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Tuesday, October 29, 2013

Create an Income Stream Versus an Annuity

An ongoing conundrum in the financial community is why single premium immediate pay annuities (SPIA) aren't more widely accepted?  After all, they go a long way towards avoiding running out of money in old age (the number one fear of retirees), no matter what the market does.  Furthermore, used intelligently, SPIAs can be used to enable a retiree to take on a bit more risk in the other assets they own.

So what's not to like?  First off, retirees lose control of the money.  For example, suppose the retiree comes home and finds a leak in the attic crawl space?  The roofer guy is going to come out and tell the retiree he or she needs a new roof!  Where do you get the money from?  Hint:  not the annuity. Secondly, though useful, today the timing may not be right with interest rates close to historically low levels.  With the yield on the 10-year Treasury note at 2.50% and the Federal Reserve printing money akin to Anatasios Arnaouti on steroids, many feel that higher yields will be available down the road. Thirdly, most people would rather wallow in their own fear of a market collapse than talk to a silver-tongued insurance agent who has been trained to sell you products that will destroy a retirement portfolio faster than you can get out a high-powered electronic microscope to read the fine print.

So, does it leave the retiree at the mercy of the usual portfolio approach trying to beat the market?  Not necessarily.  Some are constructing a sort of hybrid portfolio whereby the allocation to fixed income is replaced partially with high dividend stocks.  This is not a couch potato approach in that it does require some time on the part of the DIYer but could pay high dividends (sorry, couldn't help it) if done correctly. And, as a matter of fact, a whole industry of bloggers (see below)  has arisen to help the DIYer in this endeavor.


To see one way to approach this, let's look at an account I recently set up.  We began with the usual important first step of doing an asset allocation.  This is for a couple in their 60s.  Income will become important to them shortly.  The allocation was 50/50 stocks/fixed income.  The stocks portion was invested in low-cost diversified index funds.

The twist came with the bond portion.  Instead of bond funds, the fixed income portion was invested in dividend stocks that have a dividend of 3% or greater.  It was decided that the dividend stock positions would be less than 5% of the overall exposure in the dividend sector, making each position less than 2.5% of total assets.  Importantly, it was agreed to carefully look at diversification - the last thing you want is to load up on bank stocks, energy stocks, etc.

With these specifications, here is a partial listing of the  portfolio that was constructed:

Source: Schwab

You'll notice that NLY is in for a lesser amount.  It is a riskier issue with a yield in excess of 11%.  Its purpose is to juice up the yield of the portfolio a bit with the understanding that its dividend is considerably less secure compared to the other holdings.

The thing to get your head around is that, in one sense, you really don't care about the prices of the stocks.  After all, if you had put the money in an annuity, you would be dealing with an income stream!

Having said this, if prices move higher and this is a taxable account (which, in this case, it is), you have some options.  You can realize long-term gains if you find better replacements and can actually take advantage of tax-harvesting by capturing losses.

Once set up, the next step, which takes all of 30 minutes, is to do an Excel sheet showing dividends received:

The portfolio will be comprised of approximately 20 stocks.  The bottom line is to seek to have income increase over time.  This, of course, won't happen with a bond.  Buy the 10-year Treasury note and you'll get a fixed interest payment every 6 months for the next 10 years.

Here's the bottom of the Excel spread sheet:
The arrows show that already the dividends have increased and, in fact, they will increase this month with the final payment due in.  The goal is to see them double approximately over the next several years.

Obviously, unlike the annuity situation, the investor has control over the assets.  If  the roof leaks or Aunt Maude in Stuttgart Germany kicks the bucket, the investor can sell assets to pay the roofer guy (or gal) or get on an airplane to Stuttgart.  A DOWNSIDE IS THAT THE YIELD WILL BE LESS THAN WITH AN ANNUITY, AT LEAST AT THE BEGINNING!  This is because, with an annuity, you are receiving an actuarial rate based on a group's mortality.

The newbie DIYer should be able to find on his or her brokerage site a history link that shows all cash flows that come into an account.  This is a convenient place to track your dividend receipts to put into your Excel spreadsheet.  In Schwab, it looks like this:

If this intrigues you in the least bit, you should realize you can go at it at whatever size you want.  For example, if your asset allocation calls for 40% fixed income, you could consider putting 20% of your fixed income allocation in dividend stocks and think of the allocation as your personal annuity!

The obvious question is how do you find good dividend-paying stocks without having to spend an inordinate amount of research effort? Actually, today this is easy because there are several really good blogs dedicated to finding good dividend payers.  Here are a few:


Disclosure:  This post is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.


  1. If you start early enough, this can be much more lucrative than an annuity (and less costly). As with all investments, you need to be disciplined about the price paid and hopefully pick long term dividend growers. For those scared of individual issues, they can look at some of the dividend achiever ETFs and dividend focused ETFs like those offered by Wisdom Tree.

    1. Good points. Also, beneficiaries get assets when the inevitable happens,

  2. Great post, Robert. Moved most of my assets to dividend paying stocks several years ago. Love the excellent stock recommendations from Morningstar Dividend Investor newsletter and do the "dividend drill" myself. Constantly looking for steady payers and increasing payouts. Takes the focus of stock prices. Also, sell puts to buy the dividend stocks and sell OTM covered calls to lower my cost basis. Compounding income is wonderful thing to watch.

  3. Thanks,,,always great to hear from a practitioner. Interestingly I've been reading a lot about trusts lately and it seems to me that this is close to a perfect fit for trusts that pay out income and then have the assets move on after the death of a person. This investment approach can fairly easily be implemented by most trustees.