Promises, Promises: Annuities, Bonds, & Dividend Stocks
Discover what’s behind the promise of three very different retirement products: annuities, bonds and dividend stocks.
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.
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.
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.
John Bevacqua on September 29, 2011
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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