A Portfolio Of Preferred Stock Will Provide Life Income Superior To An Equivalent Life Annuity

by: Bruce Miller

Summary

Preferred Stock Pay a Fixed Dividend that can serve as the base for building one's own life annuity.

Preferred Dividends are Reliable but they do carry income risk.

An income portfolio can create life income superior to what you'd buy from an insurance company.

The Trade Off? Greater income risk and a lot of work.

Fixed dividend Preferred Stock pay a fixed quarterly or monthly dividend that does not change over time. Preferred stock have features that make them attractive to an income investor and features that create income risk. First, the good stuff....

  • The preferred stock dividend is paid before the common stock dividend, making their dividend more secure than common stock
  • Dividends are generally secure. During the 2008-2009 recession, with 3 exceptions, all preferred dividend suspensions came from pure financial companies and no suspensions from utility or insurance preferreds and 3 suspensions from REIT preferreds, 2 of which later resumed dividends
  • Once preferred stock are purchased, there are $zero expenses year to year

Now the bad stuff....

  • For most, at 5 years after issue, the preferred stock may be redeemed by the issuer at their discretion. This typically happens when interest rates are falling, which allows the issuer to redeem and reissue the preferred stock at a lower dividend rate. This creates 'reinvestment risk', where the reinvested dollars may not be able to reproduce the same level of preferred stock income as those that were redeemed. This is a much lower risk when interest rates are no longer declining or are rising.
  • Most preferred stock are less liquid then their common stock counterparts so need to be purchased with limit orders and patience. This can be time consuming when building a portfolio of nothing but preferred stock.
  • Preferred stock dividends may be suspended and if the dividends are not cumulative, they will likely be lost. If they are cumulative, they will only be paid if the company's financials improve and it elects to renew dividends.
  • To diversify for dividend default risk, the retiree should limit the portfolio income of any single preferred stock to no more than about 3% of portfolio income. This means the portfolio should contain about 30 preferred stocks. Purchasing one at a time using limit orders can be quite time consuming.

So how will an income portfolio of only preferred stock be able to provide a growing annual income to the retirement household? The following data table provides a good explanation:

As can be seen from this table, with an initial investment of $100,000, each year the portfolio of fixed income preferred stocks will pay a total of $6,500. In the first year, the required 4% income will consume $4,000 of that, with the excess of $2,500 directed into a savings account to be accumulated until it is needed in later years. The next year, this cycle repeats, but the second year's need increases by 3% to $4,120, thus leaving $2,300 in excess to again be directed into the savings account. This cycle repeats each year until finally the 3% annual inflation adjustment builds to an annual income requirement that exceeds the $6,500 the fixed income portfolio of preferreds is providing. From that point (year #18) on, the savings will be drawn down each year to add to the fixed $6,500 annual portfolio income to provide the inflation adjusted household income that is required.

There are several options for holding and investing the accumulated excess. The most conservative is to hold this growing excess in an FDIC insured pass-book savings account, making almost nothing in interest but 100% safe. A slightly higher risk option is to hold the excess in some highly liquid investment with very low risk, such as a short duration bond mutual fund, for which the above table assumes an average 2% interest growth rate. Of course, there are a multitude of other options one could use, such as longer maturity CDs, laddered bonds with maturity dates that will coincide with future need and other methods. But what I believe is essential is the excess cash should not carry market risk, as it is critical to the survivability of a long term inflation adjusted income requirement that principal not be lost.

As can be seen, using this strategy will provide the no-growth savings option with between 31 and 32 years while the assumed 2% savings option will provide between 34 and 35 years of inflation adjusted 4% annual income. At the end of these periods, the income will decline back down to the base of $6,500 which will be paid indefinitely. In effect, the retired household is building a form of life annuity without the drawbacks of a commercial annuity. That is, this self-made life annuity is inflation adjusted at least until very late in life, it has limited but real liquidity along the way and has residual value in the estate of the retiree, although it is not known what this residual amount will be as this preferred stock income portfolio's future value will depend largely on interest rates. So just for fun, lets compare this self-made variant of a life annuity with a commercial life annuity available today, using the same starting amount of $100,000.

The commercial life annuity alternative

A Single Premium Immediate Annuity, or SPIA, is not an investment (even though the IRS insists on referring to the initial single premium as the 'Investment in the Contract'), but instead is a contract with an insurance company, where the retiree (the annuitant) gives the insurer a fixed amount of dollars in exchange for a promise from the insurer to pay a fixed amount each month for the rest of the annuitant's life. The advantage of this option over the above portfolio of preferred stock is the fixed payment will continue for as long as the annuitant lives and the insurance company has a lower default risk than the preferred stock that make up the income portfolio. The principal disadvantages of the insurance provided life annuity is that the payment stream is not adjusted for inflation, the retiree cannot access the original lump sum given to the insurer and if the annuitant dies prior to their life expectancy, any 'unused' part of the lump sum initially given to the insurer will be lost.

