The deficit threat to dividends

A slew of corporate collapses in recent times has fuelled this fire. It has been nearly two years since construction giant Carillion crumbled, leaving behind a pension deficit of around £600m. Meanwhile, in 2017 the Pensions Regulator secured £363m for the BHS pension scheme from Sir Philip Green, a former owner of the beleaguered shopping chain. Both companies attracted criticism for paying out dividends as they marched towards the brink with substantial pension deficits in tow. 

We are now mired in a deficit in trust between politicians, regulators and the boardroom. Watchdogs and elected officials are training their fire on companies with the intention of averting disaster before they go to the wall. In April 2018, former De La Rue (DLAR) chief executive Martin Sutherland received a letter from Frank Field, chair of The Work and Pensions Select Committee, decrying the banknote producer’s dividend policy. Mr Field observed that between March 2011 and September 2017, De La Rue’s deficit had increased from £103m to £191m while paying out £231m in dividends over this period, and asked whether, “in view of the substantial pension deficit”, proceeds from recent divestments would go towards plugging the deficit. 

In response, Mr Sutherland highlighted a working group set up by the company and the scheme trustees in 2017 with the aim of tackling the deficit. He pointed out that as of March 2018, the deficit had dropped to around £100m from £239m in the prior year. De La Rue has since continued with its efforts to bring down its scheme deficit, and as of September 2019, the scheme’s net deficit sat at £37.9m. It also recently scrapped its dividend, with the viability of the business now firmly in question.

In one case, this direction of travel has even managed to suspend a dividend policy altogether. Earlier this year, the Pensions Regulator secured a commitment from an unnamed company to cease dividend payments for six years in favour of a more generous deficit recovery plan. The DB scheme is now better funded after an upfront payment of £10m, a reduction in the recovery plan length from 13 to seven years, annual deficit recovery payments of £3.7m and the suspension of the dividend policy, the regulator says. “We will continue to intervene where we have concerns that a DB scheme is not being treated fairly by an employer,” Nicola Parish, the regulator’s executive director of frontline regulation, said at the time. 

Some criticism of dividend policies may be merited, and experts agree that companies are taking a more proactive role in ensuring the viability of their schemes. This appears to be paying off – 46 per cent of FTSE 350 companies now run an accounting surplus, a level that has doubled from 23 per cent just five years ago, according to consultancy Barnett Waddingham. In the past year, FTSE 350 DB pension scheme deficits have fallen by nearly a third, from £55bn to £39bn. 

This increases the prospect of companies seeking to transfer their pension liabilities to an insurer in what is known as a buyout, which would significantly strengthen their balance sheets. One in 20 FTSE 350 businesses will be in a position to buy out their DB schemes in the next two years, Barnett Waddingham says. This will be attainable for 21 per cent of the FTSE 350 in the next five years, while over half will be able to do so in the next decade. 

One in five FTSE 350 companies could now afford to buy out their DB scheme using less than 10 per cent of the cash on their balance sheet. While achieving a surplus is insufficient for conducting a buyout, most FTSE 350 financials and utilities companies have schemes with accounting surpluses, which is worth bearing in mind for prospective investors.

DB schemes still account for two-thirds of FTSE 350 company spending on pensions, though. “DB scheme liabilities have long weighed on company balance sheets,” observes Nick Griggs, head of corporate consulting at Barnett Waddingham. “Despite the measures taken to limit their cost,” he adds, “they remain a far greater drain on resources than their defined-contribution (DC) counterparts”.

Investors must consider the impact of a scheme deficit when assessing a company. An arduous deficit recovery plan may act as a drain on capital that could otherwise have been spend on investment in the business or acquisitions. But taking a baton to greedy shareholders is unlikely to guarantee a positive outcome for pension schemes. It could inhibit the business's long-term ability to fulfil its duties as a scheme sponsor. Ensuring the viability of pension schemes is a laudable objective that sits in the interests of shareholders as well as pensioners. Schemes must be treated equitably alongside a company’s corporate objectives. This cuts both ways. The destruction of shareholder value wrought by an excessive approach to pension scheme stability should be a concern for investors beyond those focused on income. 

Beware unsustainable dividends

The challenge of maintaining a sustainable pension scheme for companies in 2019 has been amplified by a volatile year for DB scheme funding. In August, the aggregate deficit of the UK’s 5,450 corporate DB pension funds leapt by £100bn to £340bn, according to PwC’s Skyval index, its highest level since 2018. But in November, it fell by £30bn to £190bn – its lowest position since May, when it hit £180bn. “The reduction in deficit this month is mainly due to a rally in global equity markets boosting pension fund's assets over November,” says PwC’s chief actuary, Steven Dicker. 

