There’s a lurking danger for investors, if headlines of recent months have any weight:

  • ‘The giant pension scheme thwarting Tata Steel rescue’ (Citywire, 4 April)
  • ‘The BHS collapse: A pensions chicken comes home to roost’ (Economist, 25 April)
  • ‘FTSE 100 firms’ pension deficit soars, says LCP’ (BBC, 17 August)
  • ‘Woodford bails out of BAE over pension’ (Sunday Times, 14 August)

The last one is particularly alarming. For if the UK’s best known fund manager has concerns about companies with underfunded pension schemes, it suggests we would be unwise to dismiss the issue lightly.

Deficits and dividends

Due to falling bond yields and rising longevity, the cost to companies of funding pensions has doubled over the last seven years. Bond yields have taken another hit since the Brexit vote and the Bank of England’s decision to cut interest rates from 0.5% to 0.25%.

Pension consultant LCP estimates that the combined pension schemes deficit of FTSE 100 companies has soared from £25bn to £63bn in little more than a year.

LCP suggests: “Companies with large deficits may see regulatory pressure on their dividend policy in light of the Select Committee’s report into BHS.” And over at the pensions regulator, policy director Andrew Warwick-Thompson has been quoted as saying: “We expect trustees to question employers’ dividend policies where debt recovery contributions are constrained.”

Back to Neil Woodford

In explaining his recent sales of both BAE Systems and BT, Woodford mentioned concerns about their substantial pension deficits in the same breath.

At its latest balance sheet date of 30 June, BAE had a deficit of £6,066m, while last year’s dividend payout was £663m. Put another way, it would take 9.1 years of dividends to clear the deficit. BT’s deficit is reckoned to be markedly higher now than the £6,382m it reported at 31 March, but even on that number we’re looking at 5.9 times last year’s dividend payout of £1,075m.

BAE and BT have well-above-average pension obligations relative to the generous dividends they’re paying to shareholders, suggesting there could be downside risk to future dividend growth.

Three more to consider

There are other blue chips whose dividend growth could potentially be constrained by pension pressures. Let’s consider the three in the table below.

  Pension deficit (£m) Dividend (£m) Pension deficit as no. of years of dividend
GKN (LSE: GKN) 2,101 149 14.1x
Tesco (LSE: TSCO) 3,175 0 n/a
BP (LSE: BP) 7,127 4,219 1.7x

Engineer GKN’s deficit surged 35% in the six months to 30 June, taking its pension liabilities to over 14 times its annual dividend. After a number of years of strong dividend growth, the board drastically slashed the latest interim increase to just 1.7%. With a skinny yield of 2.9%, investors could be facing some lean income years.

Tesco called a halt to dividends last year, as it seeks to repair its battered balance sheet. Total debt in the business is well in excess of the company’s market cap, and with continuing fierce competition in the supermarket sector, I reckon analysts predicting a resumption of dividends this year are wearing rose-tinted spectacles.

BP’s deficit is the biggest of the lot, but its dividend (current yield 7%) is also the most generous, so that the pension shortfall represents just 1.7 years of payouts. If a gradual recovery of the oil price in the coming years plays out as forecast, I would expect BP to be able to maintain its dividend and narrow its pension deficit.

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G A Chester has no position in any shares mentioned. The Motley Fool UK owns shares of GKN. The Motley Fool UK has recommended BP. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.