How long can your LICs continue to pay dividends?

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The central premise that "retained profit reserve" is a meaningful measure of how long an LIC can continue to pay dividends, in hard times, is an utter fiction, and is entirely misleading. Surely someone noticed that a LIC's "retained profit reserve" bears utterly no meaningful relationship to long how that LIC can continue to pay dividends when it's received dividend income dries up? "Retained profit reserve", is purely an accounting measure. It bears no relationship to the actual assets held by the LIC, and tells you nothing about what they have done with that "retained profit reserve". To all meaningful intent and purpose in this context, "retained profit reserve" is identical to "retained earnings". Where you do think that "retained profit reserve" is sitting, exactly? When an LIC pays out less in dividends than it receives, it will almost invariably use those funds to purchase further assets. For example (pretty much chosen at random): You state that state that WHF has 8.1 years of "dividend reserve", and that this indicates that they have 8.1 years of "dividend coverage" remaining, alongside a payout ratio of slightly over 200%. Yet Whitefield currently has 0.87% of its assets in cash (~$4m) and an NTA of $5.40/4.86 (pre/post tax) (source: April NTA update), and paid around ~$20m in dividends last year; and the Dec 2020 quarterly update states that they intend to repeat this in the year to come. See the issue here? They hold cash of about $4m and intend to pay $20m in dividends. There are only two ways to do this - to assume that the future income flow for year will be in excess of $16m (that's possibly true, or at least close), or, to sell down some of their investment folio and use that to pay dividends. Their "retained profit reserve" is ~$80m (2020 annual report). So at this point, it is fair to ask: What does their retained profit reserve have to do with their ability to pay dividends? In what meaningful way does the "retained profit reserve" in their annual report indicate that they have 8.1 years of dividend coverage at the current rate? The answer: None whatsoever. If they want to pay dividends in excess of their cash earnings, and in excess of their cash holdings, they must either liquidate their investments, or borrow. Exactly like any other company, and regardless of what their books state their "retained profit reserve" is. Finally: it has been quite a few years since an Australian Pty Ltd company was actually required to pay dividends "from profits". It was once the case that this had to be so; but this was abolished a while back. Further, one of course can always pay profits from retained earnings (of which WHF has $54m). So an LIC that has $X spare cash, which it wishes to distribute, and has $0 in "retained profit reserve" can always still distribute that $X as a dividend. If they have sufficient franking, they can still frank it.

The retained profit reserve is utterly irrelevant to an LIC's ability to maintain dividends.  

Ben, Scott Whiddett from Pitcher Partners is an expert on LIC accounting and provided this reply.

Ben is correct to have identified that the amendments to the Corporations Act in 2010 meant that a Company no longer needed to identify profits to pay a dividend (1).

However, what your reader may not be aware of is that these changes to the Corporations Act in 2010 led to the Commissioner of Taxation issuing a taxation ruling around the franking of dividends. In essence it warned that a dividend declared in accordance with the Corporations Act, does not necessarily mean franking can be attached to the dividend.

So the issue to highlight is really around being able to frank a dividend.

The Commissioner of Taxation’s ruling details that a franked dividend may only be paid when the Company can identify ‘profits’, as the term ‘profits’ is not defined in the Income Tax Act, the Commissioner of Taxation’s ruling suggests that ‘profits’ are those amounts determined in the context of the Accounting Standards. It was noted that where a Company has prior year accumulated loss the Company must make a decision to transfer the current period profits to a profits reserve and not allow the current period profit to be offset against a prior year loss (and taint current year profits). That is highlighting the importance of transferring profits to a reserve as a method of quarantining profits for future franking of dividends.

As far as how a LIC funds a dividend, I think it is fair to remind readers that LIC’s cash holdings can move significantly throughout a year and may not necessarily represent capacity to make a dividend. Some LIC’s have high take up of dividend reinvestment plans, so a smaller proportion of cash dividend paid. Many boards budget their dividend payments in advance and would be making capital management decisions around portfolio realisations and dividend and other cashflow inflows.

Kind regards Scott

Footnote 1

From 28 June 2010, the test became a three pronged test stating that a company must not pay a dividend unless:

1. The company’s assets exceed its liabilities immediately before the dividend declaration and the excess is sufficient for the dividend payment;

2. The dividend is fair and reasonable to members as a whole; and

3. Creditors are not materially prejudiced.

Thanks for the reply from Scott, but even Scott (eventually) notes is that what Ben said was absolutely correct in that retained profit reserve does not represent the LIC's ability to fund their dividend. I wonder when the misinformation around LIC's stop being perpetuated. I suppose never while there are vested interests.

While this is helpful I think that what is really relevant is how long can LIC's maintain dividends that are fully franked .
An unfranked dividend is equivalent to a return of capital which is not in the interests of the LIC .
Most shareholders in an LIC are true investors looking for a franked dividend.
As an example PIA has a stated intention to pay a constant dividend fully franked . They may have " profit reserves " of 10 years but there were losses at some stage and the unused franking credits will not cover anything close to 10 years .

I have often been told that this is an advantage over ETFs which pay out all profits. Doesn’t this really mean that ETF holders get their returns sooner to do with as they wish. In the end all the profits will have to be returned sometime. The idea that some LICs have 2 to 4 years profits held back from investors mean investors are losing out if the LIC is holding the profit in cash.

Yes, ETF s payout everything.... So your money now. But in reality it maybe a feast or famine effect... With no reserves there is nothing to distribute during lean times. The retaining of dividends is part of a capital management strategy that smooths dividend payments a bit like an allocated pension. Consistently paid and a consistent amount +/-. Retained dividend monies also allow the LICs to access buying opportunities without going cap in hand to the market or holders as a function of their closed ended structures. Noting they also often have loan facilities too

Spot on Justin. ETF's are managed funds (unit trusts) dressed up with a market maker. Not only do they have to pay out all income but realised capital gains must also be distributed. In my experience this has led to some large fluctuation in distributions (i.e. your capital being paid back to you) with profound tax consequences. It was one of the reasons I left he industry. The most egregious example was a fund paying roughly $800 to $1000 in quarterly dividends and then, as a result of trading profits, dumping a $13,000 quarterly dividend in my lap at the financial year end with unexpected tax consequences. Added to this was the fact that the fund went ex-dividend and the unit price fell to reflect the payout. Over 9 years my quarterly dividends fluctuated between nothing and the $13K and the unit price rose by less than 3% over the same period. LIC's do not have to pay out realised gains and can reinvest the proceeds from sales on behalf of investors.

Peter,

Nobody is "dressing up" anything. An ETF is a fund that is traded on an exchange. It's literally the whole — Exchange Traded Fund.

You talk about the tax consequences of ETFs, when an accumulator who spends 4 decades accumulating still has unnecessarily high tax effects due to distributions form LICs paid out the entire time.

Also, it is a drag on returns that the LIC holds cash reserves to pay out their dividends, when an ETF investor can reinvest it sooner for those 40 years of accumulation.

As for "smoothing dividends", where do you think the dividends come from if not from the value of the shares? The man in the moon? Consequently, you can easily "make your own dividend" by selling (and you even get 50% off your CGT bill).

Hopefully those reading this are aware that they need to fact-check your comments if they want to make an informed decision.

Interesting article. Thanks for sharing it.

What is the impact of cross holdings (Example MLT owning shares in SOL) or fund of funds (Example HM1) that comprise several different funds? Doesn't this help to sustain dividend payouts?