“The volatility, including the recent run of deficit reductions, has been due to continued economic uncertainty impacting real asset values globally and UK government bond yields in different ways at different times," he adds. Low interest rates have dragged down bond yields, reducing the payout schemes can expect from their allocation to bonds and adding pressure to scheme funding.

This is set against an environment of higher profits and falling global dividend cover. Global profits rose last year to a record level, but dividend cover was forecast to sit at a 10-year low, according to Henderson International Income Trust research. Dividends have grown at an annual rate of 10.3 per cent, outpacing 6.5 per cent profit growth. Global dividend cover was therefore expected to drop to a multiple of 2.2 this year. The UK has the third-lowest cover in the world, at a level of 1.6. “Investors need to tread carefully,” says Ben Lofthouse, Henderson International Income Trust fund manager. “Our research shows that dividends from approximately one-fifth of the world’s companies... are potentially unsustainable, especially if the global economy weakens.”

Some of the highest-yielding stocks in the FTSE 100 fall beneath an average 2019 forecast dividend cover of 1.56, according to research from AJ Bell. For example, BT (BT.) shares yield around 8 per cent, with a dividend that has cover of approximately 1.4 on an earnings basis, or just 0.7 on free cash flow. BT’s pension deficit widened in 2019 from £6.8bn to £7.2bn, despite the company making £2bn in pension deficit payments, compared with £1.5bn in dividends. Its pension scheme was the joint second-worst funded in the world in 2016 according to MSCI research, and some analysts expect BT to trim its dividend.

When Centrica (CNA) cut its dividend by more than half at its half-year results in July, group chief executive Iain Conn cited increased demands on the energy company’s cash flows, which included “additional pension contributions” – its scheme deficit was calculated at £1.4bn following its triennial valuation. Centrica’s overall deficit contributions, including the previously disclosed asset-backed contribution arrangements, will amount to £223m in 2019, falling to £175m a year from 2020 to 2025 before “a balancing payment of £93m in 2026”. These payments are likely to represent a fairly sizeable proportion of its full-year cash flow – Centrica registered net cash flow of £1.9bn in 2018, and these levels are falling.

“In the past couple of years, we’ve seen greater scrutiny and pressure to effectively restrain dividends and ensure that pension schemes are at least treated equitably,” says Darren Redmayne, chief executive of covenant adviser Lincoln Pensions. “That has been interpreted as quite a linear ‘deficits versus dividend contributions’ discussion, he adds, “when in fact it’s quite multi-dimensional, because dividends are an important and legitimate part of a financing structure. Pension schemes are major investors that require the income from dividends as well, and therefore it’s in danger of becoming an overly simplified ‘dividends bad, contributions good’ discussion.

“The debate is a healthy one, but the mood has been effectively greater and greater scrutiny around appropriateness of dividends.” 

Walking the tightrope

Lord Balfe’s direct attempt at regulating dividends may have fallen by the wayside for now, but there are other legislative proposals in the works that may make it harder for companies to maintain dividends while presiding over scheme deficits. The Pensions Schemes Bill was also canned by the general election, but the bill, which is thought to have cross-party support, includes proposals that could reduce the incentive to increase dividend payouts.

Should it return to parliament and pass, the Pensions Regulator would be empowered to issue contribution notices (compelling companies to pay into their pension schemes) in certain cases should a DB scheme’s sponsoring employer, in its view, take a decision that materially reduces the value of its available resources. In the view of law firm Herbert Smith Freehills, this could include “the payment of excessive dividends”.

There is, however, recognition among pension trustees, whose role it is to uphold the interests of pension schemes and secure funding from employers, that a scheme’s prospects are tied with those of the sponsoring employer, and that the decision to pay dividends is an acceptable corporate choice. 

Hugh Nolan, a professional pensions trustee and director at consultancy Spence & Partners, says that while Carillion’s pension trustees sought the best deal for their scheme, they were “mindful of the fact that having to aggressively dip into dividends for immediate payments could kill the goose that laid the golden egg”. Trustees are wary of pushing too hard in funding negotiations and placing the sponsor at risk. “That typically means that an increase in dividends is something where you’d look for an increase in contributions, and if dividends are very high compared to contributions, then you’d look to squeeze a bit extra to get something through,” he says.

Chief financial officers and financial directors are much more involved in discussions around pensions than previously, according to Simon Kew, head of strategy and relationships in Deloitte’s pensions practice. He echoed the view that the health of the sponsor should be considered when pension recovery plans are agreed.

“Affordability is a massive issue,” he says. “Deficit repair contributions should be affordable and not overly onerous on an employer, because a strong employer is the best support for a scheme – but the scheme does need to be treated equitably.”