What Is an Automatic Reinvestment Plan (ARP)?
The term automatic reinvestment plan (ARP) refers to a plan that automatically reinvests investment distributions back into an investor's portfolio. As such, they are reinvested rather than paid to the investor. This investment option is commonly found in dividend reinvestment plans (DRIPs) for a variety of investment vehicles, including mutual funds. Investors who use ARPs benefit because of compound interest. An ARP is not the same as an automatic investment plan (AIP), which allows investors to contribute new money to an investment account at regular intervals to be invested in a pre-set strategy or portfolio.
- An automatic reinvestment plan reinvests investment gains back into an investor's portfolio rather than paying them out as distributions.
- ARPs are commonly found with different investment vehicles, such as mutual funds and employee stock options.
- They are offered by brokerage firms, mutual fund companies, and public companies.
- Investors can use ARPs to take advantage of compounding.
- Don't confuse ARPs with automatic investment plans, which let investors make regular contributions to an investment vehicle automatically.
Understanding Automatic Reinvestment Plans (ARPs)
Some people invest their money to generate income. Gains accumulated through these investment vehicles can be taken as cash distributions at regular intervals. But there are some options that allow investors to use their gains to increase their positions in the investment. As such, gains are automatically reinvested back into their portfolios through a program called an automatic reinvestment plan.
ARPs are common in different investment options, such as mutual funds and employee stock options (ESOs). Brokerage firms are known to offer ARPs to their clients, as do mutual fund companies and publicly-traded companies to their shareholders. In the case of a mutual fund, for example, capital gains and fees produced by the fund would be used to automatically purchase more shares instead of being distributed to the investor as cash.
ARPs help investors take advantage of the compounding effect to produce further gains. The added value produced over a period of years by automatically reinvesting gains can turn out to be worth a substantial sum. For instance, opting to reinvest a mutual fund's gains results in purchasing more shares of the fund. More compound interest accumulates over time and the cycle of purchasing more shares continues to help the fund. As such, an individual's initial investment in it grows faster in value.
Reinvested gains can include dividends, distributions, and capital gains, among others.
Automatic reinvestment plans are a great way to take advantage of compound interest. But taking the dividends and reinvesting in other parts of an investment portfolio can help increase diversification, since reinvesting the dividend back into the same mutual funds means that you're keeping a growing pile of eggs in the same basket. It may be prudent to use the dividends to create secondary safe harbor investments. Reinvesting dividends elsewhere can also be part of a rebalancing strategy.
Benefits of an ARP
As noted above, one of the benefits of reinvesting the gains earned from an investment is compounding. Compound or compounding interest is calculated on the initial principal balance and on the accumulated interest of previous periods of a deposit or loan. Compound interest can be thought of as interest on interest and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount.
In order to calculate compound interest, multiply the principal amount by one plus the annual interest rate raised to the number of compound periods minus one. The total initial amount of the loan is then subtracted from the resulting value.
Here's how it works using a hypothetical investment. Consider investing in a mutual fund with an initial deposit of $5,000 and subsequent ongoing annual additions of $2,400 at the beginning of each year. With an average of 12% annual return over 30 years, the future value of the fund is $798,500. Remember that compound interest is the difference between the cash contributed to the investment and its actual future value (FV). In this case, the cumulative interest is $721,500 ($798,500 - $2,400 x 30 = $721,500).
Automatic Reinvestment Plan (ARP) vs. Automatic Investment Plan (AIP)
As mentioned earlier, an ARP is different from an automatic investment plan. While an ARP allows investors to reinvest any gains from an investment back into the plan, an AIP lets investors make regular contributions to an investment account automatically. This is normally done through payroll deductions or by debiting a bank account.
AIPs are common options for retirement planning, such as through employer-sponsored plans 401(k)s and individual retirement accounts (IRAs). People may also choose to have money transferred automatically from their checking to savings accounts.
Example of an ARP
One example of a type of automatic reinvestment plan is a DRIP, which is a program that allows investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date.
A DRIP can be set up as an automatic reinvestment arrangement set up through a brokerage or investment company. As mentioned above, this option can be initiated directly by a public corporation to its existing shareholders.