An Immediate Annuity versus High Dividend Stocks

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1 1 An Immediate Annuity versus High Dividend Stocks (Preliminary Version) Floyd Vest, May 2014 An immediate annuity guarantees monthly payments for a certain period of time (a period certain annuity) or for the rest of your life (a lifetime annuity). Unlike the volatility of the stock market, this gives you certainty, along with Social Security, of how much income you can plan for. The main advantage of a lifetime annuity is it offers protection against longevity risk the chance that you will outlive the annuity income. One in ten men retiring at age 65 can expect to live another 27 years (to age 92), and for women, another 30 years (to age 95). Six percent of retirees, not in a defined benefit pension plan, buy an immediate annuity. Example 1. John F. Wasik in the article How Much Should You Annuitize? , at Morningstar.com gives the following example of a $500,000 lump sum payment to the insurance company for a 4% annual income payment. He assumes that the annuity pays an interest rate of 2% per year. According to the calculator, you d get $1,666 monthly (just under $20,000 per year) for roughly 34 years. This example is based on the low interest rates on bonds at the time the article was written. (See the Side Bar Notes for other examples.) Wasik didn t say how old the annuitant was. He says that this period certain product is guaranteed for 34 years. For example from age 62 to age 96. If the annuitant dies before 34 years, the payments go into their estate. At 34 years, they have made 2% on their money A similar lifetime annuity would offer a higher interest rate. The immediate annuity given above does not protect against inflation of living expenses. Annuity income is taxed. In the 25% income tax bracket, for a lifetime annuity, the taxes are about 6.825% for the first number of years, and at 25% thereafter. (See the Side Bar Notes and Exercises.) Wasik recommended that the highest rated insurance companies by A. M. Best, Weiss, and others are used. (Companies that were rated A by A. M. Best have failed.) Example 2. Wasik suggests that an alternative to the annuity is investing in high dividend stocks. The retiree could easily assemble a portfolio of quality stocks averaging a 4% dividend yield or better. (See the Exercises for some current examples.) Investing $500,000 in stocks averaging 4% dividends would provide about $20,000 per year in dividend income. For many people, qualified stock dividends at taxed at 15%. The problem with investing in stocks is that prices can go up and down and if $20,000 per year (adjusted for inflation) is withdrawn from the portfolio, there is a small chance that the money won t last 30 years. (See the article in this course The 4% Rule for Retirement Withdrawals and others in the References.) But on average, in the long run, the price of stocks has increased. For example, the S&P 500 Index prices have averaged 7.15% annual increase from the end of 1944 to the end of (See the article in this course, Annual Total Return Table for the S&P 500 Index of Stocks, July 2013.) Since no one knows the future of stock prices, we can only generate scenarios. Assume the price of the stocks on the portfolio increase at an average of 5% a year and continue to pay 4% dividends. To deal with this example, we will shift to a stock priced at P 0 = $100, and pays

2 2 a dividend D 0 = $4 by the end of the first year. At the end of year one, P 1 = 100(1 +.05) = $105 and for the year, D 1 =.04(105) = $4.20. You can calculate that the initial $20,000 in dividends has also grown at 5%. The dividends have grown at a rate greater than the long term inflation rate of 3.24%. (See the References and Exercises.) Thus while the immediate annuity does not protect against inflation, there is a high probability that the dividend stocks will. Income taxes. Income taxes are an important consideration. For qualified stock dividends, most people would pay 15% income tax. For the first year, the after tax return on the $4 dividend is 4(1 -.15) = $3.40. For the second year dividend of $4.20, the after tax amount is 4.20(1-.15) = $3.57. Considering 3.24% inflation and $3.4( ) = $3.51, the after tax dividends have outperformed inflation. The immediate annuity will still be paying 4% income payments which is $4 on the $100. The $4 annuity payment is also taxed. We assume at the 25% tax bracket, it is taxed at 6.825% giving an after tax payment of $4( ) = $3.73. Since 4% of $500,000 is $20,000, we have the after tax payment of $20,000( ) = $18,635. (See Immediate Annuities, More Income and Lower Taxes, at investopedia.com.) For the $20,000 in stock dividends, the after tax value is 20,000(1-.15) = $17,000. For the second year, 20,000(1+.05)(1-.15) = $17,850. For the end of the third year, 20,000(1.05 ) 2 (1-.15) = $18, The dividends have surpassed the effect of the advantage of the 6.85% tax on annuity payments since 20,000( ) = $18,635. Historical Example. Consider a historical example of a high dividend stock, Johnson and Johnson (JNJ): , dividend yield = 2.80%, Price = $100.88, Dividend = $2.80, beta =.53, P/E = 19.24, EPS = $5.23, given in Table 1. (See the articles in this course on stock pricing models.) Assume the stock was purchased at the beginning of 2009 at $54.77 given in Table 1. (See Nasdaq.com for dividend history.) Table 1. Year Price at beginning of year Dividend Yield Percent of $54.77 paid 2013 $71.55 $ % 4.8% % 4.45% % 4.16% % 3.9% % If you had bought the stock at the beginning of 2009 at $54.77 with yield of 3.58% and dividend per share of $1.96, your dividend income per year would have increased to $2.16 in 2010, $2.28

