Choosing Between An Annuity And A Dividend Portfolio

By: ispeculatornew
Date posted: 11.02.2011 (5:00 am) | Write a Comment  (10 Comments)

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The other day, I spent an entire evening talking to a good friend of mine about annuities. Why? Because his father was considering buying one as he has just retired and while he has a decent amount of savings, the idea of having a cash flow for life is certainly appealing. He is far from the only one. Annuities have been gaining popularity very quickly in recent years and in many ways, they can be compared to dividend portfolios although they do also have important differences. Let’s take take a look at a few questions that he had:

What Is An Annuity?

An annuity is a financial product that is often purchased by retail investors that will guaranteee them an income flow, usually for their entire life. That income can either be fixed over time or can become tied to factors such as inflation, stock market returns, etc.

Why Are Annuities So Attractive To Individuals?

The main reason is that many recently retirees (such as my friend’s dad) start to wonder if they will have enough money, how much they can spend per year, how long they can “afford” to live. I think everyone can understand those very legitimate concerns. An annuity makes it very easy to see exactly how much someone can spend every year. At least that is usually the case. More complex annuities that are tied to future stock market returns for example can become a lot more complex.

Why Are Financial Institutions Lining Up To Sell These?

Think about it for a second. What are the most profitable activities of most financial institutions? They revolve around imperfect markets that are difficult to trade. Brokers do not make millions of commissions selling stocks. They can however make a lot of money selling credit default swaps and other complex deriviatives and products. In many ways, these products will exactly this need.

Why Are The Margins So High When Selling Annuities?

The main reason is that these products are very difficult to price and to compare. There are so many conditions and they combine life insurance features as well as financial derivatives positions. Those 2 combined make up a product that only a slim portion of the population will be able to price. That makes it a perfect sell for companies.

High Margins = Hard Sells

Think of all high margin products and you will understand why the selling process for these annuities is so developed. If a company can sell a financial product that is worth as much or more as your mortgage but can make 10 or 20 times as much profits (it’s easy to compare fixed or variable rates which makes very small margins), there is a lot of money to go around. If a company can make a $15-20K profit on selling 1 annuity, you can imagine how it can manage to pay a 5K commission on those which results in a lot of (very!) motivated salesmen.

How To Judge An Annuity Quote

Personally, I think that one great way to compare an annuity that you are thinking of buying is to compare it to a dividend portfolio. I told my friend to take a look at the “Ultimate Sustainable Dividend Portfolio” that I wrote about.

Differences Between A Standard Annuity And A Sustainable Dividend Portfolio

Pricing: Because of all of the fees involved and parties that each take a cut, annuities do end up costing a lot more to the investor than a dividend portfolio.

Certainty: There is no question that an annuity buyer will tend to have more certainty as most of the aspects are known far in advance and are often guaranteed. Compare that to a dividend portfolio that still is impacted by the economy, the financial markets, etc.

At Death: While some annuities pay out an amount at death, that would still be a fairly small amount, especially when you compare it with what a sustainable dividend portfolio would leave you with; a very valuable portfolio that would continue to pay out dividends long after your passing.

Inflation: While a large portion of annuities do not account for inflation, which can make a very significant impact on the quality of life in the later years, a sustainable dividend portfolio would account ofr that and the dividend income should increase by a higher pace than inflation leaving the holder with little imapct

Investment Required: While the money required for a similar cash flow is much smaller for a dividend portfolio, there is a lot more time required as stocks must be bought and sold, dividends reinvested, etc. An annuity buyer can basically buy and then simply wait for his check every month. That is not the case for dividend investors which can have a systematic approach but it will still require

Flexibility: Need to pay out a bigger expense, have a bigger or smaller need for income for certain specific periods? One of the big downsides of signing up for an annuity is that you lose your flexibility. The conditions and cash flows are set and can only be changed if you are willing to pay out significant penalties.

The Biggest Difference

In my opinion, the biggest difference between the two is the growth of the income generated.  Supposing that an investor would receive a 5% lifetime income flow (indexed to inflation that we will estimate at 2%) that you compared with a 3% dividend yield that increases by 4% annually (very reasonable in my opinion). Let’s take a look at the income generated by these two solutions for a 500K portfolio:

These are fairly comparable after just a few years but then think back at some key aspects:

At death, the dividend portfolio remains while the annuity is worth $0!!!
This does not include the capital gains that would be fairly significant over 25 years

In The End, It’s A Very Easy Choice

Personally, I consider the choice between an annuity or a dividend portfolio to be a no-brainer. I think a systematic, sustainable and disciplined approach to dividend investing will outperform in almost all cases and while it will require a bigger time investment, that is a small price to get more flexibilitty, better returns and a much stronger growth potential. Do you agree? Or would you still consider buying an annuity?

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10 Comments

  1. Comment by awake — November 2, 2011 @ 10:44 am

    Great Article! It seems to me like an annuity might make more sense in a scenario where one is older and just does not want to deal with a portfolio at all. Even in that case it might still make sense to go the dividend portfolio way and pay someone to manage it instead of paying all the fees required to setup a annuity.

  2. Comment by IS — November 2, 2011 @ 5:06 pm

    @awake – No doubt, I think it’s worth it no matter what but yes, the less years you have, the smaller the impact, I agree. Thanks for the feedback!

  3. Pingback by Articles You May Have Missed — November 4, 2011 @ 7:08 am

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  4. Comment by Doug — November 4, 2011 @ 1:57 pm

    I’m an Investment Advisor and all I do is dividend portfolios, this is a very conservative estimate for dividend paying stocks, very conservative indeed. I find it very hard to justify most annuity products to most people. That is certainly my own view point. I would like to say that sometimes annuities make sense.

    I think you are correct here, thanks.

  5. Comment by IS — November 4, 2011 @ 4:36 pm

    @Doug – Thanks for the comment, I’d love to hear under what type of circumstances annuities make the most sense in your opinion?

  6. Comment by Thomas — November 17, 2011 @ 10:53 am

    Good and fair comparisons among the two products !

    I’ve the majority of my life savings in IRA as most people are these days, if I withdraw money from IRA to buy annuities, will that amount I withdraw be taxed as ordinary income ?

  7. Comment by IS — November 17, 2011 @ 7:46 pm

    @Thomas – Good question, will try to read more about it, if anyone knows the answer, would love to hear it:)

  8. Comment by pw — November 30, 2011 @ 9:54 am

    Based on your chart, one will have larger income with the annuity for the initial 25 years, but you still vote for the dividend plan. Maybe I am being selfish, but why would I care that my plan goes to zero AFTER I DIE, or that it will produce more income/capital gain after 25 years (POSSIBLY AFTER I DIE)?
    Annuities solve one important problem. They efficiently use ALL of the money you worked for.
    One can plan on leaving the money for the next generation, but it is not everyone motivation.

  9. Comment by awake — December 2, 2011 @ 7:02 am

    @pw… it’s wort leaving it for a stupid great grand kid to blow 😉

  10. Comment by IS — December 2, 2011 @ 7:02 pm

    @pw – No doubt, I think each person probably has a very different feeling about that. I would personally like my wife and kids to have something left when I will pass away but we each have our different objectives and values!:)

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