Alternatives To An Annuity For The (Moderately) Hands-Off Investor: Part I

Includes: PTY
by: Alpha Gen Capital

An annuity can provide safety and be a great way to generate base income in your retirement plan.

Annuities get a bad rap but there's really no difference between it and a traditional defined benefit pension which tends to be loved.

For those wanting to avoid the loss of principal but still creating an income stream, closed-end funds can be a great tool.

For the right investor who can handle volatility, a diversified portfolio of CEFs complimenting other portfolios pieces can provide an annuity-like income stream.

While there is volatility in this strategy, even if your principal falls, it's still an improvement to the annuity which provides similar income at a loss of principal.

Part I of II - Alternatives to an Annuity

Often just mentioning the word “annuity” can have a profoundly negative effect on an investor - and for good reason! This once good solution for managing longevity risk has too often been bastardized by "innovations," high fees, and unscrupulous sales tactics. It should be noted though, that in the right situation a carefully-selected annuity can still provide significant benefits via the pooling of mortality credits. What did he just say?

In the past those investors/soon-to-be retirees who were “annuity averse” (and were also stock market averse ... or worried about sequence-of-returns risk), had often implemented bond ladders. A bond ladder, when combined with other base income sources like Social Security and pensions, could provide the desired income flooring for each year of retirement. At the present time, however, a bond ladder going out a number of years can "lock you in" to very low interest rates. And what awaits if those rates suddenly begin a path climbing steadily upward?

Searching then a bit desperately for something on the positive side, these currently low rates may mean that the number of actual payments from the bond ladder are more certain ... that is, call risk may be reduced. And if the person does not live as long as the bond ladder ... well, at least there are assets left over that can be used for legacy or charitable giving. People hate not having their benefits utilized in some desirable way. If a consumer buys a Groupon and holds it for a few months, that person is likely get a notice that the Groupon is about to expire. The consumer then tends to use it quickly for fear of not receiving a benefit for which they had paid good money.

For annuities, the fear is always that you will not live long enough to recoup via the cash flows the amount that you “invested.” Yes, there are bells-and-whistles to address that “fear” ... but basically the time horizon of a lifetime annuity is known. That is, it will last only as long as you do. By joining a pool of many people who all seek to establish lifetime income streams, you can lower the amount of upfront cash needed to create those lifetime income streams. That's because some people will die early and help pay for those who live longer. With a large pool of people, we can predict to a fairly accurate degree just how long the pool of individuals will last ... but not exactly which individuals will die last. And, of course, we cannot predict exactly which individuals will die early (and long before their “full benefit” is received).

Since a basic (no bells-and-whistles) lifetime annuity does not have a residual value, it leaves no legacy for your heirs or for charities. The annuitant, then, would need to be at peace with the possibility of not getting a“full benefit.”

Given the real risk, however, of outliving one’s money, the lifetime annuity could still be a reasonable way to help create a “base income” (also called a “spending floor”) and to help reduce the amount of stress placed on the portfolio. That stress is defined by how much you are withdrawing each month from the portfolio. Obviously the more you withdraw each month, the greater the stress placed upon the portfolio ... and the riskier the coverage of your longevity becomes.

(Source: Dick Cotton)

Whether an annuity has a place in your portfolio is a very personal question and is actually outside of the scope of this report. Annuities are highly investor specific based on a myriad of factors. You also may want to reference a few of our past articles where we discuss some of those factors including, "Participate In Higher Rates Without Risk Of Principal" and "Some Possible Solutions That Not Many Advisors Are Discussing - Part III."

Essentially, it comes down to risk tolerance and personal retirement planning. For those who are highly risk averse, annuities can reduce the risk that you will run out of assets ... and reduce the risk that you will have to spend your intended legacy. If one lives “too long,” it's still not a good feeling to have to spend the assets that one had intended to leave for one’s children and/or for charities. For those who are concerned with preserving legacies – and/or for those who are a bit more risk tolerant - an additional solution (or perhaps a combination of solutions) could offer more benefits.

A “No Sales” Portfolio

Here we introduce one of those solutions – the concept of a "No Sales” portfolio of CEFs (closed-end funds) and other income producing securities. By matching up your spending needs/liabilities - net of any other non-portfolio income sources (Social Security, etc.) – with the income produced from a portfolio, you can significantly reduce sequence-of-returns risk. We discuss this in our article from earlier this year titled, "LDI Investing Is No Longer Just For Pension Funds."

If, over time, you can move into a position where the income from your portfolio plus the income from your non-portfolio sources is sufficient to meet your monthly spending and taxes, then you will never have to “sell shares” in order to meet your spending needs. It is, in fact, the selling of shares approach that exposes an investor to sequence of returns risk. That's a risk which, if realized, can be absolutely devastating to your portfolio during retirement.

