How pension deficits put dividends at risk

Shares that pay a chunky dividend might be an attractive investment proposition, but it could be the ‘canary in the coal mine’ warning of troubled times ahead.

rather than a sign of robust health, higher than average dividends could be a hint of problems at some companies.

If a business is a riskier investment than its peers, then it may increase its payout to compensate investors for the risk they’re taking – but problems come if the dividend is not sustainable.

and a particular warning sign is when the firm has a large pension black hole compared to the overall company size.

Prior to its collapse, Carillion was yielding a hefty 7.7pc – more than double the FTSE all share.

Russ Mould, investment director at Aj Bell, says: ‘Carillion’s yield drew a lot of incomeseekers to their doom.

‘The dividend was cut to zero as the profit warnings rained in and the shares collapsed.’

This week it emerged that Carillion bosses were warned about the damage that spiralling debts were doing to its pension fund as far back as 2012, even as the company continued to pay out chunky dividends to shareholders.

The pension deficit became a huge financial burden, growing to 37pc of the company’s £2bn market capitalisation in 2016.

THE infrastructure giant finally went bust last month with a deficit of £990m in its pension fund, which has 28,500 members.

simon McGarry, senior equity analyst at Canaccord Genuity, says: ‘Carillion’s pension deficit wasn’t the only reason it went under – but it was a sign of the trouble the company was in. a large deficit could be the canary in the coal mine for companies, which may be forced to cut dividends.’

a large pension deficit is bad for two reasons. First, it has to be filled, and that’s a drain on cash which might otherwise be used to invest in the business.

second, a big liability on the balance sheet is a major deterrent to any wouldbe buyer.

Both factors can hold the firm’s share price back, and that’s often when it will start hiking its dividend to attract investors.

But if that dividend is being paid to the detriment of the company’s finances, then debt spirals, becoming a burden on profits and, in the worst cases, causing collapse.

Donald Maxwellscott, technical investment manager at broker rowan Dartington, warns: ‘Pension deficits are presenting more of a threat to a company’s health, with as many as one in ten FTse firms struggling with a ballooning deficit.’

The main reasons for this are low interest rates, low bond yields and rising life expectancy – it means it is harder to grow money invested in pension schemes while they also have to pay out for longer than ever before.

research by Canaccord Genuity shows at least three FTse 350 firms have a larger pension deficit as a proportion of their market capitalisation than Carillion did. The aa has a pension deficit equivalent to an eyewatering 42pc of its £940m market capitalisation and, at the same time, has a dividend yield of 6.1pc.

Tesco’s deficit, meanwhile, is equivalent to 39pc of its £17bn valuation and BT’s 38pc of its £26bn market cap.

startlingly, Maxwellscott adds: ‘If BT’s pension deficit was a company, it would be large enough to be in the FTse 100.’

To avoid getting into a sticky situation, it is vital investors do their home work before buying shares in any company. Key things to look at are a firm’s net debt, cash flow and dividend cover.

But a large pension deficit isn’t a definite sign you should avoid investing in a company. after all, as interest rates rise it is likely that the gaping holes in these funds could narrow. still, companies also need to be demonstrating they are working at plugging any gap in their scheme.

This week, for example, defence-technology company Qinetiq revealed that after making recovery payments to close the deficit, its pension scheme was back in surplus, while BT is working on a pension settlement with staff which could reduce its liabilities.

Mould adds: ‘Investing in shares means you are buying partial ownership of that business.

‘If you wouldn’t buy the whole business – assuming you had the resources – because you don’t fancy taking on the pension deficit, then you must ask why anyone else would.

‘and if neither you nor anyone else wants the risk of owning all of the shares, why should you even consider buying a single one?’