Once again I'm electing to postpone my annual forecast for the economy and capital markets due to a more pressing issue - the need to debunk the slick variable annuity sales pitches making the rounds. Annuity salesmen from insurance companies such as The Hartford, Prudential and Mass Mutual, and stock brokers from the likes of E. D. Jones, Wachovia, and Morgan Keegan (Regions Financial) are preying on peoples' fear of running out of money before they die to sell them variable annuities. Variable annuities are expensive, restrictive, and usually poorly performing investment vehicles that were designed to shelter high-income earners from paying more taxes than absolutely necessary; they've morphed into guaranteed income investments for the elderly. However, they are wildly inappropriate for most individuals who are simply looking to ensure a certain level of income in retirement. At least one retired couple has learned to just say NO to variable annuities after getting a complete explanation of what these expensive insurance contracts actually could and couldn't do for them. The husband related how the E.D Jones broker was "pushy" when told that the insurance contract was about to be cancelled (during the free look period); clearly Mr. Broker didn't like the idea of losing his big, fat commission. Fortunately, the husband and wife had had a change of heart once they'd read the prospectus (which they finally received) and realized how much they were paying and how little they were actually getting once the boilerplate was boiled down to reality.
Nevertheless, the retired couple's basic problem still remains - how to earn a sufficient return on their savings to meet their retirement needs? (in a perpetually low interest rate environment that continues to punish savers and reward borrowers - thank you for nothing Federal Reserve!). Fortunately there is an answer that is far less expensive and far less restrictive than the Variable Annuity. It's called a diversified stock and bond portfolio!
A properly constructed, diversified portfolio will contain assets (stocks, commodities, real estate) that hedge against inflation in order to preserve purchasing power over the long run. The portfolio will also contain sufficient fixed income assets to generate a minimum level of current income to meet current liabilities. The wonderful thing about bonds is that they throw off a well defined stream of cash that can be used to meet liabilities as they come due! You don't even have to take credit risk if you stick with Treasuries and investment grade corporates and municipals. It is relatively easy for a qualified investment advisor (as opposed to a broker-dealer representative aka fee-based advisor) to construct a diversified bond portfolio that will yield 4% or so without taking any meaningful credit risk. As well, it is fairly easy currently to build a diversified portfolio of blue chip, dividend paying stocks with an average yield of 3.5%. The 4% rule tells us that a 60/40 stock/bond portfolio will last a minimum of 30 years, which gives us a starting point, at least, for positioning a portfolio for the decumulation phase of an investor's life cycle. The math: a bond portfolio yielding 4% and comprising 40% of the overall portfolio yields 1.6% to the investor, while a stock portfolio yielding 3.5% and comprising 60% of the overall portfolio yields 2.1% to the investor. Total yield of the 60/40 stock/bond portfolio is 3.7%.
Let's take a $1,000,000 portfolio as a case study to see what kind of current income we could generate while still positioning ourselves for a 30 year retirement. We would allocate $400,000 to bonds and currently could construct a portfolio of investment grade corporates and municipals that would give us an average yield of at least 4% with a duration of between 5 and 10 years. Interest produced would run at least $16,000 per year. We would allocate $600,000 to a diversified portfolio of blue chip stocks and could currently easily get a 3.5% average dividend yield, which would throw off at least an additional $21,000 in dividends. Total income generated by the entire $1,000,000 portfolio is at least $37,000, or approximately 3.7% per annum (almost meeting our 4% rule). Careful stock selection focusing on high-quality companies with well-covered dividends will provide an additional benefit in that the dividend income will rise over time as the companies raise dividends. Companies like Proctor and Gamble, Johnson and Johnson, Coke, and Microsoft can provide an annual and growing annuity unencumbered by the strait jacket restrictions placed on Variable Annuities sold by insurance companies.
And there you have it: a portfolio of stocks and bonds becomes that low-cost variable annuity that can provide a payout of (in this example) 3.7% per annum without touching principal - something you aren't allowed to do anyway in most variable annuities for between 5 and 10 years if you wish to qualify for the minimum income guarantee. The portfolio's overall yield will rise over time as the dividend paying stocks in the stock portion raise dividends regularly. Additionally, the 3% plus per year in average variable annuity expenses stays in your pocket rather than going to the insurance company. And finally, should your situation change and you need access to your money because of an unforeseen emergency... well, you have access without having to pay any of the penalties or forgo any of the guarantees.
One last thought:
Individuals with a shorter time horizon (less than 30 years) could construct portfolios with a greater allocation to bonds and reduced allocation to stocks, thus increasing the overall portfolio yield. Likewise, investors with excess wealth can reduce their allocation to stocks, if they wish to reduce variability in cash flows, since purchasing power risk isn't as much of a concern. After all, someone with $5 million of assets and a time horizon of only 15 years is likely to be able to survive on a 3% draw ($150,000) or even a 2% draw ($100,000) to meet everyday basic needs.
Our retired couple made a good call cancelling the annuity contract. They were looking at paying an up front commission of 3.5% and better than 3% annually in costs for a contract that was unlikely to benefit their income needs in any meaningful way. Now they need to construct a properly diversified stock and bond portfolio that will throw off sufficient income to meet their everyday needs while still protecting them from the long-term risk of inflation. By saying no to high-cost, restrictive and poorly-performing variable annuities and YES to low cost, flexible, diversified portfolios of blue chip stocks and bonds, our retired couple will get an acceptable level of income and still retain control of their assets!
