Dividends beat annuities

Dividends beat annuities: Why I expect RIRP to trounce annuities

Dividends beat annuities. Now that both the main measures of the cost of living in the UK are above 5% for the first time in 20 years, the Editor has suggested that this would be a good time to review “the more philosophical aspects of RIRP: longevity for example, comparing the fixed annuity rate for life at your age with the potential income from RIRP”.

It has proved an interesting, if sobering, exercise.

Fortuitously I am in my 65th year, the lowest conventional starting date for most annuity projections. For the illustrations in this article I am also pretending to be a non-smoker with no impairments. It is true that being a sickly smoker would improve the annuity quotations, but as Table 1 shows, any such improvement would need to be pretty spectacular for annuities to make any sense for me.

Dividends beat annuities

What is often forgotten is that annuity projections are quoted gross, but the income is taxable. True, if held outside a pension fund, some of it is regarded as a tax-free return of capital, but at my age the proportion is so low as to make little difference.

The net income comparison is startling. The table assumes that your state pension will use up your tax-free personal allowance, and that you are a basic rate taxpayer. So effectively all your annuity income suffers tax at 20%, while the RIRP tax liability is already discharged by the dividend tax credits you receive on your dividends.

Doomsday inflation

The attractions of the 4% RIRP net income target are immediately clear. It beats everything except a level annuity from day 1.

The impact of a prolonged period of inflation, even at “only” 3%, is shown in the bottom four scary lines. Even inflation around the current level for just 4 years slashes 20% off the buying power of the level annuity.

The maths holds true for higher and top rate taxpayers too. For example, higher rate taxpayers see the first year’s figures (second line of Table 1) slashed to £3,730, £2,708, £2,326 and £3,000.

Obviously I cannot predict what the RIRP will deliver longer term. It aims to achieve dividends which rise in excess of the worst cost of living measure. I am frankly amazed that in the current economic climate a recent survey showed that brokers are expecting the 200 biggest UK companies to raise their dividends by more than 12% both this year and next: I just hope they are right.

To show what a difference the odd percentage point makes, I have projected long-term annual increases for the RIRP at 1% above the 3% inflation assumptions and at 2% above the 5% assumptions — though these are only illustrations, not a forecast!

Table 2 below shows the RIRP goalposts both for the current year and to date since the RIRP’s launch in February 2008. This year’s projected yield on the fund represents an increase of over 40% on the original 4% target used in table 1, so it is comfortably ahead of the 14.6% needed to stand still in real terms.

Dividends beat annuities

Statistically, the RIP date for my RIRP could still be at least 20 years away, given my inherited longevity on my mother’s side and despite my self-inflicted impairments — I smoke cigars occasionally, drink too much, am overweight and am among the growing army of oldies on pills for blood pressure and cholesterol.

And this constitutes much of the rationale behind this issue’s purchase of the first tranche of what will probably be the final addition to the portfolio: GlaxoSmithKline, a global leader in what should be the continually burgeoning healthcare sector.

Booming demand for care pills

I am typical of a generation of baby boomers retiring after a lifetime of dietary over-indulgence and decreasing exercise. Demand in the developed world for the pills which seem to combat the worst effects of these excesses will rise strongly for at least a decade. Meanwhile demand in developing countries is growing too as expanding middle classes care increasingly for the health of themselves and their children.

GSK is well positioned on both counts. Sales outside the US and Europe already account for nearly 40% of underlying turnover, more than compensating for a third quarter decline in sales in Europe. The company is focused on bringing new products to the market: over the past 3 years it has launched more products and received more US FDA approvals than any other company.

The balance sheet is strong, with net debt at end-September under £9bn against a market capitalisation around £70bn. Since January 2008 the dividend has gone up by 26%, and the third quarter dividend is being raised 6% to 17p.

Historically this forms the floor for future quarterly payouts, bringing the prospective yield to a shade over 5%. Sadly the shares went xd in the week before publication, which means the RIRP will not get its first dividend from the shares until April.

Dividends beat annuities
How the RIRP trounces annuities

Elsewhere it has been a fallow period for RIRP results but the Greek referendum market jitters triggered further “automatic” top ups of RSA and Balfour Beatty in the week before publication. The interim trading statements from FirstGroup and Sainsbury were encouraging. So the fund makes its third purchase of Sainsbury and takes advantage of our newly amended buying limits to top up with an extra unit of FirstGroup, following what seems to me to be an unwarranted fall for their shares.

Scottish and Southern has decided to waste a lot of money changing its name to the meaningless SSE, but despite the latest political posturings both it and United Utilities say they remain committed to above-average dividend increases and are well placed to continue to deliver them.

First published in The IRS Report on 5th November 2011.

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