Wednesday, May 11, 2016

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 the past the, the government considered income annuities 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?

The following problems exist 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 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 would be paid to you and your spouse for as long as you both live. That’s basically a 5% 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 effectively be cut each year. You can buy an inflation-adjusted annuity, but when you do that, your initial payout goes down.

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, 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% 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 that have increased their dividend over 40 consecutive years and will provide a yield-on-cost greater than 5% in ten years, based on the listed assumptions:

3M Co. (MMM) provides enhanced product functionality in electronics, health care, industrial, consumer, office, telecommunications, safety & security and other markets via coatings, sealants, adhesives and other chemical additives.
Yield: 2.6% | Dividend Growth: 7.3% | 10-Yr. YOC: 5.3%

Genuine Parts Co. (GPC) is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products.
Yield: 2.7% | Dividend Growth: 6.9% | 10-Yr. YOC: 5.3%

Johnson & Johnson (JNJ) is a leader in the pharmaceutical, medical device and consumer products industries.
Yield: 2.8% | Dividend Growth: 6.7% | 10-Yr. YOC: 5.4%

The Coca-Cola Company (KO) is the world's largest soft drink company, and also has a sizable fruit juice business.
Yield: 3.1% | Dividend Growth: 6.1% | 10-Yr. YOC: 5.6%

Abbvie Inc. (ABBV) is a global research-based pharmaceuticals business that emerged as a separate entity following its spin-off from Abbott Laboratories at the start of 2013. AbbVie's key drug is Humira for rheumatoid arthritis.
Yield: 3.7% | Dividend Growth: 7.9% | 10-Yr. YOC: 7.8%

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 ABBV, JNJ, KO, MMM, GPC, in my Dividend Growth Portfolio. See a list of all my Dividend Growth Portfolio holdings here.

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(Photo Credit)
Additional source: Why Annuities Won’t Fix The Retirement Problem