3 3 in 2011, $2.44 in 2012, $2.64 in In May of 2014, the dividend yield was down to 2.80% but your income had increased. In 2013, you made in dividends, 4.8% of the original price of $ (See the Exercises.) Has the rate of increase in JNJ dividends kept up with inflation? The bucket approach. For protection against the hazards of the volatility of the price of stocks and of dividends, the bucket approach has been recommended so that you won t deplete the original value the portfolio or its annual accumulated dividends. Keep several years of needed income in an emergency liquid account for unfortunate years when dividends don t supply the inflation adjusted equivalent of $20,000 per year. In such a case, cut your spending, and if necessary draw from the emergency fund. (See Approach to Retirement Income at Morningstar.com.) Even if the price of your stocks have not kept up with the market, in this discussion we are primarily interested in the dollar amount of the dividends. Most likely, it won t be hard for the stock dividends to stay ahead of the constant $20,000 a year paid by the annuity ( ,000 = $20,000). (See the Side Bar Notes and Exercises.) Side Bar Notes: For quality high dividend stocks, see Morningstar s Stock Investor which gives wide moat value stocks with high dividends. There are other sources such as Dogs of the Dow, and high dividend mutual funds. Morningstar s wide moat stocks. Morningstar says that they look to invest in companies with strong growing competitive advantage and are trading at a reasonable prices, preferably at cheap prices. Wide moat firms are judged able to sustain their excess cash returns over a very long period of time. These stocks are listed in Morningstar s Stock Investor and some are included in two portfolios which have been very profitable and with exceptional performance since their inception in For a coverage universe of 1500 stocks, the companies are processed through qualitative and quantitative screens of nearly 100 tests including mathematical discounted cash flow analysis projecting future free cash flows. For the individual, these analyses are not investable strategies. To replicate the analysis, the costs would exceed the prospective profits. Morningstar has access to large computers, computer programs, data bases, and teams of analysts. The individual investor can access the results of the analysis from Morningstar.com at a small fee. There are other companies that do stock analysis. The wide moat analysis is based on the work of successful value investor Warren Buffet. In fact, he coined the phrase wide moat. (See wikipidea.org.) (See Build a Moat in Your Portfolio, at Morningstar.com.) Interest rates paid by immediate annuities: From annuitywatch.com , for 2013 the average rate for a five year annuity was about 1.49%. For a fifteen year annuity it was about 2.97%. Zero percent taxes on qualified dividends for those who fall in the 10% or 15% income tax brackets. They have taxable income up to $73,800, for 2014 (novelinvestor.com/taxes).

4 4 For information on annuities, see Morningstar.com. Go to Real Life Finance, then down to Annuities for several articles. Also see the internet for the confusing array of different types of annuities and different insurance companies. You can buy a lifetime inflation adjusted annuity at vanguard.com, Brokerage. Watch for the difference between advertising examples and the actual interest rate paid. Go to money.cnn.com. Search annuities from CNN Money. Sort by Relevance for Articles. Write a report on annuities. For stock split history, see getsplithistory.com. This site gives other information on stocks. The total student debt carried by Americans has more than quadrupled in the last ten years from about $230 billion to $1.08 trillion (The Dallas Morning News, May 4, 2014, p 3D). See the article in this course, Working Your Way Through College vs Sallie Mae, Oct The debt load causes loan rates on an automobile and a home to be higher, and less money available to save for retirement. The article claimed that the average debt load could cost about $208,000 in a lifetime. An automobile can make a 30 year immediate annuity. Trade in your 20 mpg car on a 40 mpg car and at 12,000 miles per year, save $1100 in fuel cost. For age 65 to age 95, 30 years, an annuity at 3% paying $1,100 per year would cost $21,560. According to Canadian statistics, half the Honda Civics are still on the road after 20 years. A person age 65 could make the car last 30 years (360,000 miles?) and get close to 40 mpg. At least, it would probably last as long as they do. At the average one year CD rate of.24%, the bank would pay the amount $51.74 a year on the $21,560. You might as well invest in the car. The money saved on fuel costs is tax free. (Figure the tax rate on the annuity.) You can spend the trade-in value on the old car on a vacation, or invest it in an annuity or high dividend stocks. At the 25% income tax bracket, the $1100 is worth $ before taxes. For a retiree to get this much from a one year CD would require $611, If short term investments had earned the historical 4%, we could buy a $36,667 car (Scott Burns, Denton Record Chronicle, May 4, 2014). To find out what the trade-in is really worth, don t mention the trade-in, and negotiate a cash price below factory invoice, not dealer invoice which is higher. Then get the value of the trade-in. If it s a good car, sell it to a friend at that price. (See the article in this course Lease versus Buy for an Automobile, April 2014) (PS: I found two substantive corrections for that article.) See if you can figure out what they are. (See the article in this course Examining a Lifetime of Automobile Purchase Expenses. ) Are we in a bond bubble? With interest rates at all-time low, the bond bubble will eventually burst. When this happened in 1994, bond holders lost $1 trillion. Why not hold stocks of strong companies like Coke (COKE, 1.20%, P/E 28.43) and Intel (INTC, 3.40%, P/E 14.07) which have loads of cash and are building the world s fastest growing markets, and grow dividends that beat inflation. When interest rates rise, they can absorb the cost of capital and continue making a profit for themselves and their stock holders. What s good enough for Warren Buffett is good enough for us (Time, July 2012). Which would you prefer Coke or Intel?

