Britain's Pension Gaps Could Prompt Dividend Cuts

Inside the Rising Pension Gap at U.K. Companies
  • FTSE 100 up 8.4% since Brexit as valuations near records
  • Lower capital spending, dividends seen as likely solutions

U.K. firms running out of ways to pay retirees are having decisions forced upon them that could end up penalizing another constituency, their shareholders.

According to UBS Group AG, steps such as reducing dividends and cutting capital spending are the most likely route for chief executives of companies facing widening pension deficits, which for FTSE 100 Index members have almost doubled in a year. So stark are the choices that firms with the biggest gaps are already paying a price in the equity market.

It’s another example of the stress created by near-zero bond rates as central banks around the world struggle to stimulate economies, particularly in Britain, where voters approved secession from the European Union in June. Difficult choices aimed at preserving cash are increasingly a threat to a share rally that has lifted U.K. stocks almost 10 percent in two months.

“Investors seem to be focused on the currency wins in the wake of Brexit,” said Karen Olney, equity strategist at UBS Investment Bank in London. Her firm favors equities from continental Europe to those from the U.K. “But are they also considering the downside of post-Brexit lower bond yields? Probably not.”

Using a rule of thumb that holds that each 1 percent drop in gilt yields increases a company’s pension liabilities by at least 10 percent, UBS estimates those obligations could rise by between 65 billion ($86 billion) and 130 billion pounds for FTSE 100 members with defined-benefit plans, depending on the program’s lifespan. For the broader FTSE 350 Index, the total could climb by as much as 150 billion pounds. Slash capital expenditure, lower dividends or ask employees to take a partial cut in benefits are among the few options for British firms with ballooning deficits, Olney said.

Pension deficits have already began to swell. At FTSE 100 members, they increased to 46 billion pounds through July 31 from 25 billion pounds a year earlier, according to a report this month by consultant Lane Clark & Peacock. At the same time, analysts project corporate capital expenditures will slide for a third year to less than 150 billion pounds, data compiled by Bloomberg show. That would be the least since 2010.

While the U.K. gauge has benefited from the weaker pound, climbing 8.2 percent since the referendum, companies with the biggest pension plans haven’t fared as well. BT Group Plc and Tesco Plc have slipped, while BAE Systems Plc has gained less than the FTSE 100. That’s partly because investors are concerned about dwindling sources of retirement funding, according to Alex Dryden, a global market strategist at JPMorgan Asset Management, which oversees $1.7 trillion.

“This is something that will probably continue for the foreseeable future because the only way to fix it is by taking it out of the earnings,” the London-based strategist said. JPMorgan is overweight U.K. stocks. “That’s where you are starting to see firms move to -- make bigger and bigger distributions from their earnings into their pension pots, and that’s what’s weighing on their share prices.”

Public-transportation companies Go-Ahead Group Plc and Firstgroup Plc are among the most at risk in the FTSE 350, with their pension deficits exceeding 10 percent of their market value last year, according to Bloomberg Intelligence. Their payouts may need reining in, though companies reaping the benefits of a weak pound may be able to better address the concerns, said BI analyst Jonathan Tyce.

BT already warned in May that “higher deficit payments could mean less money available to invest, pay out as dividends or repay debt as it matures.”

“Decades ago, companies never expected yields to be skirting negative levels,” UBS’s Olney said. “Companies are frustrated, and some will argue that defined-benefit plans were a mistake in hindsight.”

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