Dividend reinvestment rate plans (DRIPs)
DRIPs allow stockholders to have the company automatically use funds that would have been placed in employees' 401K or company pension plans to be used instead to purchase additional shares of the firm. A chief popularity of DRIPs stems from the fact that there are no brokerage fees associated with the transaction. The chief negative associated with DRIPs is that they can also lead to a negative cash flow situation since the receiving shareholder must pay taxes on the shares just as if he/she were receiving cash dividends (unless the plan is tax-deferred).
Perhaps the biggest negative of a DRIPs plan is that it can lead to loss of the employee's retirement portfolio diversification. When the DRIPs stockholder is also an employee of the company this can easily occur. The automatic nature of DRIPs in this situation means the employee uses some (or all) of the retirement contribution of his/her paycheck to reinvest in the company's stock. This can quickly over-weight the employee's retirement portfolio in favor of the company's stock and reduced portfolio diversification benefits result. All is fine as long as the company's stock price is rising. However, this is not assured. Such was the case with many employees of now-defunct companies as Enron and WorldCom. Employees on the receiving end of reinvested dividends were not paying attention to the loss of diversification effects as their retirement nest eggs became concentrated in company stock. You know the rest of the story . . .
Summary of influences on the firm's cash dividend policy
It is appropriate to close with some general conclusions about the corporation's cash dividend procedures that we see in practice:
- firm's try to maintain stable and smooth dividends over time even in the face of poor or negative earnings.
- firm's do publicize their dividend policy.
- Transitory changes in earnings are unlikely to affect a firm's dividend payout.
- Managements tend to change dividends only after a long-run sustainable earnings pattern is recognized.
- Managers and stockholders focus more on an unanticipated change in dividends than on the dollar level of dividends.
- Managers are unlikely to make a dividend change that may have to be reversed. They are particularly concerned about having to recind a past dividend increase.
