As the Pensions Regulator takes aim at the growing gap between dividends and deficit repair contributions, a handful of schemes and sponsors are taking formal steps to align their interests.
The chair of the Financial Conduct Authority’s Institutional Disclosure Working Group has targeted complacent asset managers and swept at a Kafkaesque system that prevents schemes from truly understanding their costs.
Employers with defined benefit schemes need this information too, he says, because it is they who have to pick up the tab when things go wrong.
Dividends are perceived by the regulator as money leaving the business that will not come back into the business
Simon Kew, Deloitte
The black belt and ex-police officer then takes up a somewhat unexpected new target.
“I have watched with great interest the varying degrees of chastisement that employers have had for failing in what should be considered their breach of duty to their underlying current and former employees,” he says.
“The idea that dividends are paid ahead of contributions to pension funds is frankly shocking to me,” he continues. WPC chair Frank Field agrees.
High profile failures like BHS and Carillion have sharpened the minds of government, regulators and business leaders, not least because of their impact on pension scheme members.
While the overall number of pensioners in poverty has risen, workers and pensioners have seen their benefits reduced or transferred to the Pension Protection Fund, and in the case of British Steel many proved easy targets for unscrupulous advisers and scammers. Meanwhile, Richard Adams, Carillion’s former finance director, was reported as having called pension payments “a waste of money”.
The Pensions Regulator, maligned by the committee for its response to these collapses, has shifted its attention away from protecting sustainable business growth in a drive to be clearer, quicker and tougher on bad business. It has singled out companies that pay large dividends relative to deficit repair contributions in its latest annual funding statement.
Companies need to justify dividends
But even as the pendulum swings towards tougher governance and greater scrutiny over dividends, experts insist that we must not lose sight of the important function of shareholders. Large, well-governed companies cannot thrive without a solid investor base, they say, and will need dividends.
DRCs have become “a bit of a cause célèbre” for the regulator, according to Darren Redmayne, managing director at covenant specialists Lincoln Pensions. He singles out the use of dividend to DRC ratios for criticism.
According to the regulator’s analysis of FTSE 350 DB schemes with valuation dates between September 2017 and 2018, the median ratio of dividends to DRCs has risen to 14.8:1, from 10.2:1 in 2012.
In its analysis, the regulator explained that the change in the median ratio was “mainly driven by the significant increase in aggregate dividends over the period, without a similar increase in contributions”.
“The debate can be improved by the recognition that simply comparing dividends to DRCs is a very blunt measure, and is very case-specific,” Redmayne counters.
However, he adds that companies are currently failing to properly explain their logic behind paying dividends to shareholders.
“Companies need to do more to justify why paying dividends [is] appropriate and [does not] increase the risk [that] the pension schemes may not be able to meet their deficits,” he says.
Consider deficit as debt
Some companies have taken pains to coordinate their dividend and pension policies, such as supply chain operator Wincanton.
Its 2018 annual report indicates a 8.8 percentage increase in its dividend to 9.9 pence per share. In August, the company announced a new recovery plan with its scheme trustee.
In addition to establishing a new rate of annual DRCs, it also implemented a mechanism linking DRCs to shareholder distributions and the company’s financial performance.
The company has agreed to pay additional contributions on a 50 per cent matching basis if distributions to shareholders grow year-on-year above 10 per cent, and on a full matching basis should distributions grow year-on-year above 15 per cent.
It will also make a one-off payment to the scheme of £6m in any year if both its underlying profit after tax is lower than the level of profit after tax reported in the 2017/18 financial year, and the dividend payout ratio increases to over 40 per cent of profit after tax.
Charles Cowling, chief actuary at JLT Employee Benefits, says businesses are being compelled to treat their pension obligations “as a hard debt that has to be serviced”.
He says: “They are having to manage their capital structure and service that debt in a way that perhaps hasn’t had the same prominence as might have been the case a few years back,” adding that this is partly behind the trend towards scheme derisking.
Recovery plans reduce dividends and investment
Ten years on from the global financial crisis, the regulator and government have said that they are determined to ensure that schemes are protected from corporate mismanagement.
The regulator is to receive new powers and has vowed to be more proactive with schemes it deems at greater risk. Less than a third of trustees, however, think the regulator will monitor funding agreements fairly, according to Willis Towers Watson research.
The Bank of England has to put a price on predicted DRCs, which were estimated by drawing a relationship between DRCs and predicted deficits.
The BoE found that companies with larger pension deficits do not pay less or lower wages than companies with smaller deficits, but they do pay lower dividends.
“Once a firm is required to make [DRCs] by [the regulator], it changes its behaviour in a noticeable way, paying a lower dividend on average, and investing less than firms without deficit recovery plans,” the report reads.
Every pound of predicted recovery contributions has the estimated effect of reducing dividends by 32 pence, it says. Investment in the company would be expected to fall by about 33 pence in the pound.
Martin Hunter, principal at consultancy XPS Pensions, says that the introduction of the regulator’s sustainable growth objective in 2013 prompted discussion of company investment between employers and trustees.
Companies sought “an equitable share of the cash regenerating – some going to the scheme, some going to the shareholders, and also some being invested in the company to boost its sustainable growth and ultimately improve the covenant over the longer term”, he says.
Dividends can help schemes
Shareholder distribution can actually benefit schemes, according to some experts.
Jonathon Land, a partner who leads PwC’s pensions credit advisory team, argues that the ability to access capital markets in the form of rights issues “for companies that have a level of distress, or rights issues for companies looking to make other acquisitions”, has helped many pension schemes.
“They’re one of the most positive things a company can do to improve the position of the scheme actually, and to make the employer covenant stronger,” he says.
One-fifth of FTSE 350 companies do not declare DB funding positions
Employers should be legally required to disclose their defined benefit scheme deficits on a technical provisions basis, along with details of the associated recovery plan durations and contributions agreed, Lincoln Pensions has said.
“Dividends are perceived by the regulator as money leaving the business that will not come back into the business,” says Simon Kew, director at Deloitte.
“Companies need to pay dividends,” he argues. Shareholders can be patient and accept some years without a dividend, he says, but they will require returns in the long run.
“If they perceive that they’re not going to be getting any investment any time soon then they’re likely to pull their investment.”
