax treatment as the underlying security. For most stocks, specifically those classified as regular corporations, these are qualified dividends, meaning taxed at the same rate as long-term capital gains (0%, 15%, or 20% depending on your marginal tax bracket).
Concluding Thoughts on FRIPs
While Scottrade’s FRIP may not be for everyone, if you have a relatively large portfolio and have the time and interest to follow your holdings rather closely, then its superior flexibility and ability to target where your dividends get reinvested could be a reasonable way to optimize your portfolio’s long-term income and wealth compounding power.