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Promises, Promises: Annuities, Bonds, & Dividend Stocks

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Issue

Discover what’s behind the promise of three very different retirement products: annuities, bonds and dividend stocks.

Synopsis

Three financial vehicles that are often touted as good sources of retirement income are annuities, bonds, and high dividend stocks, but rarely are the differences in their risk profiles adequately disclosed and compared in a meaningful way.  Rather than inundate you with opinions, predictions, or similar forms of rhetoric, I believe it is more helpful for you to understand some basic facts about these instruments: what promise is being made, what is backing the promise, what legal standing do you have relating to the promise, and the associated risks.

So, here is what you need to know to make better comparisons across these strategies and arrive at a more balanced retirement income plan.

Explorations

Exploration 1: Dividend Stocks

Definition: Dividends are a distribution of cash to shareholders, usually excess cash deemed not necessary to be reinvested into the business, service debt, or be held as capital. Decided by the company’s board of directors, a dividend represents a distribution of the company’s earnings. A dividend stock strategy typically involves identifying companies that are expected to have a higher than average ability to maintain, or increase, its dividend for many years and whose stock is trading at a low cost relative to its dividend, resulting in a high “dividend yield”.

The Promise: The implied promise of a dividend stock is that it will maintain its existing dividend scale, but there really is no formal or binding promise.

Behind The Promise:  The cash used to pay dividends is generated by the earnings of the company’s business operations.  The issuing company does not post a liability for future year’s dividends, so it is essentially a “pay as you go” arrangement supported by each year’s business earnings.  The dividend interests of shareholders are not safeguarded by regulatory oversight.

Legal Standing:  Dividends are not obligatory and can vary with the company’s performance.  Stockholders receive dividends only after obligations to bondholders (interest payments and maturities) are fulfilled.  Basically, you’re taking on the ownership risk of the company.

Risks:  Dividend stocks do not have a maturity value, so the principal that you invest will increase or decrease in value with the share price, just like any other stock investment – this can be a problem if you need to access the principal in the future.  The company may also change the dividends paid to shareholders for a number of reasons, including changes in the profitability of its business, a shrinking market for its products or services, a need to invest in infrastructure or acquisitions, or changes in the company’s ability to secure other sources of financing (for example, a company that has maxed out its debt capacity may have to reduce or eliminate dividends).

Exploration 2: Bonds

Definition: A security issued by a corporation to a bondholder that has specified interest payments and a maturity schedule.

The Promise: The company is contractually obligated to make the interest and maturity payments defined by the terms of the security.

Behind The Promise: Similar to dividend stocks, the cash used to make interest and maturity payments to bondholders comes from the earnings of the company’s business operations, although companies frequently “roll over” their debt, using cash from newly issued debt to pay down maturities on older debt.  Unlike dividends, companies must record a liability on its balance sheet for all future interest and maturity payments; no additional financial provisions are required to meet this obligation.  Bondholders interests are not protected by government regulators.

Legal Standing:  Companies are required by law to repay bondholders before any other distribution to shareholders; bondholders have first dibs on the earnings of the company.  Bondholder agreements often impose strict limits upon the company to protect the interests of bondholders.

Risks:  So long as the company has the resources to meet the interest and maturity obligations, the cash flow realized from a bond is fixed and known with certainty.  However, when a company cannot meet its bondholder obligations, an indication of financial distress, the company must either renegotiate the terms of the debt with bondholders or declare bankruptcy.  While better off than stockholders, bondholders are still exposed to the risk of not being repaid if the company defaults on its obligation.  If the bond is sold by the investor prior to its maturity, there is also a risk that the value of the bond may be less than the original purchase price due to changes in interest rates or the credit quality of the issuing company.

Exploration 3: Annuities

Definition: An insurance product, not a form of financing for a corporation.

The Promise:  A guaranteed income benefit for as long as you live.

Behind The Promise: Unlike business earnings fueling the payback obligation like a bond or dividend stock, annuities must invest the premiums received for the annuity in an investment portfolio that is used to back these obligations.  Insurance companies invest in low-risk, well-diversified portfolios to be more certain to pay annuity holders back.  Insurance companies must post a liability on their balance sheet for all future benefit payments that they must make, as well as assigning risk capital as a “belt and suspenders” approach to meeting their future obligations.  The interests of policyholders are safeguarded by state insurance regulators who must review and approve each insurance product that the company sells in the market, monitor the financial condition of the company, and place restrictions on the types of investments that can be purchased and the amount of capital they must maintain to meet future obligations.  Insurance companies can make lifetime guarantees by pooling mortality risk with other annuity holders, which makes the aggregate cost of insurance very predictable, due to the Law of Large Numbers, thereby allowing individuals to transform a highly uncertain cost into a more certain one.  Smart, huh?

Risks: Annuity holders are exposed to the credit risk of the insurance company – they can only receive their benefits so long as the company has sufficient assets to pay them.  Most states have a guaranty fund program that set aside funds to cover shortfalls if an insurance company is not able to meet its benefit obligations.   Immediate annuities are also highly illiquid – unlike dividend stocks and bonds, they cannot be exchanged for cash.  There is also a risk that you may not reach your life expectancy, which could have a detrimental effect to your heirs.

Advantage: Regardless of the Insurance company’s performance, annuity holders have a specific portfolio dedicated to meeting annuity holder obligations.

