* World no. 2 miner pays hefty 2016 dividend
* Sets $500 mln buyback in focus on returns
* Sees strong iron ore prices
* Underlying earnings up 12 pct (Recasts, adds analyst comments)
By James Regan
SYDNEY, Feb 8 (Reuters) - Global miner Rio Tinto put its focus on returning cash to shareholders on Wednesday after beating profit forecasts on the back of cost-cutting and a strong recovery in iron ore prices.
The world's No. 2 iron ore miner said it will pay a bigger-than-expected annual dividend of $1.70 per share and announced a $500 million buyback, taking shareholder returns to about 70 percent of underlying earnings.
The move comes just a year after Rio Tinto was forced to abandon its previous payout policy of never cutting payments year to year after tumbling iron ore prices slashed profits across the industry.
"It's quite comforting that they're sticking their necks out a bit," said Brenton Saunders, a portfolio manager at BT Investment Management in Sydney. "It gives you comfort that they have quite a lot of momentum still in the cost-out strategy - so that's all good."
Rio Tinto said on Wednesday it has already achieved $1.6 billion in cost savings of the $2 billion targeted across 2016 and 2017.
"We enter 2017 in good shape. Our team will deliver $5 billion of extra free cash flow over the next five years from our productivity programme," Chief Executive Jean-Sebastien Jacques said.
Underlying earnings rose 12 percent to $5.1 billion, beating analysts' estimates for around $4.87 billion, according to an externally compiled consensus, and marking a turnaround from 2015 when Rio posted its worst underlying earnings in 11 years.
"It certainly looks and feels like the 'old school' Rio swagger is back," said Shaw & Partners analyst Peter O'Connor. "It sets the stage for the other big miners reporting this month."
The full-year dividend was well above expectations of about $1.33 a share, according to the external consensus, but is still below 2015's dividend, which partly reflected the previous payout policy.
Analysts were mixed on whether Rio Tinto would lift returns to shareholders in 2017 or hold on to more cash amid forecasts for a retraction in commodities prices.
Rio Tinto's chief financial officer Chris Lynch said the bigger-than-expected dividend and buyback "sent a strong signal to shareholders" that the company had the capacity for big payouts.
The price of iron ore surged 81 percent last year and now sells for around $80 a tonne, despite analysts' expectations for a retreat to around $55.
The concern is that millions of tonnes of additional low-cost supply from Australia and Brazil will overwhelm demand in 2017 and send prices into retreat.
However, Jacques said the greater threat was China could restart more of its own iron ore mines, cutting its requirements for imports.
Reporting by James Regan; Additional reporting by Sonali Paul in MELBOURNE; Editing by Richard Pullin