5 5 Exercises: Show your work. Label answers, variables, and numbers. If calculating with a financial solver, name your device. #1. In the above Example 2, at a stock value appreciation rate of 5% and a tax rate on qualified dividends of 15%, and dividends maintaining 4%, how long does it take for the after tax dividends to get to the original before tax $20,000? #2. For the above Example 2, with dividend rate a constant 4%, what increase in stock price keeps up with 3.24% inflation? What rate of increase of dividends keeps up with inflation? #3. Do the calculations for Example 1 to solve for the 34 years. Solve with both a financial solver, and with formulas, algebra, and a scientific calculator. Set up a formula for a version of the problem to solve for the interest rate. How can you solve? #4. List and discuss the advantages and disadvantages of the immediate annuity in Example 1 and other annuity products. See the internet. What do you think of the wide range of illustrated interest rate payments? What are some insurance companies with A+ ratings by A. M. Best? #5. List and discuss the advantages and disadvantages of investing in quality high dividend stocks. How long and how deep was the latest bear market, for example from 2000 to 2012? See the article in this course, Annual Total Return Table for the S&P 500 Index of Stocks. Consider S&P prices and Total Returns. During this period, what was the average annual rate of earnings with dividends reinvested? What were the several causes of this very long bear market? What is the current average dividend rate for the S&P 500? During this period, how did JNJ compare to the S&P 500? For JNJ discussed above, beta =.53. What does that tell you? #6. Apply some of the stock pricing models given in articles in this course to your favorite high dividend stock, or one of your selection from some source, or to Johnson and Johnson (JNJ) given in Historical Example. #7. Read the article How Much Should You Annuitize? by John F. Wasik, at Morningstar.com. Check off the more than 100 quantitative and qualitative finance terms and variables that are presented as consideration in the stock screen for wide moat. List them if you can. What percent of wide moat companies drop their rating? What percentage of companies receive a four star moat rating? How do wide moat companies fit into investing for consistent long term dividends? #8. For the bear market from 2000 to 2012, look up the history for JNJ price, dividends, and dividend yield. Calculate and discuss. Use both finance.yahoo.com and Nasdaq.com. What happened to the dollar amount of dividends during the bear market? Did they keep up with inflation? #9. List and discuss some of the high dividend stocks in Dogs of the Dow. What is Dogs of the Dow? See Dogs of the Dow on the internet. Go back to the history of Dogs of the Dow and see how their dividends have performed. Watch for stock splits. See stocksplithistory.com for stock splits. #10. What is the probability that one or both of a married couple at age 65 would outlast a 30 year joint annuity? In John F. Wasik in Morningstar.com, see the link for a study in the Journal of Economic Perspective (befi.allianzgi.com).

