If you are reaching retirement age, there is a good chance that you have already considered creating a guaranteed income stream during your golden years.
After all, nobody wants to worry about the basic costs of living and healthcare during their retirement. Most people in retirement try to build a diversified portfolio to create a guaranteed monthly income and they often end up choosing two vehicles to reach their goals. The first one is buying immediate fixed-income annuities that add a predictable source of income while at the same time protecting you against market volatility, and the second one is buying dividend stocks.
Besides dividend stocks and annuities, you can also consider investing in bonds that will pay you a fixed interest. However, as interest rates have remained at historically low levels over the last decade since the global financial crisis, investing in dividend stocks has become the preferred way of generating reliable periodic income during retirement in recent years.
Our Life Insurance & Annuities Center offers more practical information about annuities.
Things You Need to Know About Annuities
By annuities, most people think about immediate fixed-income annuities. However, there are actually different types of annuities that can pay you a variable periodic income based on the terms of the annuity. There is also something called equity-indexed annuities that offer payments linked to an index.
Regardless of the type of annuity you invest in, all types of annuities will pay you a certain amount per month or per quarter based on their respective terms. But the sad truth is that even the equity-indexed annuities will pay you a much lower rate of return due to how this financial product is structured, which we will discuss in the next section.
Difference Between Annuities and Dividend Stocks
Unlike annuities, when you buy a dividend-paying stock, you are actually directly buying a piece of a company through your stockbroker. When the company you invested in decides to distribute their income, they are paying the dividend directly to you. There are no middlemen involved.
However, annuities are offered by private companies, which include insurance companies, independent brokers, banks, wealth management firms and other financial groups. When you buy an annuity, these companies charge their own set of fees and invest it themselves, thereby providing you only a share of the profit as a fixed periodic payment.
To run their operation, they need to employ office staff and skilled wealth managers. Hence, they charge various fees to cover expenses like mortality and expense (M&E) fees, surrender charges, investment management fees and optional rider charges. In the end, it is the investors of the annuities who pay these bills, which leads to the lower rate of return compared to buying dividend stocks and, sometimes even, bonds.
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Dividend Stocks Offer Growth Prospects
Being a fixed-income financial product, annuities hardly offer any income growth opportunities. As you may already know, the purchasing power of the dollar is reduced by inflation. So, unless your future income can keep up with inflation, which is inevitable under the current fiat currency system, your purchasing capacity is going to get diminished over time.
If you invest in an annuity, there is a good chance that within a short period of time, you will start to feel the effects of inflation on your monthly budget.
However, when you buy dividend stocks, there is a good chance that the company will increase prices of their products or services as the cost of the raw materials or labor goes up with inflation. Hence, dividend stocks can offer much higher payouts in the future, even if they don’t get any secular growth.
In reality, if you do your homework and include the right companies in your portfolio, you will probably see dividend growth that will not only surpass periodic inflation but also deliver an inflation-adjusted increase in net yield. Moreover, when you invest in dividend stocks, the price of the stocks can also grow with time. This way, you get an opportunity to sell your stocks at a higher price and earn some profits as well.
Have you ever wondered how much money you could make by investing a small sum in dividend-paying stocks? Find out just how much your money can grow by plugging values into our Compounding Returns Calculator.
Dividend Stocks Offer Better Tax Benefits Compared to Annuities
Usually, when you earn income from annuities, they are taxed as ordinary income at a much higher rate. Moreover, if you decide to start taking income before the age of 59.5, you might have to pay a 10% IRS penalty.
However, when you buy certain qualified dividend stocks, you can get away with paying a much lower tax rate. Also, under the latest Tax Cuts and Jobs Act, long-term capital gains tax is capped at 20%, meaning if you hold on to a dividend stock for more than a year, you will be taxed at a lower rate than short-term investors!
Learn more about the downsides of annuities.
The Bottom Line
Sure, when you buy annuities, they pay you a certain amount of income regardless of the health of the economy or how the equities markets are performing at any given time. However, as there is no free lunch in life, the opportunity cost of that apparently risk-free fixed income is that you will likely earn a lower rate of return on your investment in annuities than dividend stocks.
Hence, instead of buying annuities, you might want to consider investing in dividend stocks that could provide a much higher rate of return in the long run. In fact, you might not even be aware that there are many great companies in the U.S. and around the world that have over 30 years of dividend-growth history and consistently pay a higher rate of return compared to the annuities available in the market. For instance, AT&T (T ) currently yields 5.29% and has a dividend-growth history of 33 years!
However, be mindful that with dividend stocks, you would take up some risks as the price of the stock can take a nosedive if the financial condition of the company deteriorates, which may prompt management to reduce or suspend dividend payments.
But we all take risks, whether we are aware or not. If you know how to properly screen dividend stocks and only invest in viable companies with great dividend histories, you can get away with earning a much higher income with dividend stocks compared to buying annuities.
Use the Dividend Screener to find high-quality dividend stocks based upon 16 parameters. For instance, you can create a view like this to explore common stocks, funds, ETFs and ETNs that pay monthly dividends. Or, you can create a view like this to see stocks that have consistently grown dividends over the last 25 years. Furthermore, you can screen stocks with DARS ratings above a certain threshold. Stocks with the highest DARS ratings are Dividend.com’s current recommendations to investors.
