The Biggest Risk to your Dividends Following last week’s thumping general election victory that the Conservative party enjoyed, it was little surprise that the stock market liked the news. In fact, the FTSE100 market rallied well over 100 points fuelled by double-digit growth from several blue-chip companies with particularly strong performances from some of the housebuilders including Persimmon which rallied by a staggering 15% on the open and closed up 12% on the day. Unsurprisingly the City was very busy on Friday as nervous investors who were worried about a possible hung parliament or even Corbyn victory scrambled to get their cash into the stock market. Indeed, it turned out to be the busiest trading day for the entire year for London Stone with volumes far greater than any other single day of 2019. However, it’s important not to get carried away with this single euphoric moment in time. That’s because there appears to be something quite sinister that could risk entire portfolios, but which to date most investors seem to be missing. And this sinister danger is the real risk of a dividend cuts. Most of the largest, UK-based blue-chip companies pay a dividend of some description. Indeed, it’s probably fair to say that receiving a regular income from a share is usually one of the reasons that investors buy these companies. And that’s okay, in fact it’s a sensible strategy as it has been shown over the course of time that dividend paying companies tend to give a greater total return than portfolios which concentrate only on capital growth stocks only. However, this is a double-edged sword because whilst a dividend is very attractive and has many fantastic benefits to the investor, a cut in a dividend works in the exact opposite way and can have a disproportionate impact to the shareholder. The shareholder not only loses the dividend but it also will usually experience a sizeable fall in share price. Moreover, it also signifies a bad situation for the paying company because a board of director will very rarely choose to cut a dividend unless it’s an absolutely last resort. Shareholders don’t like to lose their income and those AGMs are not always comfortable at the best of times, less still when disgruntled investors are very unhappy. But the risk is not what you might think and no, it’s not just the dividend cover which demonstrates how easily a company can keep up with its dividend payments. There is actually a potentially bigger threat at play here and it comes down to one simple word – pensions. The Pension risk to your Dividends In recent years there have been several very high-profile cases of companies that have favoured shareholders at the expense of providing adequate funding for their pension schemes. We saw it with the FTSE250 construction company Carillion which you will recall filed for bankruptcy in 2017 and we have seen it very heavily publicised more recently when the Pensions Regulator had to step in and salvage £363m for pension holders in the BHS scheme. BT is another example. Whilst it is paying shareholders a very attractive 8.3% dividend yield and has a fairly respectable dividend cover of 1.4, its pension deficit has widened from £6.8 billion to £7.2 billion, and that’s despite the company increasing its pension deficit payments from £1.5billion to £2billion. As a result, BT is now facing the stark possibility of a dividend cut – it can’t just keep paying 8% whilst its pension suffers. Earlier this year we also saw Centrica go through the exact same problem with a huge pension deficit, and which ultimately had to be financed through a cut in dividends. The point is that blue-chip companies have played fast and loose for too long with their pension schemes and the tide is now turning. As investors you need to be aware of this. That’s because if you hold shares in companies where dividends are being paid out but where the company’s pension deficit is widening, that’s likely to come under a lot more scrutiny and your dividend and therefore capital is at greater risk. The net is definitely tightening. Just last month a new bill was introduced to the House of Lords which would require pension scheme trustees to approve any corporate dividends being paid out to shareholders. This bill is still yet to be voted on but regardless of whether it passes or not, it shows the intent to bring companies to account and the Conservative Party coming into power will only help to accelerate these pressures. Volatility adding to the Deficit Woes It’s clear that blue-chip, dividend paying companies can no longer put their shareholders at the top of the tree and ignore those in their Defined Benefit (DB) pension schemes. The current deficit of the near 5,500 corporate DB pension funds is currently around £200 billion. This sounds bad but what is worse is that in August of this year that number was at a staggering £340 billion. And it’s worse for two reasons, 1) clearly there is a big financial hole that needs to be plugged and this can only can come from a redirection of corporate profits moving away from shareholder dividends and 2) it shows the size of the volatility problem. The volatility stems from economic uncertainty which is having a significant impact on the valuations of the assets (bonds and equities) within the pension schemes. If the global equity markets increase then that’s good news for the pension schemes as it reduces the deficit that needs to be made up through a tightening of the dividend payments. However, if the market crashes this sends pension asset values through the floor which will increase the deficit problem. How to avoid the Trap To avoid this trap of holding onto companies which pay healthy dividends but have an almost absolute disregard to their pension schemes is very straightforward – you need to start paying closer attention to the pensions of those companies that you hold in your portfolio. Either legislation will be passed which will force companies to act fairly for pension holders (we think that this is a good thing by the way) or companies will continue to pay unsustainable dividends until this lack of forward planning eventually catches up with them, and then the company runs out of cash for both the dividends and the pension scheme. How risky is your portfolio? If you are concerned about whether your companies might be falling foul of the pension-dividend trade-off, email which companies you hold to our team at email@example.comRisk Warning: This report is for information purposes only and should not be construed as investment advice. All investments are speculative and the value of your portfolio can go up or down. If you are considering making any form of investment you should seek independent financial advice as the stock market may not be suitable to you.
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