6 6 #11. Some limited partnership stocks pay very high dividends. Give some examples. How are the taxes on limited partnerships calculated? #12. One article at money.cnn.com says that for a couple age 62, they can put in a lifetime annuity $200,000 and receive about $12,600 per year ($1050 per month). If one or both live to age 80, what interest rate do they earn? What about taxes? How long would they have to live to get their money back? What is average longevity for someone age 62, for men, for women, for a couple? What are the chances that that the insurance company will not have to pay out the total $200,000? What are the chances that on average, they will make money? (See the article Income for Life at money.cnn.com.) In John F. Wasik in Morningstar.com, see the link for a study in the Journal of Economic Perspective (befi.allianzgi.com). #13. Many teachers have a 403b at TIAA-CREF.com. What current interest rates do they pay on immediate annuities? How is TIAA rated by the insurance rating companies? What interest rates do they pay on the fixed annuity investments? Do they sell variable annuity investments? Do they sell indexed annuities? What does Morningstar.com and money.cnn.com say about indexed annuities? Discuss. See the link in Wasik in morningstar.com for complicated and expensive for variable indexed annuities (See Five Answers You Need Before Buying Annuities at monringstar.com). #14. Go to dinkytown.com and under Insurance, see the Immediate Annuity Calculator. Calculate to check his example to see if you agree. Also under Retirement, look at Pension Plan Retirement Options, Company Stock Distribution Analysis Calculator, How long will my savings last? and Retirement Shortfall. Calculate to check his examples and see if you agree. Report. Discuss what you learned. #15. At dinkytown.com under Investments, see Inflation-Historical Impact on Investments, and REIT Tax-Equivalent Distribution. Calculate to check his examples to see if you agree. Report. Discuss what you learned about REITs. #16. For a 65 year old retiree, assemble a temporary $500,000 portfolio of high dividend stocks at 500 shares per company. For each stock, collect the date, price, ticker, name of the company, and dividend yield. About how many stocks were included to invest the $500,000? Give your simplified and convenient qualification for each stock. For example, the stock has a four star moat at Morningstar, or the price might not be at an all time high. Collect for each stock as much information as you think is useful. If you use a broker, or a stock letter, give the name. How much is the commission to purchase, and how did you design the purchase? What arrangement would you make for quarterly stock dividends? Consider reinvesting the dividends in the stock from which they came, and once a year, selling $ (inflation adjusted) worth of your worst performing stock and paying the capital gains or taking the capital loss. What is the charge for reinvesting dividends? There should be no explicit charge. When selling, would you have to pay taxes on the dividends accumulated in the stock? #17. If because of limited resources, the 65 year old retiree doesn t want to put the whole $500,000 in high dividend stocks, what would you recommend for diversification? Describe your assumptions about the retiree s needs. Consider putting small amounts such as $20,000 in each of several high yield immediate annuities. Watch for teaser rates? What is the ratings of the insurance companies? How high do the interest rates go? Consider buying direct from the insurance company. Use the internet.

7 7 #18. For Example 1, figure the income tax rate on the $20,000 per year for a female with 34 years of payments, in the 25% income tax bracket. See in investopedia.com the article Immediate Annuities: More Income and Lower Taxes. What percentage of the $20,000 is tax free? This is called the exclusion rate. Please note that Example 1 involves a period certain annuity and not a lifetime annuity. Apply this tax rate to the above discussion under Income Taxes where the 6.85% occurs. What does this change? How long does it take the stock dividends to surpass the advantage of the new tax rate? #19. With the $500,000 in stocks appreciating at 5% per year for 34 years and all dividends withdrawn, what should be the value of the portfolio? This could be the amount left on the table at death after 30 years. This may be more than the retiree wants to leave on the table. But, averages don t always work. See the articles in this course on survivability of retirement funds and the sequencing effect. #20. With 5% appreciation of the $500,000 and 4% dividends reinvested, not considering taxes, what should be the value of the portfolio after 30 years? See the articles in this course on dividend stocks. What about the value of the portfolio subtracting taxes on the dividends? #21. Work your way through Immediate Annuities: More Income and Lower Taxes in investopedia.com. (a) Calculate the tax rate for the first period. (b) The 65 year old lady has and average life expectancy to age 85. If she dies at this age, what rate of return does she get on her investment? Are these annuity quotes realistic for highly rated insurance companies today? Give your date. Lambert s figures look good if the terms of his annuity are realistic. Explain Lambert s calculations and his conclusions. When does the period of a tax rate of 25% start? References in this course: Using USInflationcalculator.com, Dec Funding Retirement in a Worst Market Scenario, Sept The 4% Rule for Retirement Withdrawals, Sept Investing in Tax Deferred Variable Annuities, Fall, Annual Total Return Table for the S&P 500 Index of Stocks, July High Dividend Yields on Stocks and Low Interest Rates on CDs and Bonds, Jan Joint Life Expectancy and Sustainability of Retirement Funds, Nov Dividend Growth, Feb Delayed Social Security and Increased Benefits, March, America s Retirement Challenge, Aug Stock Pricing Models, Jan For a free course in financial mathematics, with emphasis on personal finance, for upper high school and undergraduate college, see COMAP.com and click on the box and register. They will you a password. Just click on an article in the annotated bibliography, download

8 8 it, and teach it. Unit 1: The Basics of Mathematics of Finance, Unit 2: Managing Your Money, Unit 3: Long-term Financial Planning, Unit 4: Investing in Stocks and Bonds, Unit 5: Investing in Real Estate, Unit 6: Solving Financial Formulas for Interest Rate. Unit 7: More Advanced or Technical (for about ten articles in this area, see the UMAP Journal at COMAP.) Develop a lifetime file on financial mathematics. In this file, put the articles with answers, and other accumulated resources from this course.