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By J. André Weisbrod

October 31, 2016

In part 1 I described the types of investments that can produce retirement income.  To make good decisions we need to understand how they work and apply practical math in order to compare possible and probable results. 

I made the case for dividend-producing stocks over bonds and CDs.  Interest rates are just too low to get a real return above inflation and taxes.  While many retirees will prefer balanced portfolios that contain 20-40% in Bonds and CDs, they will have to keep their spending lower to make it work.  My comparison today will be between an income-equity portfolio of Stocks and Real Estate Investment Trusts (REITS) and a Single Premium Deferred Annuity with a 6% payout “for income purposes.”

I actually did a 35 year analysis going out to age 101.  I compared the results of both alternatives using the following assumptions:

 

ASSUMPTIONS

   

Retiree Age:

66

 

Investment Assets Available:

1,000,000

to Produce Income

Income From Investments Needed:

30,000

3% of starting principal, before tax, $23,325 after tax

Inflation Assumption: 

3%

per year (Income taken is raised annually)

Principal Growth Assumed

0%

for first comparison

Principal Growth Assumed

3%

for second comparison

Tax Rate on Taxable Income

25%

For the annuity, at age 66 the taxable portion will be approx. 44.5% of the distribution.   The tax rate on the equity income portfolio could be less.  See note below.

Note: I am using 25% for comparison purposes, which favors the annuity because if the equity portfolio has 50% "qualified" dividends or gains taxed at 15% the taxes would be less and the results for the equity income portfolio would be better. 

The  Annuity:

As I explained in Part 1, a retiree at age 65 or 66 (the government’s current official retirement age) has a statistical life expectancy of roughly 17 years.    Therefore an insurance company might agree to guarantee him an income based on 6% of the principal invested (the amount invested divided by 17).  The insurance company keeps the principal if he dies.  Of course this is for illustration only and does not represent an actual quote from any insurance company.

For our illustration, $1,000,000 invested will produce $60,000 of income per year in annuity income.  However, our retiree’s budget requirements are $30,000 per year before tax.  After taxes there is $23,325 left over to spend for year 1.  It is this after-tax income that we use to calculate the comparison with the equity income portfolio.  We want to get the same net income out of each portfolio and see what we end up with in any given year.  The income taken will increase each year at an assumed inflation rate of 3%. 

One important note:  Annuities often have other options that can be considered.  For instance you can take a smaller payout and get a survivor benefit.  A typical example is that a spouse would get 50% of the payout if the primary annuitant dies.  There can be “periods certain” wherein the amount will be paid for a guaranteed number of years regardless of whether the annuitant dies or not.  I did not have the time or space to compare all the possibilities, so I am just doing the simplest one, what is sometimes called a “straight life” annuity.

The Equity Portfolio:

The first comparison assumes that the equity portfolio gained 0% over 17 years.  It also assumes the initial dividend does not increase.  There have been a couple long periods in modern history where stock prices (DOW prices only, dividends not included) gained very little, for almost 17 years (from 1966 to 1982) and for almost 12 years (2000-2011).  These could be considered the bad-case if not worst case scenarios.  (Note that if equity markets were to lose value over 17 years it would be possible that the insurance company’s health would be in danger.)

The second comparison assumes that the equity value increases at 3% a year.  Added to the 3.5% dividend yield that is a total return of 6.5%, a reasonable, if not modest projection compared to historical averages.

Disclaimer:  There are a number of ways a comparison such as this could be done.  Any comparison is only as good as its assumptions.  I have tried to be fair and conservative on the equity side.  It is not hard to create a portfolio that can pay out 3.5% today using utilities, high income blue chip companies and REITs.  To provide a high level of diversity I used ETFs in a number of sectors.  Targeting select individual stocks would make it easier to build a higher yielding portfolio, but it would tend to be a bit riskier.   I have tried to examine results from a phenomenological standpoint, going year by year as the mechanics would actually occur.   Change the assumptions and you will get different results.  What I was looking for was whether there was a definitive difference in results that would allow a generalized conclusion that could help investors make better decisions.  Of course no one can predict the future and the actual results will be more or less depending on how the future unfolds.

The Results:

The following chart Shows the set-up and results for years one and two.

