Wed. Aug. 4, 2010

Income Annuities vs. Dividend Stocks *

I was born in 1962 which puts me on the tail-end of the Baby Boomers (those born between 1946 and 1964). We have been described by some as “the pig in the python.” Over the decades, the sheer size of our group has redefined many aspects of society. As we approach the tail of the python and look toward retirement, once again we have the government and others scrambling to figure out how to handle this aging and albeit disruptive force.

One concern is how will Social Security, pensions and other retirement vehicles withstand the strain. The 2008 market crash has added concern to the viability of these plans. In a New York Times article, “The Unloved Annuity Gets a Hug From Obama“, income annuities are what the administration is promoting to alleviate the pending problem, but is this really a workable solution?

What are income annuities?

The New York Times article describes annuities  as:

“At its simplest, which is how the White House seems to want to keep it, an annuity is something you buy with a large pile of cash in exchange for a monthly check for the rest of your life.”

What are the problems with income annuities?

Charlie Farrell in “Why Annuities Won’t Fix The Retirement Problem“, described the following problems with income annuities:

I. Cash Out Is Determined By Cash In
The income an annuity will produce is directly related to the amount of money you put into the annuity. So if you don’t have much money saved for retirement, you won’t get much of an income stream from an annuity. And most people don’t have much money saved for retirement.

II. Payment Rates Aren’t High
At today’s interest rates, you’ll get about $5.85 of income per year for every $100 you contribute to the annuity (based on a recent quote from a highly-rated insurer). And this $5.85 would be paid to you and your spouse for as long as you both live. That’s basically a 5.85% payout on your savings in retirement.

III. No Provision For Inflation
Annuity payments don’t increase and are fixed for life. So if inflation runs at 3% a year (the average for the last 80 years), your retirement income will be cut by about 45% by the time you’re 85. Meaning that the $5,850 of income will buy you about $3,220 of stuff in today’s dollars, and the $58,500 will buy you about $32,200. You can buy an inflation-adjusted annuity, but when you do that, your initial payout goes down to somewhere around 4%.

IV. Investment Risk
With an annuity, you lose access to your money. Essentially, you gave your money to the insurance company to purchase the annuity. It’s theirs to keep forever, and your income is dependent on the insurance executives running a sound insurance company for the next 30 or so years. That’s always hard to predict and carries it’s own risks.

Dividend Stocks – A Viable Alternative

Instead of turning over your life-savings to an insurance company (that could be the next AIG), why not build a diversified portfolio of dividend growth stocks? This works best if you have time before retirement. The initial rate may not be as high as the 5.85% quoted above, but careful stock selection will allow growth well in excess of inflation. Unlike depending on a single insurance company, a diversified portfolio of at least 30 stocks will greatly reduce the risk. Below are some good dividend growth stocks that will provide a yield-on-cost greater than 5.85% in ten years, based on the listed assumptions:

Current Dividend 10-Year
Company Analysis Yield Growth YOC
Sysco Corp. (SYY) Link 3.16% 6.52% 5.95%
Piedmont Nat. Gas (PNY) Link 4.17% 3.74% 6.02%
Clorox Company (CLX) 3.24% 6.83% 6.27%
Intel Corporation (INTC) 3.07% 7.44% 6.29%
Coca-Cola (KO) Link 3.19% 7.32% 6.47%
Chevron Corp. (CVX) Link 3.73% 5.95% 6.64%
General Dynamics (GD) Link 2.68% 10.07% 6.99%
Procter & Gamble (PG) Link 2.95% 9.87% 7.55%
Universal Health (UHT) 7.26% 1.47% 8.40%
CenturyLink, Inc. (CTL) 8.14% 3.57% 11.56%

Social Security was never intended as a retirement plan, but as a supplement to savings. The key to a successful retirement is not to rely on any single income stream, but to build multiple income streams. These would include Social Security, 401(k), IRA (Roth and/or Traditional), pension plan, bonds, and of course, good dividend growth stocks. There is a reason the insurance companies are excited that Obama is focusing on annuities, and it isn’t because they care about you.

Full Disclosure: Long SYY, CLX, INTC, KO, CVX, PG, CTL. See a list of all my income holdings here.

Related Posts
Retirement Planning With A Defined-Benefit Pension
Where To Find Great Dividend Stocks
When Is A Lot of Cash A Bad Thing?
Rev-up Your Portfolio With Asset Allocation
What Would Warren Buffett Do?

(Photo: sanja gjenero)

7 Responses to “Income Annuities vs. Dividend Stocks *”

  1. dizzy7 says:

    I’m retired and use a combination of dividend paying stocks and annuities for income. As far as annuities go, I agree entirely with you that income annuities are a bad investment for most people. However, the type of annuity I use is the so-called “CD annuity” which operates exactly as a CD–you purchase one for a specific amount and receive a specified rate of interest for a given period of time. You can either let the interest compound tax deferred or receive a monthly check. When it matures, you have the option to either roll it over, convert it to a lifetime annuity, such as those you describe, or have your investment refunded. As with a CD, most allow early withdrawal with a surrender fee. The state where I live (Iowa) even allows you to receive up to $6,000/yr. in annuity income tax free.

    They are insured in that every state has a fund which refunds your money if the insurance company goes bankrupt. The amount varies by state, but where I live the maximum insured amount is $100,000/policy. I was skillful (ok, lucky) enough to purchase several right at the start of the financial crisis in the fall of ’08 when rates shot up and locked in 7%+ rates for 4-7 years. There are sites which do a good job of letting you compare rates and policy terms from many companies. Two that I like are http://www.annuityadvantage.com/ and http://www.directannuities.com/ You can purchase directly from them, but what I did is just used those sites for rate comparison purposes, then called the companies I wanted to use and got the name of local agents.

  2. Dividend Disciple says:

    @D4L – Unrelated to the main purposes of the article, what prompts your final decision to pull the trigger? Let’s say at the end of July, you’re reviewing your portfolio and watchlist, and you determine that you will buy MCD because it is a 5-star stock trading below your buy price. Are you just waiting on available cash/dividend income to purchase or are there any other reasons that determine when exactly you will purchase the stock during the following month? Thanks in advance.

  3. D4L says:

    Dividend Disciple: I try to buy the best stock that is available, that fits within my needed allocation. I will then wait at least 3 months before I consider buying the stock again.

    Best Wishes,

  4. jimmy says:

    I would like to make a small correction to your statement about income streams. There are 3 basic streams: Social Security (government), pension (employer), savings/investments (personal). Your list was a variation of this theme.

  5. sdb says:

    Jimmy, your three basic streams are bogus for most people with 20+ years until retirement and for a lot of people with less than that.

    Social Security? It started spending the so-called trust fund this year and without any changes will be broke before 20 years. Current projections are that current tax rates will only pay 75% of benefits. And personally I think that’s optimistic. It’s a Ponzi scheme, and those always run out of money. This one won’t because the gov’t will print enough to make good even if it the paper isn’t even good enough to wipe with. Your 3 streams are looking pretty funky with one of them cut at least 25%.

    What about leg 2, pensions? There isn’t anybody but gov’t doing defined benefit pensions any more. I’ve got > 20 years of work and my pension was frozen a few years ago when the program ended. I got lucky and cashed it out (lump sum to an IRA) at near max value when interest rates tanked early 2009. It was well under 1yr salary. There’s no pension in my future or in the future for most people in the work force now.

    What’s left? My one legged stool of savings and investments and whatever my skill and luck can make of them. Of course a winning powerball ticket could blow into my hands one day.


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