Dividends in danger? 11 shares with big pension deficits

The ticking pensions time bomb has been building in the background for years, exacerbated by the progressive decline in bond yields and much-improved life expectancy.

Pension fund deficits don't just pose a problem for members of final salary pension schemes - income investors too may feel the heat if they are invested in a company that decides to forgo dividend payouts in favour of covering their pension black hole.

This potential headwind was recently acknowledged by the respected investor Neil Woodford, manager of CF Woodford Equity Income, who cited concerns over pension deficits as one of the one of the factors behind his sale of holdings in BT and BAE Systems earlier this year.

FTSE 100 firms pay five times more in dividends than pension contributions

THE 'UNEXPLODED BOMB IN INVESTMENT PORTFOLIOS'

'At the stock level, an increasing number of companies face mounting challenges in tackling their pension deficits. In particular, previously nationalised businesses have substantial amounts of unfunded pension liabilities on their balance sheets,' he said.

'The presence of a substantial pension deficit is therefore a consideration for investors and could put further pressure on the cash available for distribution via dividends, particularly in an environment where the balance between deficit reduction and shareholder returns is being called into question.'

Canaccord Genuity Wealth Management shares the same concerns, to the extent that it has conducted research to find out which dividend-paying firms in the FTSE 350 index have the biggest pension deficits.

Simon McGarry, senior equity analyst at Canaccord Genuity Wealth Management and author of the research, found that some pension deficits are up to a staggering 30 per cent of the company's listed value. He says firms with big pension deficits are the 'unexploded bomb in investment portfolios'.

McGarry points out that a couple of months ago UK plastics manufacturer Carclo took the market by surprise and slashed its dividend, despite declaring in June that it would pay a final dividend of 1.95p per share.

'This was particularly noticeable given that for more than 14 years - a period which included the biggest economic meltdown in a generation - they had managed to either grow or maintain the dividend on an annual basis,' says McGarry.

FREE CASHFLOW DISTRIBUTIONS

'The bogeyman was the company's pension deficit, which ballooned due to the collapse in UK government bond yields in the immediate aftermath of the UK's vote to leave the European Union in June.

'The sharp move effectively extinguished the company's available distributable reserves, making it impossible for them to pay their final dividend.'

The table below shows 11 companies with pension liabilities in excess of 17 per cent of their market cap.

Leading the pack, with the biggest pension deficit under this measure, is Carillion, a reliable dividend payer, having upped payouts annually for the past 17 years. Thomas Cook takes second place in the pension deficit league table, followed by GKN.

BAE and WS Atkins, which both maintained their dividend payments during the financial crisis, also look vulnerable in terms of their pension deficit size.

But Adam Avigdori, one of the co-managers on the BlackRock UK Income fund, says high pension deficits do not necessarily shorten the odds of a dividend cut.

'Pension deficits can change rapidly. For every 20 or 30 basis points move in the gilt market, hundreds of millions of pounds can be added or wiped off (depending on whether yields fall or rise),' says Avigdori.

'To assess the risk of the pension deficit I look where the free cashflow is being distributed. In the case of BT, which generates £4 billion of free cashflow, around £1.5 billion goes towards the dividend.

'The rest is invested back into the business and the pension. If the free cashflow figure dropped to £3 billion, the pension deficit would potentially be more of an issue.'

11 companies with the biggest pension deficits
CompanyIndustryPension deficit as % of market capDividend yield (%)No. consecutive years of divi growth per share
CarillionConstruction & engineering377.617
Thomas CookHotels, restaurants & leisure302.81
GKNAuto components292.96
BAEAerospace & defense294.112
Mitchells & ButlersHotels, restaurants & leisure272.81
Morgan Adv MaterialsMachinery264.06
FirstGroupRoad and rail243.60
TescoFood & staples retailing220.80
WS AtkinsProfessional services192.813
AADiversified consumer services173.51
BTDiversified telecoms services174.27

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