Conclusion

Know your stuff if you’re counting on these 3 types of investment vehicles for upwards of the next 50 years! At Nested Interest, we’re here to help you help yourself towards a smarter retirement. We are your go-to source for fresh tactics to keep you in control of your future.

Posted by

John Bevacqua on September 29, 2011

Filed Under

Income Strategies, Investing, Risk & Protection

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The company may also change the dividends paid to shareholders for a number of reasons, including changes in the profitability of its business, a shrinking market for its products or services, a need to invest in infrastructure or acquisitions, or changes in the company’s ability to secure other sources of financing


4 Comments

  1. Thank you insurance salesman. Dividend portfolios have the possibility of growth. Immediate annuities are usually fixed.


  2. Dean

    Thanks for your feedback. Dividends do have the possibility of growth, but they also have the possibility of loss; and you are right that immediate annuities are usually fixed. The point I was trying to make in my article is that dividends are dependent upon the ability of the corporation to make a profit, so you as an investor are sharing this risk – thus, the income you receive will be tied to the ability of the firm to make a profit. There is no promise made that these dividends will continue to be made. Ultimately, the assumption of this risk must be made by the investor but he/she should do so understanding the risks involved. Annuities provide a more secure form of income, because of how they are managed (as described in the article). Deciding whether to purchase an annuity or invest in a dividend stock should only be made after the difference in the risk profiles are understood. I am not making any judgement as to which is “better” or “worse” – I don’t have a crystal ball.

    I would also like to point out that I do not sell insurance – I am not licensed to do so, and never have been. I am a fee-only financial adviser, so my compensation is not connected in any way to the products or investments that are associated with the advice I deliver. In fact, if you read several of my other blogs you will see that I am also a big advocate of bonds, which I believe is a better alternative for many conservative, income-oriented investors than dividends.


  3. Good Article. I am insurance licensed and do offer fixed annuities to clients, but with one caveat: They must have income riders. The very best income riders on fixed annuities will absolutely destroy any variable annuity on the market from a guaranteed income standpoint. We do not ever recommend variable annuities because of the risk, high fees and inferior income payouts.

    Interest rates are too low these days for recommending immediate annuities. They simply don’t provide much benefit. Fixed, Deferred, and Indexed Annuities with income riders provide tremendous flexibility, growth and income in these low interest rate times!

    As far as safety is concerned- insurance companies are unparalleled. They have a dollar for dollar legal reserve system, state regulation, re-insurance, state guaranty funds and several other checks and balances. When companies go under, contracts transfer and a new company will take over those contracts.

    In the past 10 years, we’ve had 500 banks go under and only 3 insurance companies. Needless to say, insurance companies are very secure and have been providing guaranteed income for hundreds of years.

    Finally, today’s fixed annuities with income riders are relatively liquid. 10% -20% of your account value each year for most annuities and several have return of premium features that allow you to get back 100% of your deposit without fees or costs at anytime. Plus, almost all provide 100% liquidity without fees in the case of entering a nursing home or being diagnosed as terminal.

    By diversifying a portfolio of income riders with differing term periods, you can guarantee inflation protected income for life. Pretty cool stuff we can do these days! Throw in some asset-based LTC and solid cash value or guaranteed universal life insurance and you can have a complete retirement income, ltc and wealth transfer plan all from the safest and most secure industry on the face of the earth!

    Keep up the good work!


  4. Troy

    Thanks for the feedback & comments.

    Most of the pros and cons I mention apply to all types of annuity products. Even with income riders on deferred annuities you often have a limited ability to make excess withdrawals (doing so typically reduces your guarantees), so there is a bit of a limitation. However, the most important consideration keeping a good balance between less liquid, longer term income producing vehicles vs. more liquid, lower income producing investments.

    I’m not as negative toward variable annuities as you appear to be, Troy, but it is really a matter of what you are comparing them against. I would argue that a good VA (there are bad ones out there) with a lifetime income guarantee is a much better retirement income solution than any systematic withdrawal strategy. It does have higher fees, but this is largely due to the cost of the downside market protection that the product offers; the flip side is that it does offer some upside. Fixed deferred annuities can offer “cheaper” income guarantees because they do not have to hedge against this risk.

    You are right that our current low interest rate environment does make immediate annuities more expensive, but this is true of any interest sensitive product or investment (e.g. bonds, fixed deferred annuities). My suggestion is to instead dollar cost average into immediate annuities over time (vs. buying it all at once today), so if interest rates go up you have not locked in your income benefit at today’s low interest rates (of course, there is still the risk that interest rates may go down even more). Immediate annuities give you more income “bang for the buck” than a deferred annuity (i.e. you get more guaranteed income per dollar of premium), because you are giving up more liquidity. This does not necessarily make them “better”, but it is an important trade off to understand.

    Your comment on the historic stability of the industry is quite true, largely because of the regulatory oversight and other factors I mention in the article.

    Finally, I agree that LTC can be an important part of a comprehensive financial plan for retirement, but I am not as enthusiastic about life insurance for the average person. This may be perfectly appropriate for some people (your clients may be somewhat more affluent than the average person), and there are some benefits that it can provide for retirement, but for most people that have a limited amount of savings for their retirement I would be much more comfortable steering them toward the right type of annuity and investments vs. life insurance. The concern for most is secure lifetime income; bequest motives for most of today’s generation of retirees is less of a concern.


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