Retirement Income Part 3: Immediate Annuities and Dividend Stocks + Their Pros & Cons
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Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm breaking down the pros and cons of two more popular retirement withdrawal strategies. The first is an immediate payment annuity, also known as a single premium annuity or SPIA. And the second is dividend stocks. To grab all the links and resources mentioned today, just head over to youstaywealthy.com/123.

So a few months ago, a listener emailed me with a great question. She asked, what do I do if I want to run all of my retirement accounts down to zero, down to zero dollars?

We don't have any heirs, we aren't charitably inclined, and we know that most retirement withdrawal strategies take a conservative approach and leave most people dying with money in the bank. So what's the most prudent strategy if we want to enjoy retirement to its fullest and eliminate the risk of outliving our money while also making sure that we don't leave a healthy chunk behind at death?

The short answer to her question is to buy an immediate payment annuity, but there are a number of things to take into consideration here that aren't obvious on the surface. Before I dig into those, let's just first touch on the basics of an immediate annuity, again, also called a SPIA, which stands for Single Premium Immediate Annuity.

A SPIA is the most basic type of annuity. You write one single irrevocable check, meaning you don't get the money back. You write one single irrevocable check to an insurance company and in return, they give you an ongoing guaranteed stream of income for a specified period of time. It could be five years, it could be for the rest of your life, your spouse's life, or until both of you pass away.

There are a number of different options you can choose that will reduce or increase your guaranteed income amount. For today, we're going to keep it really simple. Let's just say the husband and wife are both 65 years old and they have a total of $1 million in retirement savings. They want to die with as little money in the bank as possible and will want to maximize their retirement income by using an immediate annuity.

As a general rule of thumb, a non-inflation adjusting immediate annuity for a joint policy at age 65 pays about 6% of the balance or $60,000 on a $1 million policy. Again, this covers both spouses. So if spouse A passes away tomorrow, spouse B still receives the full amount until the end of their life.

As mentioned, there are dozens of different ways that you can slice and dice these policies, which may increase or decrease the guaranteed income amount. But 6% of the premium amount is a good rule of thumb and a starting point for discussion.

With those numbers in mind, we can now start to dissect this as a retirement income solution and determine if it's appropriate by evaluating the pros and cons. Before we do that, I just want to highlight that anytime insurance is involved, you are naturally going to be "paying more" for something that if insurance wasn't involved. You're paying for protection, for peace of mind, for guarantees, and those things are never free.

Insurance companies are incredibly smart and have access to a lot of data and they know how to price these things so that they come out ahead. There's no super top secret insurance strategy to generate higher than normal retirement income without giving something up. You can't have your cake and eat it too. So get it out of your head that there's some sneaky good deal out there that you don't know about. When you hear insurance, just remind yourself that you're paying for that insurance.

The fancy marketing brochure might make it sound like there's some unicorn of a deal that you're getting, but trust me, it's never the case. And it doesn't mean that it's bad to buy insurance or bad to buy an insurance product, but just don't be fooled into thinking that you just found this magic bullet. You're paying for whatever sort of guarantees they are advertising to you.

Okay, end of that rant. I actually just want to start with some of the cons of immediate annuities because these are more nuanced and more interesting to me than the pros. So the first con is that the single premium check that you write to the annuity company is irrevocable. In my example, that's the $1 million check that the couple wrote or wants to write in exchange for income of $60,000 per year for life.

They could write that check today and then pass away tomorrow, and that $1 million is in the insurance company's pocket. Again, you can tweak the policy in a few different ways so that if that did happen, your estate would get a portion of the money back, but doing that would lower your guaranteed income amount. So you have to decide what's most important to you and then craft the policy accordingly.

In a similar vein, you could also live until 95, but end up still leaving a lot of money on the table because of a raging bull market. In other words, while the guaranteed income might have sounded good to you at the time, you might find out later in retirement that if you had just invested the money in the stock market in plain vanilla index funds, you could have had the same amount of income or more and had money to leave to charity or your heirs at death.

A lot of people say, you know, today when they're planning for retirement, they say they don't care about having anything left over at the end of life. But sometimes they change their mind when they see how much it really could have been.

The second con is that your interest rate is locked in. If you buy an immediate annuity today, you would be buying during a period of record low interest rates. In fact, you may not find an immediate annuity that pays 6% today to a 65-year-old couple given how low interest rates are. It might be closer to 4.5% or 5%.

Let's say that you buy a 5% policy and two years from now, interest rates have shot up and 6% immediate annuities are the norm again. You might be kicking yourself for writing that million dollar check during a period of record low interest rates. On the flip side, we could see low interest rates for another 10 plus years. We don't know the future.

Once again, you have to decide what's most important to you and make the best decision you can with the information you have at that time. We can't time the market and we can't time the interest rate environment with your retirement date.

Number three, the third con is perhaps the biggest and most important. And that is that it can be difficult to find inflation adjusting immediate annuities. And if and when you do, you'll find that the payout percentages are much lower. The example I shared about the million dollars for the 65 year old couple at a 6% payout rate.