Year 1

1. Annuity

2. Income Equities No Growth

3. Income Equities 3% Growth

Beginning Balance

1,000,000

1,000,000

1,000,000

Gross Income Rate

6.00%

3.50%

3.50%

Capital Growth rate

0.00%

0.00%

3.00%

Income Produced

60,000

35,000

35,000

Income Taken

30,000

30,325

30,325

Income Retained and Re-invested

30,000

4,675

4,675

Income Tax @25% Aggregate

(6,675)

(7,000)

(7,000)

Net Spendable Income

23,325

23,325

23,325

Ending Balance

23,325

1,004,675

1,034,675

 

Year 2

     

Beginning Balance

23,325

1,004,675

1,034,675

Gross Income Rate

N/A

3.50%

3.50%

Capital Growth rate

0.00%

0.00%

3.00%

Income Produced

60,000

35,164

36,214

Income Taken

30,900

31,258

31,468

Income Retained

29,100

3,906

4,746

Income Tax @25% Aggregate

(6,675)

(7,033)

(7,243)

Net Spendable Income

24,225

24,225

24,225

Ending Balance

45,750

1,008,581

1,070,461

 

Now let’s take a look at the results after 10 years.

Yr 10

1. Annuity

2. Income Equities No Growth

3. Income Equities 3% Growth

Beginning Balance

175,152

1,010,026

1,355,401

Gross Income Rate

N/A

3.50%

3.50%

Capital Growth rate

0.00%

0.00%

3.00%

Income Produced

60,000

35,351

47,439

Income Taken

39,143

39,538

41,956

Income Retained

20,857

(4,187)

5,483

Income Tax @25% Aggregate *

(6,675)

(7,070)

(9,488)

Net Spendable Income

32,468

32,468

32,468

Ending Balance

189,334

1,005,839

1,401,546

Note that if the equity income portfolio has no appreciation, in year ten the 3.5% yield is not sufficient to maintain purchasing power and principal must be used for income, which is why there is a negative number in the Income Retained column.  In reality, even if the capital appreciation is zero for ten years, the dividends of these holdings historically have gone up over most ten year periods.  Therefore, a zero appreciation scenario could still support increasing income without going into principal for a longer period of time.

Now let’s jump ahead to approximate life expectancy at age 83.

Yr 17

1. Annuity

2. Income Equities No Growth

3. Income Equities 3% Growth

Beginning Balance

261,844

950,983

1,711,847

Gross Income Rate

N/A

3.50%

3.50%

Capital Growth rate

0.00%

0.00%

3.00%

Income Produced

60,000

33,284

59,915

Income Taken

48,141

48,123

53,449

Income Retained

11,859

(14,839)

6,466

Odinary Income Tax @25% Aggregate

(6,675)

(6,657)

(11,983)

Net Spendable Income

41,466

41,466

41,466

Ending Balance

267,027

936,145

1,769,668

Here, the annuity is starting to catch up to the zero appreciation equity income portfolio (Scenario 2).  But you can see that both equity income portfolios are still way ahead.  Now look at age 96.

Yr 30

1. Annuity

2. Income Equities No Growth

3. Income Equities 3% Growth

Beginning Balance

203,209

582,697

2,633,752

Income Rate

N/A

3.50%

3.50%

Capital Growth rate

0.00%

0.00%

3.00%

Income Produced

60,000

20,394

92,181

Income Taken

70,697

68,101

82,458

Income Retained

(10,697)

(47,706)

9,723

Income Tax @25% Aggregate

(6,675)

(4,079)

(18,436)

Net Spendable Income

64,022

64,022

64,022

Ending Balance

185,838

534,990

2,722,488

By this time the annuity’s 6% payout on the original $1 million is no longer more than or equal to the inflation-adjusted income needed.  This scenario finds the client having to spend down what was saved during the time when the annuity payout was more than the income needed.  While the Scenario 2 portfolio is losing value, its remaining estate value is still much higher than the annuity estate value.

I went to age 101 and Scenario 2 still had more estate value than the Annuity scenario.  However, if you lived past 104 the annuity would finally be superior in that it would keep paying the original amount (much less than the inflation-adjusted income) while the zero appreciation equity income portfolio would have been spent to $0 and there would be no more income.

