Drilling down into the dividend: a new item for the danger list

There’s a potential black cloud looming for dividends, which could halt the recovery. David Prosser explains. 

Good news and bad for income-focused investors. On the upside, the collapse in dividends caused by the Covid-19 pandemic appears to be over, with a recovery now well under way. Less happily, new pensions regulation could threaten the sustainability of that recovery.

This year’s bounceback in dividends is certainly welcome. According to data from the Link Group Dividend Monitor, the Covid-19 crisis saw UK companies reduce their dividends by 44% last year, with total payouts reaching £61.9 billion, the lowest annual total since 2011.

In 2021, dividends have been restored, with payouts up 89.2% in the third quarter alone according to Link Group. It is now predicting a total payout for the year of £93.2 billion, still down on 2019’s record of £110.5 billion, but much more healthy.

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“The good news is that we have consistently seen companies deliver more in dividends than we thought likely at the beginning of the year in the depths of the UK’s longest, strictest lockdown. Now, almost the whole economy here and in most developed countries is open for business, even if supply chains are in a mess,” says Ian Stokes, managing director of corporate markets at Link Group.

Black cloud looming for dividends

Not so fast, warns the actuarial firm Lane Clark & Peacock (LCP). It points to a black cloud looming into view for the dividend outlook: since the start of this month, The Pensions Regulator, the powerful body that polices the defined benefit occupational pension scheme industry, has begun considering how the dividends that companies pay might affect their ability in future to fund their schemes.

The technicalities are complex, but the principle is simple enough. The regulator is worried that companies paying large dividends to investors should actually be keeping some of that cash back to fund the pension promises they have made to their staff. And in cases where it is particularly concerned, it has powers to order companies to make additional payments into their schemes.

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The Pension Regulator’s new powers will be most likely to unnerve companies whose defined benefit pension funds are currently in deficit – that is, their assets aren’t currently sufficient to meet their pension promises. But for the purposes of this exercise, the regulator will take a conservative approach to judging which schemes are in shortfall. LCP reckons around 75 companies in the FTSE 100 would have been judged as being in deficit at the end of 2020.

“Had the regulator’s new powers already been in force, the payment of dividends by some of these companies could have potentially breached the first threshold [for the regulator’s tests],” says Laura Amin, a principal at LCP.

“This would potentially have given the regulator the power to consider opening an investigation.”

Worst-case scenario is that boards now rein in their payouts

Amin believes this change of focus from the Pensions Regulator will now give many companies pause for thought about the future course of their dividends. The worst-case scenario is that boards now rein in their payouts to investors for fear of falling foul of the regulator. Companies whose final salary schemes are significantly in deficit will feel particularly pressured.

Investors need to keep a careful eye on this issue, warns Rebecca O’Connor, interactive investor’s head of pensions and savings. “It’s not certain yet how companies will respond to the new regulations, but there is a chance that some could choose to restrict or reduce dividend payouts as a result,” she says.

“It is worth keeping an eye on, particularly if you are aware that a company paying you dividends is operating a significant deficit on its pension scheme. It will also be worth keeping an eye on any change in tone regarding future dividend payments in company statements.”

A risk for UK equity income funds

One constituency that will need to watch this issue particularly closely is the fund managers of equity income funds, in both the open- and closed-ended fund sectors. These funds rely on dividend payments to finance their own distributions to investors.

“We’re always looking for issues that might affect the medium-term cash flows of a business as this may slow the flow of future dividends – or worse, cut it off altogether; if a company has a significant pension scheme deficit it has always been a warning flag for us as this may require future cash injections,” says Andrew Marsh, co-manager of the Artemis Income fund.

“This is a risk that many companies are reluctant to admit to and consequently the stock market often overlooks. The new powers of The Pensions Regulator mean this form of living in denial may be harder to maintain in some circumstances.”

Other equity income fund managers contacted said it is still too early to say what The Pension Regulator’s new approach will mean in practice. Until the regulator begins to launch investigations – and to make payment orders – companies may not take the threat seriously. On the other hand, high-profile cases have the potential to spook boards.

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Mick Gilligan, head of managed portfolio services at Killik & Co, thinks one impact of the shift in regulation could be to give investment trusts a competitive advantage over their open-ended rivals. “It makes revenue reserves even more valuable than they already are,” he says.

Gilligan’s argument reflects investment trusts’ unique ability to retain up to 15% of the income they earn on their investments each year to build up a reserve of cash. This reserve can then be used to subsidise income distributions to shareholders in years when dividend income falls back – perhaps, for example, in tough years for pension fund deficits.

The merits of revenue reserves have come to the fore during the pandemic. The average UK Equity Income open-ended fund reduced its pay-out to investors by 29% in 2020 as the companies in its portfolio cut their dividends. By contrast, of the 23 UK Equity Income investment companies, just two reduced pay-outs – and 19 actually raised their distributions.

Income funds that focus on smaller companies are less exposed

A second impact of the new pensions regulation, Gilligan argues, could be a shift in investor sentiment. “It is likely to favour smaller company income funds, which are less exposed to legacy defined benefit schemes, rather than funds invested in larger companies,” he suggests. As he points out, income funds with fewer investments in companies struggling to finance defined benefit pension funds will have less reason to fear an impact on their dividend income.

The bottom line here is that pension scheme funding issues have the potential to become a red flag issue for funds that are investing with an eye on generating income. It may be too early to say how serious this issue will prove – much will depend on how aggressively The Pensions Regulator makes use of its new powers – but it is certainly one for managers’ watch list.

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There are other red flags for equity income fund managers too, of course. Their focus has to be on a broad range of financial metrics at the companies in which they invest – and not just profitability. A company declaring a good profit this year may feel able to declare a good dividend, but this data doesn’t give much guidance to future levels of profitability, or the sustainability of payouts.

For this reason, many income fund managers point to the need to scrutinise companies’ free cash flows over an extended period. Is a business repeatedly allocating significant chunks of cash flow to capital projects? If so, it may have been under-investing and now facing a battle to catch up. Is it reporting high levels of profitability on relatively low levels of cash flow? If so, that may prove unsustainable. Is it financing M&A activity, notoriously difficult to drive value from, from cash flow? Is a large proportion of cash flow being used to service debt, another worrying sign?

In practice, there are plenty of reasons why companies reduce their dividends, even against a supportive economic backdrop. Equity income fund managers’ challenge is to anticipate such reductions – and to protect investors accordingly. Now they must add pension scheme liabilities to the danger list.