A dive in dividends

March 2010

Pension schemes were once again on Lord Myners’ hit list in February. At a corporate governance seminar run by the NAPF, the City minister pointed out that allowing banks to hand out excessive staff bonuses at the expense of dividend payments made no sense at all for schemes looking to get the best return from their investments.

Pension funds investing in UK equities for the income they produce from dividends will have been severely disappointed by those payments in 2009. Research from Capita Registrars showed that dividends were down 15% compared with the previous year.

One of the worst-performing sectors was banks – despite resuming generous bonus payouts. It was responsible for two-thirds of the overall reduction in dividends in 2009 (£6.1bn of a total fall of £10bn).

But financial institutions were not alone in cutting dividends – companies across the board reduced payouts in 2009. Many businesses have been fighting for survival with even the strongest seeing margins and profits squeezed. With earnings under pressure, there has simply been much less cash around to return to shareholders. Rather than paying money out, businesses have actually been tapping shareholders for more cash via rights issues and placings. UK companies raised £73bn in 2009 – £16bn more than they paid out in dividends.

But some sectors have been bucking the trend. The Capita survey found that oil and gas companies had actually increased their dividend payouts by some £3bn during 2009, while the healthcare sector paid out around £1bn more. Aside from the responsible investment issues that would arise from allocating heavily to oil companies, trying to second-guess the biggest dividends is unlikely to represent a realistic strategy.

Lord Myners argues that the way around the shrinking dividend problem is for pension funds to use their corporate governance might to extract larger dividends from companies.

That might look appealing in the short term, but for a long-term investor, it is not the most appropriate solution. To demand more in the near term could have undesirable longer-term damage – extracting higher dividends could be detrimental to a firm’s financial sustainability. Investors may simply have to sit out the dividend drought and wait for the return of economic growth.

But in the banking sector, where significant capital is being allocated to staff bonuses, does Myners’ argument carry more merit? Capita Registrars concluded that investors cannot rely on banks to provide strong dividend payouts in the future, because they are now required to maintain a much stronger capital base. Were dividends cut to pay for bonuses, or to ensure better capitalisation? It can’t be assumed that had bonuses been reined in at financial institutions, dividends would have been higher. But then again, if dividends have been cut because of stricter capital requirements, surely executive bonuses should have been reined in too?

While as a general rule pension funds have little to gain from pressing for higher dividends, they might question whether banking shares still offer value at all.