U.K. Dividends at Risk as BOE Action Swells Pension Hole

Updated on
  • Rate cut lowers yields, piling pressure on retirement plans
  • Some investors dump shares as dividend reductions loom

Workers have long fretted about funding gaps in U.K. companies’ retirement plans. Now investors are starting to join them.

Since the U.K.’s June 23 vote to leave the European Union, pension deficits
have swelled as record-low U.K. government bond yields have reduced returns on fund investments. That has added to pressure on companies facing gaps in their retirement funding, including telecommunications provider BT Group Plc, grocer Tesco Plc and military contractor BAE Systems Plc.

With little prospect of higher returns after the Bank of England cut interest rates this month, companies may have to reduce dividend payments to raise pension contributions and close funding gaps. That means investors, who have been insulated from the U.K.’s pension crisis, could feel the effects.

“There is no doubt that shareholders of companies with major pension deficits will be concerned,” said Raj Mody, who heads PricewaterhouseCoopers’ pension consulting group. “It’s happening to pension schemes but will feel like it’s happening to the whole company.”

Companies in the FTSE 100 stock index paid around five times as much in dividends as they provided in contributions to defined-benefit pension plans last year, a report published Tuesday by consultant Lane Clark & Peacock showed. 

Growing Deficits

Through July 31 the FTSE 100 companies’ combined pension deficits -- the amount by which liabilities outstrip assets -- increased to 46 billion pounds ($59.7 billion) from 25 billion pounds a year earlier, Lane Clark said. Total pension liabilities of the 350 largest U.K. companies as a percentage of market capitalization rose to 40 percent in June, the highest level in the last 10 years except during the global financial crisis, according to Citigroup. 

The collapse of privately held U.K. retailer BHS earlier this year, weighed down by a 571 million-pound pension deficit, highlighted the crisis facing defined benefit plans, which pay retirees fixed amounts based on levels of service. Only two FTSE 100 companies -- distiller Diageo Plc and chemicals provider Johnson Matthey Plc -- still offer new hires access to such plans, according to Lane Clark.

U.K. companies decide how much to contribute to pension programs based on valuations conducted every three years. That will delay the effects of growing deficits for some, but investors are already taking notice.

A fund run by Woodford Investment Management LLP last week said it sold its 160 million-pound ($209 million) stake in BAE, citing concerns over the company’s pension plan. The fund in June said it had dumped its shares in BT for similar reasons.

BAE said it took a long-term view of its pension program and had a deficit recovery plan in place.

A deepening pension hole has dragged down the share price of pub owner Mitchells & Butlers Plc, analysts at HSBC said in a note this month. Declining bond yields could push up the deficit at the bar owner to more than 500 million pounds, even though it paid 175 million pounds into the plan after a previous assessment pegged the deficit at 572 million pounds.

Plugging Gaps

If investors expect that other companies will need to plug such gaps by cutting dividends, more firms could see their share prices suffer, said David Fairs, a KPMG partner who serves as an adviser to the U.K. Pension Regulator.

“It may be that in the coming months analysts who look at deficits will anticipate the higher contributions which will follow the companies’ next valuations,” he said. “We could see an effect on the share price even though the effect on the company hasn’t happened yet.”

BT has warned that its pension deficit, which rose to 7.6 billion pounds in June from 6.4 billion pounds in March, could affect shareholders. It said in its annual report in May that “higher deficit payments could mean less money available to invest, pay out as dividends or repay debt as it matures.”

BT may have to halve annual increases in its dividend to 5 percent from 10 percent after its next pension valuation, set for June 2017, Macquarie analyst Guy Peddy said.

“Any interim pension deficit estimates need to be treated with caution as they make a number of assumptions including on inflation and discount rates which may not apply at the time of the next valuation,” the company said in response to questions about possible effects on its dividend.

Pensions Regulator

The Pensions Regulator said in May that it expected employers to adhere to timelines for deficit reduction despite lower interest rates. Before the latest rate cut, some companies already made big contributions to their pension plans -- Royal Bank of Scotland Group Plc said in January that it would pony up 4.2 billion pounds.

Companies have several options to tackle funding gaps, according to PwC’s Mody, such as offering higher payments to pension recipients in exchange for giving up future increases and looking at the risk profile of the investments of the scheme. Most will exhaust other options before moving to squeeze dividends, he said.

Still, fund manager Laura Foll at Henderson Global Investors Ltd. said large pension deficits are forcing investors to consider the sustainability of dividends. “When you talk to some of these companies with sizable pension deficits they are weighing up, ‘How much do we pay into the pensions versus how much do we increase dividends,’ ” she said.

(Updates chart with source of data.)
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