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I recently 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 the potential had:

What Is An Annuity?

An annuity is a financial product often purchased by a retail investor that will guaranteee an income flow, usually for his or her 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 recentl 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 usually makes it very easy to see exactly how much someone can spend every year. (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 in 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 fill 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 make very small margins), there is a lot of money to go around. If a company can make a $15,000-20,000 profit on selling 1 annuity, you can imagine how it can manage to pay a 5,000 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" 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 is still 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 would continue to pay out dividends long after your death.

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 for that, and the dividend income should increase at a faster pace than inflation, leaving the holder with little impact.

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.

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 $500,000 portfolio:

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

  • At death, the dividend portfolio's value remains, while the annuity is worth zero!
  • This does not include capital gains, which 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 greater 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?

Source: Retirement Income: Annuity Vs. Dividend Portfolio