Dividends, reserves and pension deficits
June 16, 2016
Dividends can only be paid out of distributable reserves, a legally defined sum of money broadly representing the aggregate of undistributed past profits and an element of value creation. A pension deficit has to be deducted from these reserves on the basis that the company's legal obligation to fund the pension scheme should come before it can make payouts to investors.
The above definition of reserves may sound, at first sight, straightforward and sensible. However, it becomes complex because the term ‘pension deficit’ for this purpose means the amount assessed under IAS 19R, the international pension accounting standard. Alternatives for determining the deficit such as the amount actually agreed with the trustees to fund the pension scheme or the amount an insurer would charge to buy out the promises are not considered.
The definition of distributable reserves creates a dilemma for boards as the company is often legally committed to pay more to the pension scheme than the pension accounting deficit. This is because the deficit funding plan is usually determined using a more prudent approach than is used for accounting. The accounting standard setters get round this issue by saying if prudence in funding a pension deficit leads to a surplus under IAS19R, this is fine if the surplus will eventually be returned to the company even if you have to wait until the last pensioner dies. If the surplus is not returned automatically when the last pensioner dies the pension accounting deficit is increased to the funding deficit. So it’s not so straightforward after all.
In addition, decisions about dividend policy cannot be made by companies in isolation of the pension scheme trustees' views. Trustees understand that shareholders require a return on their investment in the form of dividends to compensate for the risks they take. To do otherwise might lead to shareholders withdrawing their investment with consequential damage to the business. The trustees' view on the acceptable level of dividends needs to be weighed up against the security of the pension promise in the longer term and cash affordability today.
In conclusion, when considering dividend policy, boardrooms need to think carefully about not just the legal definition of distributable reserves, but also how much contributions they are obliged to pay in to the pension scheme and consequential impact on the security of the pension promise. Whatever they decide to do, directors are legally obliged to give the appropriate disclosure to their respected companies.
Brian Peters is a partner in PwC’s pensions team.