Should companies divert dividends to clear pension deficits?

Most FTSE 100 companies could clear their pension deficits in under two years if they diverted all dividend payments to their pension funds instead. Should they?

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What an ailing pension fund needs most is a sponsor in good shape
(Image credit: 2016 Getty Images)

Most FTSE 100 companies could clear their pension deficits in less than two years if they stopped paying dividends to shareholders and diverted all the cash to their pension funds instead 46 of them could do it in a year.

Total pension deficits hit around £25bn in 2016; total dividend payments came to £68.5bn.That's the finding from a new report just out from JLT Employee Benefits. This is fabulous news, being yet another piece of evidence to add to the pile suggesting that the great pension deficit disaster justisn't as bad as it looks.

But what of the idea that if companies can cover deficits by dumping dividends, then they should? Why shouldn't the Pensions Regulator just make the whole deficit thing go away by banning dividend payments by any firms without a fully funded pension fund?

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On the face of it that isn't a bad idea. But look deeper and it is. Companies need to be seen to be balancing the needs of all stakeholders (awful word, but you know what I mean) so totally prioritising the pension fund isn't ideal (not if you want to raise more money from shareholders at any point, at least).

What an ailing pension fund needs most is a sponsor in good shape (that is capable of remaining a cash-generative going concern long enough to meet all its liabilities). Force firms to divert cash from dividends and investment to pensions en masse and in scale and you could easily risk that.

At the same time it is worth remembering that these deficits are theoretical, not real. They are based on expected returns, which are in turn based on gilt yields. Gilt yields are currently very low. So pension deficits look very high. But if you fully fund the deficit now and interest rates then rise sharply (as looks likely) you will end up with a whole load of funds in surplus. That might be comforting for pension fund participants. But it isn't exactly an efficient use of corporate capital is it?

Finally, I'd point out that anyone thinking that dividends are the answer to everything might be a little late to the paying out party. As a note from AJ Bell makes clear this morning, a good many big firms have been giving shareholders rather more than they should have (everyone has been demanding yield, and chief executives mad to get their share prices up have obliged even when their profits haven't been quite up to the job).

Pearson has just cut its dividend hardly unexpected given that its dividend cover was a mere 1.2 times (although the shares still fell 27% wiping out five years' worth of income gains in the process).

It probably won't be the last to do so: as AJ Bell says "based on consensus forecasts for 2017 the aggregate dividend cover for the FTSE 100's top ten yeilding stocks now is just 1.3 times (See chart below)." That's not good: anything below two times just isn't safe.

Swipe to scroll horizontally
CompanyYields (2017 est)Earnings cover (2017 est
Taylor Wimpey8.10%1.21x
Direct Line7.60%1.11x
Admiral Group7.10%0.93x
Barratt Developments6.70%1.50x
Royal Dutch Shell6.40%1.00x
Capita6.40%2.08x
Legal and General6.30%1.40x
Standard Life6.10%1.18x
BP6.10%1.03x
SSE6.00%1.33x
AverageRow 11 - Cell 1 1.28 x
Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.