From Saga to gaga

This question arose in Bearbull last week from discussion of the likely changes to the rules controlling the use of matured defined-contribution pension plans; in particular, scrapping the obligation to turn most of the sum into an annuity. When annuities are no longer compulsory, pensioners will be able to range far and wide in their search for a stream of income that will take them from the age of Saga to the age of gaga. How should they go about it?

Equities are an obvious solution, though not the only one, because they have a clear advantage over any instrument that offers just a fixed stream of income. Obviously the days are over when a generation of rentiers invested small fortunes in the likes of Nottingham and Derby Railway stock, as in Howards End, EM Forster's classic of Edwardian middle-class manners. That's just as well since, as Forster told us, the stock "declined with the steady dignity of which only Home Rails are capable". Yet now - as then - there is still plenty of fixed-interest stock around. But it's a lousy home for a pension pot. After all, consider the following: if inflation averages just 2.5 per cent a year for 20 years, then - other things being equal - £20,000 of pension income for someone aged 65 will have the spending power of just £12,200 by the time our fictional pensioner reaches 85.

Dividends don't have this constraint. That's because they are a claim on the 'residual profits' of a company. Profits have the virtue of being able to rise since most firms have some amount of pricing power, which means their prices can respond to their costs, and rising profits mean rising dividends. However, the profits are also 'residual', which means they can be highly variable since demand - or the lack of it - does not always permit prices to compensate for higher costs; sometimes revenue even falls. No profits can even mean no dividends. For a mature pension plan that could lead to problems far worse than an income gently declining in real terms. After all, being told "Sorry, dear, we can't afford to run the central heating" is a crisis; whereas, being told "Sorry, dear, this year we'll have to holiday in Skegness not Sorrento" is just a bit of a drag.

Which is why we are so interested in the reliability of a company's dividends; more so, even than the yield on its shares. As to answering the question - which is London's most reliable dividend payer? - then intuitively we are looking backwards (which may not necessarily be the right thing to do) and we are thinking about (a) companies that have size and have the history to prove they can stick around, (b) those that are family-controlled and (c) quite possibly investment trusts.

It is true that Forster's heroines in Howards End, the Schlegel sisters, invested their capital in 'Foreign Things'. But that could have been a euphemism for Foreign & Colonial (FRCL) since London's oldest investment trust was already over 40 years old when the book was published in 1910. It's still going strong and still pushing out growing dividends. The pay-out has risen every year since 1971, enough to cover even the longest retirement.

That does not make F&C the most reliable dividend-payer. At least one other investment trust - Caledonia Investments (CLDN) - can beat that. Caledonia's website is quick to boast that its dividend has risen every year since 1967 and it's tempting to think that the company's ownership structure may be behind this. Caledonia is effectively the investment vehicle for the wealth of the Cayzers, a family that made its money shipping Forster's contemporaries to all corners of the British empire, including passages to India. The family still controls the trust, from which arises the imperative to safeguard its wealth as much as to grow it and to generate a sustainable income as much as a rising one.

If the family effect is relevant, then among FTSE 100 companies, Associated British Foods (ABF) may stand out - no other Footsie company has a remotely comparable level of family ownership. The Anglo-Canadian Weston family controls the company and its current chief executive, George Weston, is the great grandson of the founder of the Canadian bakery from which ABF grew.

Quite possibly, ABF's long-term dividend-growing record would beat Caledonia's, though the company is too modest to say. Less likely is that it would do better than the Swiss foods giant, Nestlé (0QR4). Nestlé's shares were first listed way back in 1873, but were not traded in registered form until 1959. Since then its dividend has never been cut and only 11 times in those 54 years has it been held (in the very troublesome early 1970s it was held three years running). In that period the annual compound growth in the dividend is 8.8 per cent, enough to turn £100 into £9,505.

However, if we are trying to guesstimate which companies, thanks to their formidable ability to pay dividends, are best suited to power a mature pension fund, then we need a simple formula that quantifies 'reliability'. That's what the table is about and the next three paragraphs are the detailed discussion behind it, which those who aren't interested in the technicalities can skip, and those who are interested in the source matrerial

The notion of reliability derives both from the rate at which dividends have grown and how little the pay-out has jumped about. Thus we want to know both the average rate at which the dividend has grown over a decently-long period and the volatility - the 'standard deviation', to be precise - around that average. The lower the volatility of a company's dividends relative to their average growth, the more predictable will be the pay-out, the less likely that it will be held or cut and - this is the nub - the better suited will be the shares to provide a pension.

The table handles this notion by moderating long-term annual growth in dividends by the relationship of growth to volatility. In effect, it credits companies that produce a lively growth rate in dividends, then it debits them the more that dividends - both increases and cuts in the pay-out - bounce around.

Back to Nestlé, the star performer, to explain. From 1994 to 2013, its dividends grew 11.7 per cent a year on average and there was comparatively little volatility around that average - plus or minus 6.5 per cent, which measures the 'width' of the band within which dividends grew. Another way of understanding the volatility - or lack of it - is by comparing the average growth rate with the compound growth rate, which measures the pace at which a variable - in this case, dividends paid - grows in order to get from an opening value to a closing amount. As long as there is any change in the pace of growth, then the compound rate will be lower than the average growth. But the closer together those two values fall, the lower the volatility. Put another way, even in the case of company dividends, which bounce around much less than company profits, volatility is likely to be higher than the average growth rate. That being so, we can get some measure of the reliability of dividends by moderating the average growth rate by the ratio of growth to volatility.

That is quantified in the right-hand column, 'Reliability factor', which is the 'score' of dividend quality. Nestlé tops the lot because its average growth rate of 11.7 per cent is multiplied by the ratio of growth rate to volatility (11.7 over 6.5), producing a reliability factor of 21. True, the formula might be a bit mathematically illiterate, but it does a job. Thus the 19.1 per cent average growth rate in dividends from miner BHP Billiton (BLT) far exceeds Nestlé's (though over a shorter period), but the extra volatility in the growth means BHP's reliability factor is just 18. Much the same can be said about Vodafone (VOD).

It's also important to understand that the 17 companies in the table are not the best performers from a comprehensive trawl through the London stock market. On the contrary, this is a comparative exercise between big companies that have been around for a long time, are likely to stick around and have a proven track record in dividend payments. True, it would be great to know how all the companies in the FTSE 100 index stack up, but that's a really time-consuming task.

Besides, would it be worth the effort? Let's recall what prompted this exercise - the need to know how best to capture a smoothly-rising income for retirement. It makes a lot of sense to turn to equities to fulfil this, but why rely on a small portfolio of shares to do the job when you can use the whole market? After all, the market stands a better chance of being around longer than any of its components and of delivering its dividend growth more smoothly than most companies, albeit more slowly than many.

Sure, it might be tempting to divi up your pension pot between, say, Nestlé, BHP Billiton, ExxonMobil (US:XOM) and Standard Chartered (STAN). With just those four you'll have the world covered and most of its industries plus some useful currency diversification (though it's miserable that you’ll get Nestlé’s dividends net of withholding tax, some of which you won't escape).

But consider this: as the age of Saga slips into gaga - and let's face it, it happens - the last thing you'll want to be thinking about is whether to switch out of, say, BHP and into Vodafone, or whatever. If your pension income is being delivered via a fully-replicated FTSE 100-tracking exchange-traded fund, you won't have to.

Seeking 'Mr Reliability'