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Annuities are a common investment vehicle for retirees seeking insurance for outliving their assets. They are used primarily to provide peace of mind through a consistent and steady stream of income. Although annuities are considered effective ways to mitigate longevity risk, there are better options for retirees to invest in a way that virtually guarantees they do not run out of cash. An investor can essentially create his or her own perpetual cash flow that increases at a rate greater than inflation through creating a portfolio of dividend growth stocks.

Disadvantages of Annuities

Commissions and various other fees

Many annuities are loaded with fees that can take serious chunks out of your capital. Insurance companies can charge up to 10% alone as commission, which doesn't include management fees and insurance charges, usually totaling another 2-3% annually. Online discount brokerages are easy ways to invest in equities and charge as little as $5 per trade.

Loss of purchasing power due to inflation

Fixed annuities do exactly what the name implies - they pay a fixed amount for the remainder of the insured's lifetime. With inflation rates averaging about 2.5% over the past 10 years, a fixed payment stream will lose a significant amount of purchasing power over long periods of time. Depending on future inflation, a dollar in 20 years could have the same purchasing power as only 60 cents today.

No liquidity or preservation of capital

Annuities typically pay out only until the insured dies, at which point all value is surrendered to the insuring company. This makes them a poor option for building an estate to pass on to heirs. Most people would like to have the option of passing on an annuity to spouses or children, but are not given this choice.

Benefits of a Dividend Growth Portfolio

Preservation of Capital

A portfolio of large-cap equities with stable and growing dividends is very likely to give investors consistent capital appreciation over the long term. One of the biggest advantages that a dividend portfolio has over an annuity is that its value will not disappear at the death of the owner. For example, $100,000 invested in a dividend growth portfolio at age 40 could conservatively grow at 8% a year and have a value of $4.7 million when the investor is 90 years old. Anyone would like to have the option of passing something of this value on after death.

Increasing Income Stream

By investing in companies with a long history of consecutive dividend growth, we can almost guarantee that our annual dividends received will not only be safe, but also increase each year. For example, Procter and Gamble (NYSE:PG) has raised its payout for the past 56 years, through economic growth as well as recessions. It is safe to presume that these payments will continue far into the future.

The Power of Compounding

The graph below tracks expected annual income per year from an annuity versus a dividend growth portfolio, both with investments of $100,000 at age 40. The annuity pays 4.3% annually; consistent with typical market rates. The portfolio assumes an initial portfolio yield of 3.5% with an annual growth rate of 8%, which is conservative considering the 13.25% average dividend growth over the past 5 years for this portfolio. These rates are derived from a portfolio comprised equally of the following dividend stocks:

Stock

Yield

5 Year DG Rate

AFLAC Incorporated (NYSE:AFL)

2.80%

17.5%

Chevron (NYSE:CVX)

3.15%

9.00%

Intel (NASDAQ:INTC)

4.30%

14.4%

J&J (NYSE:JNJ)

3.25%

9.10%

Coca Cola (NYSE:KO)

2.65%

8.70%

McDonald's (NYSE:MCD)

3.25%

20.4%

Altria (NYSE:MO)

5.10%

15.0%

P&G (PG)

2.95%

10.2%

AT&T (NYSE:T)

5.10%

5.30%

Walgreen (NYSE:WAG)

2.70%

22.9%

Annual Income Produced by a $100k Investment

As you can see, an investment of $100,000 at age 40 with an initial yield of 3.5%, growing at 8% per year would increase to $22,000 within 25 years, a yield on cost of over 20%. The amazing thing is that this is assuming dividends are not reinvested. Any reinvestment could be considered a bonus that would accelerate the compounding process exponentially. So although the annuity is often considered the safest bet for retirees, it is easy to see how much an individual would be limiting future income potential by forgoing the dividend-growth portfolio for that safety.

It is important to know the risks involved with investing in a dividend growth portfolio. Depending on risk preferences, older investors may not wish to be as heavily invested in equities as this strategy would require. There is risk that the portfolio could lose significant market value at any time, so it requires patience to wait out market downturns. It is reassuring however, that, barring a big surprise, the dividend stream will remain safe. By monitoring a portfolio closely, an investor would be sure to pick up on an impending dividend cut and substitute the stock for another. I personally think that dividend-growth stocks are a no-brainer as they offer the most upside and are the clear winner when compared to an annuity for investors looking to build a growing income stream.

Source: Creating Your Own Dividend Annuity