Interactive Investor

How income seekers can cut pension deficit risk

2nd November 2016 14:06

Ben Hobson from Stockopedia

For many stockmarket investors, the yields that are on offer from corporate and government bonds are of little significance. Yet those yields are currently at such low levels that they could soon start having an impact on company dividends - and that's something that investors in shares should be wary of.

Recent press reports have raised the prospect of some companies being forced to cut future dividend payments. That's because they may have to divert those funds to plug growing deficits in their pension schemes instead. These deficits are growing precisely because bond yields are so low.

Reported research from IHS Markit looked at 206 companies in the FTSE 350 which have defined benefit pension scheme deficits. It found that dividends will be 4.4% less than the £81 billion forecast for 2017, a drop of £3.6 billion.

Runaway pension deficits have long been a problem for equity investors

Runaway pension deficits have long been a problem for equity investors. In an age of low interest rates and ageing work forces the problem is made even worse.

Many plans now struggle to earn the returns they need to stem the flow of operating profits into the so called 'pension black hole'. As a result, any investor who takes dividend payments seriously should take note of company pension deficits.

With this in mind, we took a popular dividend income investment strategy and checked it for pension deficits. The strategy is called Winning Growth and Income, and tracking by Stockopedia shows that it has returned 25.8% over the past two years, before dividends.

As the name suggests, the strategy rules look for companies that are good at generating cash, have manageable debt, below-average valuations and are having their earnings forecasts upgraded. Plus, of course, they need above-average dividend yields.

Also included is the 'pension deficit to market cap' ratio. This gives a sense of the scale of any pension deficit relative to the market capitalisation of the company. It's calculated by taking the group level pension deficit (or surplus) from the balance sheet, dividing it by the market cap of the company and then multiplying by 100 to get a percentage figure.

The results include a number of stocks with good quality characteristics on yields of more than 4.4%. Indeed, Games Workshop, recruitment group Gattaca, aviation services firm Air Partner and corporate broker Numis, all have yields of over 5%.

For the most part, the strategy has found companies without pension deficits. But there are some exceptions, including notable instances at the engineering support services company Carillion, and Norcros, which sells showers, taps, tiles and bathroom accessories. In both cases, dividends are reasonably well covered by earnings and analysts predict that payouts will grow. So there may be no need for concern. But what's interesting is that the pension deficit details offer a new perspective on these companies and any potentially troublesome obligations they might have in the future.

Given the current economic climate, where low bond yields are combining with uncertainty about corporate earnings next year, pension deficits could start to have a big influence on dividends. Dividend payouts are usually the first casualty when companies come under pressure. If recent analysis proves to be correct, it could well be that ballooning pension deficits are a trigger for more dividend cuts in the year ahead.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and "The Smart Money Playbook"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.