That's for a non-inflation adjusting annuity. As you all know, $60,000 today is not the same as $60,000 tomorrow. And a non-inflation adjusting immediate annuity would be eroding your purchasing power slowly over the years or quickly depending on the inflation environment that you're in during retirement.

Given that, you would need to keep some reserves in the bank for inflation during the later years of retirement. So with all those, now let's talk about some of the pros of an immediate annuity. The first is that it provides steady, guaranteed income and peace of mind without the hassle of having to do math every year and trying to figure out how to safely withdraw money from your investment accounts.

You also don't have to worry about the stock market and what the stock market is doing. And if you have enough money left to fund retirement, if you crunch all of the numbers up front and determine that an immediate annuity will cover your retirement expenses and maybe even more, you can just sit back and enjoy life, assuming that your expenses remain under control. It's really hard to put a price on a stress-free retirement income strategy.

The second pro is that if you have good family health history and longevity and you live well past your life expectancy, a SPIA can turn into a really good deal for you. And then number three, the third pro is that you can customize these policies to fit your exact needs.

Think you're only going to live to age 80? Well, our 65-year-old couple can opt for what's called a 15-year period certain, meaning they only get that income for 15 years and then it's done. And if they do that, they can possibly increase their monthly guaranteed income by 50% or more. So that's one example of how they can customize that to fit their exact needs.

You can also accept a lower monthly payment and ensure that your heirs receive some sort of death benefit if you were to pass away early.

You can also get creative and carve out a percentage of your retirement savings, let's say 25%, and put that into an immediate annuity for some security and peace of mind, and then use a more traditional retirement withdrawal strategy for the remainder. In some cases, using a SPIA as an alternative to bonds is a great use case, especially in an environment like we're in today.

The challenge that most people have when we bring this idea up is that, again, they're writing an irrevocable check to an insurance company. And that's just not an easy thing to get over, even if the guaranteed income stream looks more enticing than what bonds are paying today. It's really hard to get over writing that irrevocable check that you'll never be able to see and touch again.

The last thing to mention on immediate annuities before we move over to dividend investing is the taxation of the income payments. To keep it simple, let's assume that you buy an immediate annuity with after-tax money. Well, a portion of the income payments that you're receiving from that immediate annuity is really just a return of your original principal.

Back to the example of the 65-year-old couple that buys a $1 million immediate annuity, they've already paid taxes on that $1 million. So it wouldn't really make sense for them to give it to an annuity company only to receive taxable payments in return. That money is returned to you in equal tax-free installments over the payment period.

So if you opt for a life annuity where payouts continue until you die, then that payment period is the IRS's life expectancy number for someone your age. You'll owe taxes only on any portion of each payout, but beyond that tax-free return of your original principal.

So, for example, if our 65-year-old couple has a life expectancy of let's say 20 years based on the IRS's tables, we would multiply their annual income payment of $60,000 by 20 years to arrive at a total of $1.2 million. That's the amount that the IRS assumes will be paid to this couple over their lifetime, $1.2 million.

Now we divide the original million dollars by that $1.2 million figure, and you get to what's called an exclusion ratio of 83%.

In other words, 83% of their income payments or $50,000 out of the $60,000 that they're going to receive each year, 83% or $50,000 will be tax-free to them until the original investment of $1 million has been fully returned. And then subsequent payments will be fully taxable if they live longer than that 20-year expectation.

Okay, let's quickly dive into the pros and cons of using dividend stocks to create a retirement paycheck before we part ways today. And I say quickly because I've recorded an entire episode on this topic. I've written about it at length in the past, and it's fairly straightforward. First, I want to revisit David Booth's quote from last week, which was that the best investment philosophy or strategy is the one that you can stick with.

So while I don't think that using dividend stocks to create income in retirement is the most ideal strategy, it's certainly better than not having a strategy at all or changing your approach every other year in search of something better.

So in short, some companies pay a dividend to their shareholders. Some investors decide to reinvest that dividend back into the stock and some decide to take that dividend payment and maybe invest it elsewhere or save it or spend it.

It's important to note that just because a company pays a dividend doesn't make them better or more successful than another company. You could argue that a company could grow even more and thus deliver better returns to their shareholders if they didn't pay a dividend and instead reinvested those profits into things like research and development or acquisitions.

There are a number of reasons for paying a dividend versus not paying one and that's a conversation for a later date. But for today, I just want to focus on the idea of only buying dividend stocks with your retirement savings and opting not to reinvest those dividends but instead spend them as you receive them to pay for your living expenses.

On the surface, it sounds like a great idea, like buying a rental real estate property and only spending the rent that comes in. But in my opinion, the cons outweigh the pros when it comes to investing in dividend paying stocks and spending those dividends in retirement.

To keep things consistent today, let's go ahead and pick on dividend stocks by talking about the cons first. So number one, given our current extended period of record low interest rates, many investors have flocked to dividend paying stocks in an effort to find yield. They've taken money out of their bank account that's paying them nothing to go buy dividend stocks that might be yielding 3% or 4% or maybe 6%.

