Cumulative preferred stock is a type of preferred stock that offers a crucial protection to its shareholders: if the issuing company misses any dividend payments in the past, all those missed dividends must be paid out to cumulative preferred shareholders first before any dividends can be paid to common shareholders. This provision ensures that preferred shareholders retain their right to all previously promised dividends, even if payments were temporarily suspended.
Understanding Cumulative Preferred Stock
The defining characteristic of cumulative preferred stock lies in its dividend arrears provision. Unlike common stock, preferred stock typically pays a fixed dividend. If a company faces financial difficulties and decides to skip a preferred dividend payment, cumulative preferred shareholders don't lose that payment forever. Instead, the unpaid dividends accumulate and become "in arrears." The company is legally obligated to clear all these arrears before it can distribute any dividends to its common stockholders.
This feature makes cumulative preferred stock more attractive to income-focused investors, as it provides a higher degree of income security and predictability compared to non-cumulative preferred stock or common stock.
How Cumulative Dividends Work: An Example
To illustrate how cumulative dividends function, consider a preferred stock with a $2.00 annual dividend.
- Year 1: The company has a challenging year and decides to skip the preferred dividend payment. The $2.00 dividend for Year 1 is now in arrears.
- Year 2: The company continues to struggle and again skips the preferred dividend. The $2.00 for Year 2 is added to the arrears. The total arrears are now $4.00 ($2.00 from Year 1 + $2.00 from Year 2).
- Year 3: The company's financial situation improves, and it decides to resume dividend payments. Before any dividends can be paid to common shareholders, the company must first pay the current year's $2.00 preferred dividend PLUS the $4.00 in accumulated arrears from Year 1 and Year 2. So, cumulative preferred shareholders would receive a total of $6.00 per share ($2.00 current + $4.00 arrears).
Cumulative vs. Non-Cumulative Preferred Stock
The distinction between cumulative and non-cumulative preferred stock is vital for investors.
| Feature | Cumulative Preferred Stock | Non-Cumulative Preferred Stock |
|---|---|---|
| Missed Dividends | Accumulate and must be paid in full at a later date. | Are lost permanently if not declared and paid in a given period. |
| Priority | High; receives all accumulated arrears plus current dividends first. | Receives current dividends only if declared, with no claim on past missed payments. |
| Investor Appeal | More secure, lower income risk; preferred by income investors. | Less secure; higher risk of dividend loss if payments are skipped. |
| Company Obligation | Stronger financial obligation to shareholders for all past due dividends. | Weaker obligation regarding past dividends. |
Advantages and Disadvantages
Advantages for Investors (Shareholders):
- Income Security: Provides a more reliable stream of income, as missed payments are not forfeited.
- Priority Claim: Shareholders have a strong claim on company earnings for their dividends, ranking above common stockholders.
- Attractive for Income Seekers: Ideal for investors looking for stable, predictable income, such as retirees or institutions.
Disadvantages for Issuers (Company):
- Financial Burden: Creates a future financial obligation for the company, as accumulated dividends must eventually be paid.
- Impact on Common Stockholders: Can delay or prevent common stockholders from receiving dividends for extended periods if significant arrears accumulate. This can sometimes put pressure on a company's financial flexibility.
Implications for Common Shareholders
For common shareholders, the existence of cumulative preferred stock means that their dividend payments are subordinate to those of preferred shareholders, especially when preferred dividends are in arrears. Common stockholders cannot receive any dividends until all cumulative preferred dividends—both current and those in arrears—are fully paid. This can significantly impact common stock returns, particularly in companies that experience periods of financial distress.
Who Invests in Cumulative Preferred Stock?
Cumulative preferred stock appeals to a specific type of investor: those primarily seeking stable income and capital preservation rather than significant capital appreciation. This often includes:
- Individual Investors looking for steady dividend income.
- Institutional Investors such as pension funds, insurance companies, and endowments that require predictable cash flows to meet their liabilities.
