Very few companies actually cut their dividend per share to fund large deficit reduction contributions, says Professor Seth Armitage of the University of Edinburgh Business School, whose recent research found that companies usually only cut dividends in response to poor profit rather than to cash outflows.
A major reason for this is that many sponsors have had to make unexpectedly high cash contributions to scheme assets to reduce deficits. This raises the question of how companies have funded their contributions.
In some of the years with a reduction, companies that reduced dividend per share indeed paid a large DRC. However, most of these reductions can be explained by reasons other than the DRC
Reports by several consultants and by the Pensions Regulator have noted that deficit-reduction contributions could be funded by reducing dividends. Prominent newspaper headlines in recent years have suggested that some big companies might cut dividends to fund DRCs.
Yet such behaviour would be quite surprising. Existing research shows that listed companies are reluctant to cut dividends and can expect their share price to fall if they do so.
The main reason for dividend cuts is poor corporate performance, reflected in a loss or sharply lower profit. Companies with healthy profits do not tend to cut dividends to fund large cash outflows, such as for acquisitions or capital expenditure. A DRC is similar – a cash outflow that is not itself a deduction from profit. The DRC in a given year can be a very different amount from the pension expense through the profit and loss account.
Few cut dividends to fund large DRCs
In a new study that I conducted in collaboration with my colleague Ronan Gallagher, we examined the impact of DRCs on dividends and on total payouts to shareholders, including any share repurchases and special dividends.
Our sample was made up of all UK-registered non-financial listed companies with a DB scheme, for the years 2003-16. We went back to 2003 as this was the first year in which companies disclosed their unsmoothed cash contributions. The research methods incorporated those developed in previous academic studies on the effect of DRCs on company investment and dividends.
Although results differed somewhat depending on the method used to analyse the data, we found that DRCs had little or no measurable impact on regular dividends or on total payouts that include repurchases and special dividends.
This is after controlling for several factors that affect payout, the most important of which is profitability (return on assets).
The result for total payout is more surprising. Companies can reduce or omit repurchases and special dividends more easily than they can reduce regular dividends.
This is because when a company starts paying regular dividends there is an expectation on the part of investors or analysts that it will continue to do so. No such expectation applies if a company conducts a repurchase or pays a special dividend.
In our analysis, we explicitly examined reductions in regular dividend per share. In some of the years with a reduction, companies that reduced DPS indeed paid a large DRC.
However, most of these reductions can be explained by reasons other than the DRC, usually a large fall in profit or a loss. In other words, these companies would probably have cut their dividend anyway, whether or not they paid a large DRC.
Evidence that DRCs can occasion restraint in payout comes from use of a well-known model that forecasts DPS for the year, based on the current year’s earnings per share and the previous year’s DPS.
Using this approach, larger DRCs are associated with a shortfall of actual, compared with forecast, DPS. Our interpretation from this and the evidence on cuts is that very few companies actually cut their DPS to fund a large DRC, otherwise they would not have had reason to cut DPS.
More companies might exercise restraint in payout, if they pay a large DRC, by not increasing DPS as much as might be expected, given their earnings for the year.
Cash flow dictates contributions
So how do companies fund large DRCs, if not by cutting dividends? Our final piece of evidence is that they tend to make large contributions in years in which they have strong cash flows.
This helps explain how they avoid dividend cuts, and also why we observe both high DRC and high total payout during some years.
Companies with a large pension deficit do have to pay increased contributions, but they have flexibility in the timing of their payments.
This is consistent with policy statements by the regulator, which normally agrees recovery plans for deficits over horizons lasting a number of years.
Seth Armitage is professor of finance at the University of Edinburgh Business School
