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Income Annuities vs. Dividend Stocks

I was born in 1962 which puts me on the tail-end of the Baby Boomers (those born between 1946 and 1964). We have been described by some as "the pig in the python." Over the decades, the sheer size of our group has redefined many aspects of society. As we approach the tail of the python and look toward retirement, once again we have the government and others scrambling to figure out how to handle this aging and albeit disruptive force.

One concern is how will Social Security, pensions and other retirement vehicles withstand the strain. The 2008 market crash has added concern to the viability of these plans. In this 2010 New York Times article, "The Unloved Annuity Gets a Hug From Obama", income annuities are what the current administration is promoting to alleviate the pending problem, but is this really a workable solution?

What are income annuities?

The New York Times article describes annuities as:
"At its simplest, which is how the White House seems to want to keep it, an annuity is something you buy with a large pile of cash in exchange for a monthly check for the rest of your life."

What are the problems with income annuities?

Charlie Farrell in "Why Annuities Won’t Fix The Retirement Problem", described the following problems with income annuities:
I. Cash Out Is Determined By Cash In
The income an annuity will produce is directly related to the amount of money you put into the annuity. So if you don’t have much money saved for retirement, you won’t get much of an income stream from an annuity. And most people don’t have much money saved for retirement.

II. Payment Rates Aren't High
At today’s interest rates, you’ll get about $5.85 of income per year for every $100 you contribute to the annuity (based on a recent quote from a highly-rated insurer). And this $5.85 would be paid to you and your spouse for as long as you both live. That’s basically a 5.85% payout on your savings in retirement.

III. No Provision For Inflation
Annuity payments don’t increase and are fixed for life. So if inflation runs at 3% a year (the average for the last 80 years), your retirement income will be cut by about 45% by the time you’re 85. Meaning that the $5,850 of income will buy you about $3,220 of stuff in today’s dollars, and the $58,500 will buy you about $32,200. You can buy an inflation-adjusted annuity, but when you do that, your initial payout goes down to somewhere around 4%.

IV. Investment Risk
With an annuity, you lose access to your money. Essentially, you gave your money to the insurance company to purchase the annuity. It’s theirs to keep forever, and your income is dependent on the insurance executives running a sound insurance company for the next 30 or so years. That’s always hard to predict and carries it’s own risks.

Dividend Stocks - A Viable Alternative

Instead of turning over your life-savings to an insurance company (that could be the next AIG), why not build a diversified portfolio of dividend growth stocks? This works best if you have time before retirement. The initial rate may not be as high as the 5.85% quoted above, but careful stock selection will allow growth well in excess of inflation. Unlike depending on a single insurance company, a diversified portfolio of at least 30 stocks will greatly reduce the risk. Below are some good dividend growth stocks that will provide a yield-
on-cost greater than 5.85% in ten years, based on the listed assumptions:

Kimberly Clark Corp. (KMB) is a global consumer products company's producing tissue, personal care and health care products. Its brands include Huggies, Pull-Ups, Kotex, Depend, Kleenex and Scott.
Yield: 3.0% | Dividend Growth: 7.1% | 10-Yr. YOC: 5.9%

The Coca-Cola Company (KO) is the world's largest soft drink company, KO also has a sizable fruit juice business.
Yield: 2.8% | Dividend Growth: 8.0% | 10-Yr. YOC: 6.1%

McDonald's Corporation (MCD) is the largest fast-food restaurant company in the world, with nearly 34,500 restaurants in 119 countries.
Yield: 3.3% | Dividend Growth: 7.3% | 10-Yr. YOC: 6.4%

Exxon Mobil Corp. (XOM), formed through the merger of Exxon and Mobil in late 1999, is the world's largest publicly owned integrated oil company.
Yield: 2.8% | Dividend Growth: 9.2% | 10-Yr. YOC: 6.6%

Chevron Corporation (CVX) is a global integrated oil company (formerly ChevronTexaco) has interests in exploration, production, refining and marketing, and petrochemicals.
Yield: 3.4% | Dividend Growth: 9.1% | 10-Yr. YOC: 7.9%

General Mills, Inc. (GIS) is a major producer of packaged consumer food products, including Big G cereals and Betty Crocker desserts/baking mixes.
Yield: 3.0% | Dividend Growth: 10.5% | 10-Yr. YOC: 8.2%

Wal-Mart Stores, Inc. (WMT) is the largest retailer in the world, Wal-Mart operates a chain of over 10,000 discount department stores, wholesale clubs, supermarkets and supercenters.
Yield: 2.4% | Dividend Growth: 13.5% | 10-Yr. YOC: 8.6%

Social Security was never intended as a retirement plan, but as a supplement to savings. The key to a successful retirement is not to rely on any single income stream, but to build multiple income streams. These would include Social Security, 401(k), IRA (Roth and/or Traditional), pension plan, bonds, and of course, good dividend growth stocks. There is a reason the insurance companies are excited that Obama is focusing on annuities, and it isn't because they care about you.

Full Disclosure: Long KMB, KO, MCD, XOM, CVX, WMT in my Dividend Growth Stocks portfolio. See a list of all my dividend growth holdings here.

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