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STOCK MARKETS - THE WEEK IN VIEW : Pension funds await hammer blow

Investors are unlikely to undermine UK stock prices before the Budget on Wednesday. Chancellor of the Exchequer Gordon Brown is expected to repeal a dividend tax credit for pension funds, a move that could hammer the market.

At issue is the fate of the advanced corporation tax credit granted to pension funds and charities that both excludes them from paying tax on dividends received but also gives them a further 20 per cent payment from the Government on top of their dividend intake.

"Our pension funds have traditionally been equity funds, but we've now taken on bonds for the first time," said Simon Smith, an investment manager at Albert E Sharp. "Short-term funds will have to increase their bond holdings and though I don't think they can get rid of the tax credit in one go, the market is already discounting the Government getting rid of it."

Smith said this tax credit has led pension funds to load their portfolios with high dividend paying companies that can be counted on for consistency.

Utilities like National Power, Southern Electric, Anglian Water and Severn Trent have been staples of well-balanced pension funds because of their unwavering dedication to reward investors with healthy dividends.

The FT-SE Water index of eight water utilities has a dividend yield of about 5.3 per cent while the FT-SE Electricity index yields about 8.6 per cent in dividends, compared with a dividend yield of 3.6 per cent for the FT-SE 100 and All-Share indexes.

A cut in the advanced corporation tax credit may complete a one-two punch that could knock the utilities' shares prices flat since they are probably faced with a windfall tax of between pounds 3bn and pounds 5bn.

"If people are looking to maintain a gross yield of 3.5 per cent from their investments, they wouldn't start to buy again until the market fell 20 per cent," said Jim Stride, director of Sun Life Investment Management.

Analysts at BZW warn that the move may hurt most those companies that the Government is trying to give the greatest support to - the manufacturers.

Richard Kersley at BZW said the abolition of the tax credit will hurt profits since companies will have to increase the amount they pay into pension schemes.

"Tax credit change would hit manufacturers the hardest. Is this Gordon Brown's intention?" Kersley asks. "We think not. Look out for a possible offset next Wednesday."

Copyright: IOS & Bloomberg