Diageo to benefit from UK pension changes

Now that the dust has settled from this year’s Budget, City analysts and commentators are looking beyond the immediate impact of the freeze on spirits duties and the abandonment of the hated duty escalator on the drinks industry.

They are focusing on what could happen to the London investment market from next April when George Osborne’s radical shake-up of pensions takes full effect – and they have identified Diageo as one of the main beneficiaries of his changes.

The key change is that from April 2015 anyone aged 55 and over can take their pension pot and do what they like with it; no longer will most be forced into buying an annuity – handing over their savings to an insurer in exchange for an annual income for life.

Osborne’s new rules mean that anybody tempted to grab the cash and splurge the lot will be discouraged by the tax regime. The first 25% of any pot can be taken tax free but the rest will incur income tax at the saver’s marginal rate, which in most cases will be 40%. So the prudent are likely to plan ahead and draw modestly on their new-found capital over a number of years.

Their strategy will be two-fold. First, take only sufficient income on which to live and in so doing pay the minimum tax necessary; second invest the money in the hope of preserving its value, or better, increasing it each year to negate the effects of inflation. So savers who turn their backs on annuities will be looking for rock-solid shares for funding their later years.

Legal & General has calculated that the annual market for annuities could halve from £12bn to £6bn from next year and that most of the cash switched out of that market (which invests heavily in bonds paying a guaranteed return), will flow into equities.

What pensioners and their advisers will be seeking, City experts believe, are companies with healthy balance sheets, dominant global market positions and a record of strong and growing cash flow. Step forward Diageo, which fits the profile almost perfectly.

Shares, of course, can be volatile. But over the long run they beat other forms of investment. In that context analysts give Diageo the thumbs up, despite its shares having slipped by nearly 10% over the past 12 months.

Diageo gets 70% of its revenues from spirits and has six of the world’s top 20 brands in its portfolio. Beer, largely Guinness, contributes a further 20% of sales. The key factor here is that even in recession, people still like a tipple, even if they trade down for a while, as happened in the US immediately after the financial shocks of 2008. But that process was temporary and is reversing. And Diageo is now in such a strong geographic position following its takeovers of the past few years that more than 40% of its sales come from emerging markets. A downturn here or a hiccup there can be cushioned by progress elsewhere in the 180 markets it serves.

Over the past 20 years Diageo’s share price has more than tripled and over the past five years the dividend has increased by an average 7%, easily outstripping inflation. It rose by 9% last year. And crucially, although Diageo has poured more than £5bn into marketing its brands in the last three years, it has very strong free cash flow – more than £1.4bn last year. That easily covered the dividend payment. Very few companies have such an enviable long-term record.

That is why, barring a cataclysm, analysts say that at this time next year investment advisers will be counselling the newly liberated to look to companies such as Diageo as a home for part of their savings for life. The consequent impact on the shares will be positive over the longer-term.