For companies with defined benefit pension schemes, liabilities have soared as a direct result of the sharp decrease in UK government bond yields, widening the gap between the sums to be paid out and the value of assets available to fund these payments. As a consequence, a number of firms have hit the headlines with their decision to divert cash away from dividends, and use it instead to decrease their pension deficits.
No discussion of dividend prospects would be complete without talking about pension deficits and their potential impact on the ability of UK companies to pay dividends going forward. Pension fund deficits have always been an important consideration when assessing both a company’s valuation and its capacity to pay dividends; since the credit crunch of 2008 and the onset of record-low government bond yields, this issue has become even more pressing.
Defined benefit pension schemes are a liability on a company’s balance sheet, the same as any other debt owed, and should be viewed as such when analysing the potential for sustainable dividend payments.The pension deficit should be included in the enterprise value calculation, and regular payments towards reducing this deficit should be accounted for when looking at the company’s free cash flow, which is the source from which dividend payments will be made.
Clearly, a company that struggles to generate free cash, that is highly levered and that has a significant pension deficit will struggle to pay dividends. Dividends are funded out of free cash flow. The decision to pay a dividend to shareholders is a reflection not just of cash being available, but of the company’s own decision that this is the best use for the cash, rather than reinvesting it into new projects, purchasing new fixed assets, acquiring a new subsidiary or paying off outstanding obligations. Dividends are, however, often viewed in isolation and as an obligation, whereas in fact they are in essence a discretionary payment.
This is not to say that dividends are simply the icing on the cake – they are the product of countless factors, relating to both the individual company and the broader environment in which it operates. Dividend projections and forecasts do have an impact upon a company’s share price, and companies are often reluctant to cut or change dividend payments for fear of a negative market reaction. Although dividends are related to profitability, they are by no means in direct correlation with it, which is why thorough research is crucial to establishing the true state of a company’s health and the likelihood that it will pay sustainable dividends into the future.
Companies may cut dividends for any number of reasons – mining and commodity companies, for example, have been facing huge pressure on their margins as a result of lower commodity prices, and many have had to restructure and alter their business plans significantly in order to remain solvent. A company facing such complex and urgent challenges would be unlikely to spend free cash on a dividend payment; indeed, the decision to pay a dividend under such circumstances might be viewed with suspicion.
Overall, I do not see any existential threat to aggregate stock market dividends arising from the issue of pension deficits. A lot of high-profile, listed companies have been struggling with their defined benefit obligations for years, and across a range of economic backdrops. For many, this will be yet another challenge on the list of those they have already overcome, although some will of course manage better than others.
Liability matching is used extensively and increasingly by a wide range of companies to manage the size of their pension deficits and to contain the impact of a change in rates upon both liability and asset valuations. For these firms, the increase in liabilities as a result of the drop in yields will have been at least partially offset by an increase in the value of assets held against them. Additionally, the multiple-decade time horizons of many of these schemes will be helpful in making up lost ground.
It is also worth remembering that many younger companies that are just beginning to reach the stage where they start paying dividends to their shareholders will have only a negligible defined benefit obligation, and some may have none at all. This means one less claim on cash to compete with dividend payments.
I do not think it entirely beyond the bounds of possibility that the authorities may decide to smooth or otherwise adjust the interest rate that is used for the calculation of pension liabilities, in order to ease pressure on companies’ balance sheets. I am not, however, holding my breath.
I am sceptical about how effective August’s interest rate cut will be in stimulating economic growth. Although some companies will be well-positioned to manage their competing cash flow claims, any further consequences of lower interest rates and more quantitative easing may be that many are likely to be cautious and to prioritise debt management and cost-cutting, rather than investing in job-creating capital expenditure. However, with consumer spending so far seemingly unaffected by the Brexit vote, those forecasting economic doom have backtracked. In addition, supportive fiscal initiatives may well be announced by the government in the autumn. I still believe the UK is likely to experience an extended period of political and economic uncertainty and we will continue to monitor economic developments closely.
I believe it best to avoid making knee-jerk changes to portfolios until the implications of Brexit upon both the broader economy and individual companies become clearer. As both economic and political uncertainty prevail, I prefer to use cautious economic growth assumptions and to focus on firms with strong market positions, dividends backed by sustainable cash flows and robust balance sheets, so as to construct a portfolio that is resilient across a broad range of possible economic outcomes.
Martin Cholwill is a senior fund manager at RLAM
Key points
For companies with defined benefit pension schemes, liabilities have soared as a direct result of the sharp decrease in UK government bond yields.
Dividends are the product of countless factors, relating to both the individual company and the broader environment in which it operates.
The authorities may decide to smooth or otherwise adjust the interest rate that is used for the calculation of pension liabilities.