31 August 2021
Results season is upon us and we have seen a wave of dividend announcements from some of the UK’s largest companies over recent weeks.
Whereas dividends paid by FTSE 100 companies dropped from around £110bn in 2019 to just over £70bn in 2020, announcements so far in 2021 suggest much of that fall could be recovered this year.
With similar positive noises from companies outside of the FTSE100 regarding the level of proposed dividend payouts, this is good news for UK Plc and indicates optimism regarding the future growth outlook for the UK economy, after over 12 months of covid-related uncertainty for many businesses and investors.
Most company directors (and institutional investors) will be aware of the strong focus from The Pensions Regulator (‘TPR’) on the dividends paid by sponsors of UK DB schemes in recent years, following high-profile corporate failures some years back and reports of disparity between dividend payments and pension Deficit Reduction Contributions (‘DRCs’).
However, in general there appears to have been limited focus to date on the impact that dividends paid could have on the future support a company can offer to its pension scheme.
This is set to change from October this year with new powers being given to TPR under the 2021 Pension Schemes Act. These will take TPR’s benchmarking of shareholder dividends (and other forms of ‘covenant leakage’, including executive remuneration) to a new level for all corporates which sponsor DB pension schemes, not just the largest FTSE 100 blue chips whose dividend announcements make it into the news around this time of year.
As we start to look forwards, all listed companies with UK Defined Benefit (‘DB’) schemes would be well advised to familiarise themselves with the latest developments at TPR before setting their policies for dividend payments later this year.
Without acknowledging and managing this risk, company directors and associated parties may unwittingly find themselves at risk of a TPR investigation following the payment of a dividend (including intra group dividends and special dividends).
80 of the FTSE100 reported UK Defined Benefit (‘DB’) pension obligations at their 2020 accounting year end date. This group of companies paid dividends of around £70bn in 2020, alongside over £10bn of contributions into their DB pension schemes (down from around £12bn in 2019).
What are the relevant regulatory developments in the context of dividends?
The Pension Schemes Act 2021 introduces two new Contribution Notice tests.
A Contribution Notice is a formal legal demand from TPR to make a cash payment to the DB pension scheme and can be imposed on the sponsor, company director, shareholder or connected party.
The relevant new Contribution Notice test in the context of dividends is the ‘Insolvency Test’.
The trigger for this test is where a dividend (or another corporate event) results in a ‘material reduction’ in the recovery that a DB pension scheme can expect to get in the event of a hypothetical insolvency. This recovery is measured in the context of the scheme’s solvency deficit (based on the very prudent cost of buying out benefits with an insurer), rather than on an ongoing funding or accounting deficit measure.
This threshold test ignores the likelihood of the company’s insolvency and so would still be relevant for a strong sponsor, potentially including a number of the listed companies which have been reporting their dividend plans for 2021 over recent weeks.
What could this mean in practice?
The trigger for the threshold test - a ‘material reduction’ in the recovery for the scheme on hypothetical insolvency - is not defined in the law and TPR has said that it won’t be issuing guidance on it but will decide on a case-by-case basis. So this means TPR has a lot of discretion about whether to investigate further. However, TPR is required to act reasonably when using its powers.
Determining when the threshold test is met and making a call on what TPR might subsequently decide is a “reasonable” action to take, are areas requiring judgement. We therefore expect these areas will generate much debate in the early days of these new TPR powers coming into force and it may be challenging for company directors to understand where the new boundaries lie.
At year end 2020 we saw 47 of the FTSE100 report an IAS19 pensions accounting deficit – but on the more prudent metric used for the insolvency test we estimate that around 75 of the FTSE100 would have shown a deficit at their respective 2020 year ends – and these deficits are significantly higher.
Had the new TPR powers already been in force, the payment of dividends by some of these companies could have potentially breached the first threshold for the Insolvency Test. This would potentially have given TPR the power to consider opening an investigation into the use of its new Contribution Notice power.
That said, a large number of the FTSE100 schemes have covenant protections (e.g. dividend sharing agreements and/or contingent security) in place, and so these companies may have been able to point to appropriate mitigation being provided to the scheme, or to make a case as to the reasonableness of TPR pursuing an investigation.
Will this lead to any changes in corporate behaviour?
Where directors of companies with a DB scheme wish to pay dividends, and where the DB pension scheme has a deficit on the relevant measure (which most will because it’s measured by reference to the solvency deficit), we expect directors will wish to analyse the impact of dividends on the DB scheme at an early stage of discussions. This will be relevant for all corporates which sponsor DB pension schemes, not just the largest FTSE 100 blue chips. And is relevant for intra group and special dividends, as well as ongoing ‘regular’ dividends paid out to shareholders.
It will be important to carry out this upfront analysis to provide some context and comfort around which levels of dividend would potentially present regulatory risks, before reaching the Board approval process. Such an approach also demonstrates that the DB pension scheme was considered as part of the directors’ decision making and sets out the basis for conclusions on whether any mitigation to the scheme would be appropriate. This could prove to be crucial supporting evidence should TPR investigate.
In practice this will mean that in some circumstances companies wishing to pay dividends may also need to consider potential mitigation to the DB pension scheme in order to manage the regulatory risk of a Contribution Notice and the reputational risk associated with a TPR investigation. Mitigation could take the form of a cash payment to the scheme, but we have increasingly seen alternatives such as contingent security for the scheme (for example cash held in escrow, which could tip into the scheme or be returned to the company under pre-agreed circumstances).
What about schemes in surplus?
A scheme in a funding surplus, or in deficit but with a short recovery plan, may have previously seen the strength of their ongoing funding position as persuasive arguments to support companies being able to pay larger dividends.
However, the threshold tests for the new Contribution Notices are performed in the context of the scheme’s prudent ‘solvency deficit’ – and so this analysis is still recommended even for schemes which are in an ongoing funding or accounting surplus and/or where there is a short recovery plan in place.
What should companies be doing now?
Many companies are likely initially to wish to work through the analysis required in some detail ahead of discussions on dividends payable after 1 October 2021 (and so which will be paid under the ‘new regime’).
As positive noises around Q2 results and dividend announcements continue over coming weeks, it will be interesting to see if the Q3 and Q4 results later this year bring any different messaging around future dividends for those listed companies with UK DB schemes.
If you would like more information, see our note for companies around managing the new pensions regulatory risks around dividends – linked here.