Scenario 3 is very supportable historically.  A 3% appreciation is within reasonable expectations, though it cannot be guaranteed.  If that scenario is closer to reality then it will have generated the best results for you and your heirs regardless of how long you live.

A final note on immediate annuities:  There are annuities that either build in or have riders that can create income for an heir after you die.  Some may even offer a COLA (Cost Of Living Adjustment) for income.  But there will be a cost that can substantially reduce the income you receive.  Therefore, before you buy an immediate annuity that is a permanent decision, have your adviser run real numbers and go over all the implications.  And if that adviser sells annuities, understand that he or she may be biased in their favor, especially if that adviser does not also advise and/or manage equity portfolios.  Also note that this only covers immediate annuities.  “Deferred annuities” are an accumulation vehicle similar to other investment accounts in that the amount can grow and you can take it out at a later date.  Internal costs, tax ramifications and withdrawal penalties are different from other types of investments and the advantages and disadvantages also need to be carefully weighed.

Conclusion:

A Single Premium Immediate Annuity produces a guaranteed income for life.  If the annuitant dies without a period certain or a survivorship option/rider, the entire remaining amount goes to the insurance company.  The insurance company sets up the annuity actuarially so that if you live, they win regardless of how long you live, making money unless their investment performance is terrible.  If you die early, they win big.  Under this scenario the insurance company could keep as much as $800,000 less expenses if you died at age 86 even if their investments only returned 3.5%!

An equity income portfolio consists of stocks and real estate funds or REITs.  They can produce dividend income in excess of 3.5% based on today’s markets. If the equity income portfolio appreciates in value you and your heirs win.  If it does not appreciate at all, you still do better than the annuity unless you live well past 100..  If it loses money, it would have to lose $814,162 or 81.4% over 30 years to equal the annuity’s cash flow savings side fund value at age 95.  But soon thereafter you would run out of money.   

A current consideration regarding the equity income portfolio is that many of the income-producing assets have been priced a bit high.  However, the recent decline in REITs and some other income producing stock sectors makes the entry points a bit better today.  Even if we buy at a peak there is a reasonable probability that the value of the portfolio will still have increased or retained its value 17 years from now.   Wise management may be able to phase in a new portfolio over time at some lower average prices.  It is uncertain, and can’t be guaranteed, but we would rather buy when relative values are close to average or below than buy at inflated prices.

In the majority of scenarios, the equity income portfolio appears superior to immediate annuities for generating an inflation-adjusted retirement income.  If you have enough money and want to be extra conservative, you could use an immediate annuity for part of your income and an equity portfolio for the rest.  This might work well if you can live off of less than 3% of your beginning investment value.

(Second Disclaimer: I have tried to organize the numbers to reflect the mechanics of how the scenarios would actually work.  I did not start with a preconceived idea as to the results.  Depending on assumptions and actual mechanics the results could change.  I do not guarantee complete accuracy, though I have made a concerted effort to check my numbers.  If someone can show a fallacy, I will be very willing to adjust my results.  Also note that I am not against annuities, especially deferred annuities as an accumulation vehicle.   But this study indicates that you need to examine immediate annuities with considerable analysis first before buying.  Once you buy them they can’t be undone.  In all major financial decisions, especially those that are this important, you should consult your own advisers before making a decision.  And where an adviser is a salesperson pushing a particular product, get a second and even a third opinion from as objective and independent a source as possible.)  

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J. André Weisbrod is founder of STAAR Financial Advisors Inc. and the STAAR Investment Trust headquartered in Pittsburgh, PA. He has been named a 5-star Wealth Manager in Pittsburgh Magazine and is among the longest tenured fund managers with over 20 years managing the same funds. He is also co-founder of the Strategic Assets Fund 1, LP, a private equity fund for accredited investors. He is an author and speaker and has been interviewed, quoted or had articles published in a variety of media including Investors Business Daily, TheStreet.com, The Wall Street Journal, Business News Network, the Pittsburgh Post-Gazette, USA Today, KDKA TV and Reuters TV.

Actively involved in church and community affairs, Mr. Weisbrod is committed to the well being of individuals, families and businesses. Avocations include competitive masters swimming, scuba diving, painting and photography, acting and music.

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