Lloyds to set out dividend plans ahead of share sale-sources

* Bank expected to lay out dividend growth plans

* Expected to set criteria for one-off payouts, buybacks

* Investors expect ramping up of dividend over 2-3 years

* Could pay 5 pct of FTSE-100 dividend yield -hedge fund

* Lloyds expected to face new 1 bln pound PPI bill (Adds details on dividend strategy)

By Matt Scuffham

LONDON, July 21 (Reuters) - Lloyds is expected to set out its dividend plans next week, including a potential return of surplus cash to shareholders, making its stock more attractive ahead of a possible sale to retail investors, industry sources said.

British finance minister George Osborne said in June he would sell part of the government's remaining 15 percent stake in Lloyds to retail investors in the next 12 months, in a sale reminiscent of the 1980s privatisations of British Gas and British Telecom under then Prime Minister Margaret Thatcher

Lloyds' potential dividend yield and prospects for special one-off payouts would be a big part of the stock's appeal to retail investors, many of whom look for shares to provide income.

Prior to a 20.5 billion pound ($32 billion) bailout in the 2007-2009 financial crisis, Lloyds was one of the biggest dividend-payers in the FTSE 100. In 2005 and 2006, for instance, it handed more than half its profit to shareholders.

The state-backed bank has already said it intends to give shareholders at least half its earnings in the medium term, bringing it into line with rivals HSBC and Barclays (Swiss: BARC.SW - news) .

Lloyds is expected to say how it plans to meet that target when it reports first-half results on July 31 and also set out how it would return any surplus capital to shareholders, either through one-off dividends or share buybacks, the sources said.

Lloyds paid its first dividend for six-and-a-half years with a payment of 0.75 pence per share for its 2014 financial year. Investors have been awaiting guidance on dividend growth.

"We think it could ramp up from that three quarters of a penny dividend quite rapidly, up to 3 or 4 pence and possibly more, over the next two to three years," Richard Buxton, head of UK equities at Old Mutual Global Investors, said.

Hedge fund Toscafund said it expected Lloyds over time to contribute about 5 percent of the FTSE 100's dividend yield, making it one of the biggest dividend payers in the blue chip index. Toscafund also expected the bank to distribute 16 pence a share of surplus capital to shareholders, equivalent to about 20 percent of its market value, according to a report to clients seen by Reuters. Lloyds' market value is currently about 63 billion pounds, according to Thomson Reuters (Dusseldorf: TOC.DU - news) data.

Chief Executive Antonio Horta-Osorio was reported to have told investors in 2013 the bank could eventually pay out up to 70 percent of its earnings in dividends.

But Lloyds' management has since committed to a more conservative approach to dividend growth, acknowledging an uncertain regulatory environment while retaining flexibility to return surplus cash via one-off dividends or buy-backs, the sources said.

"People are really beginning to recognise the speed at which Lloyds will be building huge amounts of capital. A large part of this will end up being paid out in dividends," Buxton said.

Lloyds core tier 1 ratio, a measure of its financial strength, rose to 13.4 percent at the end of the first quarter from 12.8 percent at the end of 2014. Sources say it is likely to want to hold at least 12 percent core capital going forward.

Analysts at Morgan Stanley (Xetra: 885836 - news) expect Lloyds to set aside a further 1 billion pounds to compensate customers mis-sold loan insurance, taking its total bill to 13 billion pounds, the highest in the industry.

Morgan Stanley forecasts that Lloyds will make an underlying profit of 2.1 billion pounds while its statutory pretax profit, including PPI and other one-off charges, will come in at 950 million pounds.

Analysts forecast Lloyds will report an interim dividend of 0.75 pence per share, unchanged from the second half of 2014. (Additional reporting by Sinead Cruise and Nishant Kumar; Editing by David Holmes and Jane Merriman)