Obviously, a key difference between an investor implementing a "no sales” portfolio and one using annuities is the acceptance of a different type and level of risk ... and, perhaps, a different type and level of goals. In concept, the basic lifetime annuitant has very little concern about moves in the stock market given that their income is not dependent on the stock market. For a 65-year old, an immediate income annuity will typically pay distribution yields between 5.50% and 7.00% of the initial capital deployed. When after-tax money is paid in, the payouts are a combination of capital being returned to you in a tax-efficient manner and gains on that capital. Since the annuity is actually an insurance contract, it looks similar to an amortization schedule in terms of the components of the distribution. As you age, the monthly payout is comprised more of paid in principal and less of income earned on that principal.

For the “no sales” portfolio, we can display basically how it works using just a one-asset portfolio. Please Note: This one-asset portfolio is simply for illustrative purposes ... an actual “no sales” portfolio will contain a number of un-correlated/low-correlation assets. The one-asset portfolio we will use for our illustration is the PIMCO Corporate & Income Fund (PTY) over the course of its 16-year existence. The fund incepted in 2003 at $15 per share. The chart below shows the performance of $1,000,000 invested at that IPO price and held to today. At the inception price, you would have been able to purchase 66,667 shares of PTY at $15 per share. The initial distribution was set at $0.1375 per share per month. For the mythical investor in this one-fund portfolio, that would mean $9,167 per month in income. The dollar figures on the bottom of the illustration shows the total income earned in each given year- including special distributions.

(Source: Financial Advisor member)

The current price of PTY is $18.80, so in terms of capital gains - if none of the distributions were reinvested - we would have an unrealized gain of $253,334. That seems a low number for 16 years of market exposure. However, the fund would have produced more than $2,100,000 in distributions (income!) through April of this year. Those distributions are certainly the bulk of the total return on the initial investment. The fund has only moved the distribution twice in the last 16 years: Once in 2006 downward by 2.25 cents per share (-16%) and again in 2012 raising it by 1.5 cents per share or (+13%). For CEF investors, income is typically the ultimate goal.

Chart Data by YCharts

The key for the reader here is the extreme volatility that the investor would have needed to endure over that 16 years - and staying in - in order to achieve those income results. The price variation, especially during the 2008-2009 Financial Crisis, was truly massive. Remember, the fund started at $15 per share and over the 16 years hit a high price of $22.20 ... and a low of $5.30.

Obviously, when the price was at $5.30 and your account value fell to $353,335 (down ~65%), it would have been hard to maintain your portfolio and not panic. A certain degree of behavioral investing strength would be needed that most investors simply do not have. But the real key is the income numbers on the bottom of that first chart above. The income was still being paid!

Remember that the market price of a CEF is a reflection of the supply and demand for the fund – that supply and demand comes primarily from retail investors. In really bad '’blood in the streets’' times, there can be a complete dearth of buyers and this can send market prices of CEFs plummeting downward. But notice in that first chart above ... the income in 2009 actually rose compared to 2008 going from $91,139 to $130,580.

So in the income sense, this is very different than holding a one-stock portfolio of, say, (AMZN) ... which is up 80,000% since its IPO in 1997. $10,000 invested in the stock at the IPO is worth over $8 million today. You see these types of headlines often. But what you don't see is that Amazon had a max drawdown of 90% at one point during that time. OUCH!

Chart Data by YCharts

I'd be curious to know how many of the initial or really early investors had the stomach to hold through that kind of decline.

With price volatility, I don't know how many investors or clients of advisors would be able to hold through the same thing with a closed-end fund, even if they are truly focused just on the income production. From mid-2008 to early 2009, the total return price of PTY fell by nearly 50%.

Chart Data by YCharts

But what if we can create a diversified portfolio that significantly dampens the volatility noted above ... but actually maintains the level and basic stability of the income stream. This can make the “no sales” strategy much more palatable for investors – we can weather the storm while collecting the income.

Ultimately, we will have a diverse set of funds that provides a fairly stable income stream that very much reflects the income of a lifetime annuity. While achieving a similarly stable income stream can be a challenge, the “no sales’’ portfolio approach does overcome one of the largest negatives facing a potential annuity investor - the loss of control over the investment capital and the loss of liquidity.

In summary then to this point: We are focused on combining spending/liability-driven investment planning with the concept of a “no sales” portfolio composed of CEFs and complementary assets that can help us achieve an annuity-like income stream. At the same time the “no sales” portfolio will help us avoid or offset some of the key draw backs of an annuity.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.