As mentioned, the primary risk with an SPIA over one's retirement years is purchasing power or inflation risk. If a retiree buys an SPIA at age 65 and lives to age 90, the purchasing power per $1,000 received by the annuitant at the beginning will gradually drop to $467 by age 90, assuming an average annual inflation rate of 3%.

Now to the 'bells-n-whistles'. Insurance companies like to sell SPIAs with all manner of add-ons, much like Opticians like to sell eye-glasses with add-ons. The basic product, due to its simplicity, ease of understanding and broad need, is competitive (offered by many insurers) and so profit margins to the insurance company on the basic single-life SPIA are tight. Add-ons, as is the case with eye-glasses, is where they make their money. Now, that an insurer or eye-glass retailer makes money is great! But you and I are not here to make them profitable….like any other product, our goal is to shop for an income product that will meet income goals during retirement, and we will comparison shop to get the best price for what it is we wish to purchase. We will only consider an add-on if it is consistent with our income investment objectives. Nice-to-have is NOT a reason to buy it. What are SPIA add-ons? They are, theoretically, unlimited…but here are some of the more common add-on features:

1. Survivorship, usually to a spouse. If I am the annuitant and I die before my spouse, all or part of the annuity amount will be paid to my surviving spouse over her life time. Most insurers will offer either a 100% continuation of payment or a 50% continuation of payment.

2. Period Certain. This is a guarantee that the SPIA will pay out for some specified period, even if the annuitant dies during that period. The period certain can be for a fixed period, usually 5, 10 or 20 years only. This arrangement can pay out for only those periods, or they can payout for those guaranteed minimum periods PLUS the annuitant's lifetime if the annuitant lives past those guaranteed periods. The terminology of such a combination would be a "20 year period certain fixed immediate annuity with life."

3. Death benefit. This promises to return to the estate of the annuitant some or all of the original lump sum paid to the insurer if the annuitant dies within a certain time period. It can be for the full amount of the initial lump sum payment, or it can be a declining death benefit that is reduced by the amount of each monthly payment, which is the most common. This may also be referred to as a 'Life Contingent with Refund'.

4. Inflation adjuster. This will increase (or decrease during a period of deflation) the annuitant's monthly payment by some inflation adjustment. This adjuster can be a fixed rate per year or a variable adjuster based on something like the Consumer Price Index. But it may be capped during any given year and may have a lifetime cap, as the cost to the insurer for a period of high inflation, as happened in the late 1970s and early 1980s, could otherwise be financially catastrophic to the insurer.

5. Limited access to principal. During the payout period, this will allow the annuitant to access generally up to some maximum percent per year of the initial lump sum payment. This is often referred to as a "commutation provision". This may have a lifetime or age limit.

Adding any of these (or perhaps other) SPIA features will simply reduce the monthly benefit, as this is how the added feature is paid for.

A Comparison

So to compare these two options as closely as possible, I'll select a SPIA with a 100% surviving spouse option (annuitant is age 65 and spouse is age 63), a 'death benefit' that will guarantee at least 100% of the initial $100,000 investment in the contract is received as (monthly benefits + death benefit) and it has an annual automatic 2% increase in benefit. This is not an exact comparison, but is about as close as I can get with what is available. The monthly benefit of a simple single life SPIA with no 'bells-n-whistles' from Fidelity's Immediate Annuity calculator, for a 65 year old male is $550/month. With the preceding features added, the monthly benefit drops to $354/month.

Now, compare this to a portfolio of preferred stock with a portfolio yield of 6.5%. The following table does this by showing the total of monthly amounts collected plus residual values (if applicable) over a dual life expectancy that goes from 10 years to 30 years in 5 year increments.

As can be seen, the preferred stock income portfolio offers much greater life income and residual value. A portfolio of preferred stock does carry greater default risk than an insurance company, and there is redemption (and reinvestment) risk with preferred stock that an SPIA will not have, although that risk is much reduced in today's ultra-low interest rate environment. And there is more work in building a 30 preferred stock portfolio than the work involved with writing a $100,000 check to an insurance company. But clearly, the portfolio of fixed income preferred stock provides far superior payments and residual value to the retiree and heirs than an equivalent life annuity.

Conclusion

So, is the greater lifetime benefit received from a portfolio of preferred stock worth it when compared with the convenience and reduced income risk of the SPIA? This will, of course, depend on the retirement household, risk tolerance, willingness to dedicate the time and investment objectives. But hopefully this discussion has made the risks and benefits of an income portfolio of preferred stock vs. an equivalent SPIA better understood for retirees who are considering their alternatives for reliable income during retirement years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I rewrote this article, directing it towards building a preferred stock-based life annuity, but I still compared this income portfolio with a life annuity one would buy from an insurance company, simply for the purpose of comparison.