This chase for yield has spiked valuations of dividend paying stocks, and you may be owning a more expensive slice of the overall market, which means if you've listened to the show for a long time, you should expect lower future returns from dividend stocks relative to broad based indexes like, let's say, the S&P 500.

Number two, only buying dividend stocks is the opposite of diversification. You're concentrating your investments into just one type of company. This makes your investments riskier. If you couple this with the first point that I made about high valuations, now you're buying into an expensive asset class that's adding unnecessary risk to your retirement portfolio.

You're also making an active decision. You're eliminating a segment of the global markets and making the assumption that this is going to improve your rate of return. And as we all know, active investing typically underperforms passive investing over long periods of time.

Number three buying dividend focused mutual funds or ETFs, you know, maybe picking individual Dividend paying stocks isn't your thing. So you say I'm gonna go buy mutual funds or ETFs Well buying dividend focused mutual funds or ETFs typically costs more it takes more work for that manager or that index fund provider to screen these stocks and put the fund together and as we all know the more you pay to invest and

the less money you have in your pocket at the end of the day over long periods of time. And while fees continue to come down, on average, the expense ratio of a dividend-focused fund is typically much higher than a broad-based index fund like the Vanguard Total Stock Market Fund, which, by the way, does pay a dividend. It

It just doesn't target only dividend paying companies. So the yield on that fund might be lower than other dividend focused solutions.

Number four, dividend stocks often come with a higher tax bill. Even if you don't sell your dividend stocks or dividend paying mutual fund or ETF, and you plan to just buy and hold and spend the dividends, well, you pay taxes on the dividends you receive every year if they're held in a plain vanilla brokerage account. In other words, every time you receive a dividend, you also receive a tax bill. And the higher the dividend, the higher the tax bill.

There are, in my opinion, more tax-efficient ways for companies to allow shareholders to share in the profits than by issuing a dividend and creating a taxable event every single time.

And then lastly, number five, there are just simply more prudent ways to invest. For example, as Meb Faber notes in his research and one research paper in particular, which I'll link to in the show notes, dividend investing is rooted in value investing, which I've talked about at length on this podcast.

And historically, focusing on dividend yields rather than other value-based metrics has been suboptimal. In fact, as Meb shows, a simple value-based investing strategy easily outperforms a dividend-focused strategy over long periods of time. Again, many of these value stocks likely also pay a dividend, but just screening for dividends alone has historically not been a prudent approach.

To summarize, if you're only focused on buying dividend stocks in an effort to create income, you're likely buying into a risky, underperforming asset class that's going to cost you more money and generate a higher tax bill. Not the most ideal combination.

Now, with that, here are some of the pros that I put together to take into consideration. The first is that it's a simple strategy that most people can understand and wrap their heads around. Number two, while valuations might be higher, if you screen for dividend companies that have a long track record of paying a dividend or growing a dividend, you'll likely end up with a lot of familiar blue chip names like Coca-Cola, Colgate, Johnson & Johnson, and a lot of others.

And sometimes, investing in what you know and understand and use in your daily life every day can help combat the emotional rollercoaster of investing and keep you from making irrational decisions with your money, which can completely destroy your retirement. And then number three, I'm reaching here, but the final pro that I can come up with is that you can do a lot worse than investing in dividend paying stocks.

If it's dividend stocks or non-traded REITs, I would take dividend stocks every day. If it's dividend stocks or a cash value life insurance policy as an investment, give me all those dividend stocks. There are some really bad investments out there that deserve more attention and more warning than a boring dividend focused portfolio.

And just lastly, but before I get questions or even hate mail from dividend focused investors, I just want to reiterate that I'm referring to screening for dividend stocks only. It's a common misconception that I hear from retirement savers that they go to a platform and they screen for dividend paying stocks and they only buy the stocks because of the dividend and they spend that dividend.

I would likely be making similar arguments if we were talking about putting all of our money in rental real estate or all of our money into small value stocks for that matter. Diversification is important and it's my goal to always own as much of the global markets as possible while tilting that portfolio towards asset classes that academically have proven to have higher expected rates of returns.

Yes, there are dividend strategies that have historically done very well. And yes, there are dividend strategies that are more prudent and are more tax aware and do combat some of the cons that I laid out. But just in general, high level, only buying dividend stocks to create income in retirement is likely a suboptimal solution.

A simple total return investing strategy, which I've discussed before on this podcast, is a simple alternative to stripping dividends from the portfolio to fund retirement. If you want to learn more about total return investing as an alternative, just go to Google, type it in. There's plenty of articles and research done on it.

Okay. Thanks so much for sticking with me today. Next week on the show, we're turning things up a notch. We're getting nerdy and we're getting into dynamic withdrawal strategies, which is one of my favorite topics. For all the links and resources mentioned today, head over to youstaywealthy.com forward slash 123.

Thank you, as always, for listening, and I will see you back here next week.