Yes. You should hate annuities.

Annuities.  Gambling.  House rules win.

Last September I posted 9 Reasons Dividend Stocks were better than annuities.  I likened annuities to gambling and wondered why anyone with sense would go down that path.  With gambling you know it’s entertainment – or at least you should. 

Annuities, however, are positioned as investments, not entertainment.  It’s not fun losing your shirt, but with gambling, nobody’s being fooled.  With annuities, someone is being specifically paid to pull the wool over your eyes.

It turns out my September thoughts aren’t unique.  Earlier today, USA Today posted an article by Ken Fisher of Fisher Investments - Why I still hate annuities: Here are the reasons these investments are bogus.  Below are a few of the adjectives Mr. Fisher used in describing different types of annuities starting with Variable Annuities:

• The slow-killer cigarettes of investing
• Horsepucky!
• Offering dubious value
• America’s most expensive investment products

Fisher torches Indexed Annuities and Deferred Fixed Annuities with less colorful but equally damning perspective.

His position isn’t new.  In 2013, CNBC ran a post on the pros and cons of annuities.  The cons greatly outstripped the pros in quantity and quality.

In 2012, Forbes published an article titled, The false promise of annuities and annuity calculators.  The author detailed the math behind annuities finishing with this thought.  We don’t recommend an allocation to annuities for any portion of your portfolio.  Emphasis is mine.

If you’re bent on purchasing an annuity, consider studying Latin and learning the phrase Caveat Emptor.  You’ll be better educated and wealthier for doing so.

The thoughts expressed here are those of the author, who is not a financial professional.  Opinions should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

5.5 Reasons Dividend Payers Beat Index Mutual Funds & ETFs

Index?  Mutual?  Dividend CCC!

Over the past couple months I’ve covered a host of reasons I think investing in strong dividend paying companies is better than parking money in real estate, precious metals and collectibles, non-dividend stocks, annuities, and target date mutual funds.  Therefore, I thought I’d tackle the reasons dividend stock investing is superior to index mutual funds or ETFs.  I’ve had a lot of coffee today and it’s probably a good thing, so here we go.

1) Compound growth is more reliable with dividend stocks than it is with index mutual funds and ETFs in general.  When individually held dividend stocks pay out their dividends, those dividends turn directly into additional shares of the company, assuming you’re enrolled in a Dividend Reinvestment Plan (DRIP).  Many, but not all, index funds and ETFs will retain dividends paid, increasing the Net Asset Value (NAV) rather than turning those dividends into additional shares of the fund for you.  I hold a couple such index funds in a 529 plan for my kids and a 401k so I’m well aware of this fact.  I don’t have much choice in either case.  Otherwise, neither would be in my portfolio.  NAV can fluctuate up and down given the market movement of the stocks it holds, irrespective of dividend payments.  In comparison, directly held dividend payers don’t subtract shares from your bucket unless you sell them.

2) Management fees erode your returns.  When participating in the DRIPs of dividend paying companies, or automatically reinvesting dividends from stock held in your brokerage, you don’t suffer the penalty of management fees.  The same cannot be said of index funds or ETFs.  This is particularly true if you’ve blundered into a managed index or ETF in which case your fees can be as high as a half-percent per year.  That may not sound like much, but once your portfolio reaches $100,000, you’ll lose $500 every year.  Those losses add quickly, particularly when you factor in the power of compound growth foregone.

3) Visibility and manageability of your holdings is much better with a select portfolio of dividend payers.  An index fund or ETF attempts to hold the same companies, in the same proportion, as found in the index it tracks.  Consequently you could own thousands of firms, most of which you’ll care little about – if you know about them at all.  To find out what you own in an index fund you have to sort through multiple pages and potentially thousands of lines of the index fund prospectus to know what’s in your basket.  That’s too much for most amateurs to manage in which case you’ll pay fees for a manager.  Brokerages like this.  See item #2 regarding management fees.

4) Investment diversity is frequently argued as a simple, brilliant form of risk mitigation.  The financial industry has taken the argument to the nth degree by selling the proposition that a fund of hundreds or thousands of companies offers greater diversification i.e., less risk, than a smaller grouping of individually held dividend paying stocks.  But is this true?  I can get considerable diversity or risk mitigation with 20-30 holdings in a well-chosen selection of dividend payers.  Adding hundreds of additional companies doesn’t reduce my risk much beyond that smaller holding – particularly if all those holdings are wrapped in a single package delivered by one financial institution.  In a future post, I’ll take a brief look at the probability underpinning the maxim of investment diversification. 

An index fund allows you to hold many, many companies at once providing the touted investment diversification.  However, I would argue that a vast array of companies is not necessarily better.  Warren Buffett agrees.  Or better, I’m of the same opinion as Warren, who said “diversification is protection against ignorance. It makes little sense if you know what you are doing."  The theory is most investors don’t know a post hole from their pie hole and should buy a huge basket of everything to limit risk rather than learning something about a few things and sticking with what they actually know.  The argument is great for the croupier class taking tine pieces of considerable investment activity via small management fees tacked onto index funds and ETFs.

5) Selective quality with individually held dividend stocks is much great than it is with an index fund or ETF.  Consider the estate sale in which a box of unknown stuff is auctioned off with little or no inspection by the bidders.  Bidders are attempting to buy the box at the lowest possible price hoping they’ll find a diamond among the rubbish they know they’ll get otherwise.  When you buy an index fund or ETF, it’s the same principle.  You’re buying thousands of companies in one fell swoop hoping the handful of gems more than offset the dregs and millstones you’ll invariably get.  It's less risky to pick and choose what you're putting your money into than throwing it over the wall and hoping for the best.

5.5) Additional thoughts:  Advocates of index funds and ETFs argue that diversification for small investors is easier with an index fund than individually held stocks.  This is true if you have only a couple hundred bucks to invest.  Once your investment basket has climbed above a few thousand dollars, I’m not sure that argument still holds.

A second argument is that index funds allow people to invest in with little risk, but complete ignorance.  Investors don’t have to read, research, or even think to participate safely in the market, or so goes the story.  I’m not sure this is a stellar idea to propagate but it’s a thing none-the-less.  It's better to put in a bit of effort when participating than diving in completely unaware.  Contrary to the old axiom, ignorance is not always bliss, particularly when investing for your future.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.  

9 Reasons Dividend Stocks Beat Annuities

Gambling.  Annuities.  Same thing.

Annuity Warning

When you gamble, you’re putting money into a game playing against the casino, using “house rules”, and hoping you come out ahead.  As most people know, the odds favor the house.  This doesn’t mean everyone always loses, but over the long run, far more people lose than win making the house the big winner in the end.

Annuities are pretty much the same thing.  In this case, insurance companies and other financial institutions are the equivalent of the casino and you’re putting your money into a game with odds heavily favoring those folks – not you.

Why would anyone gamble like this?  Mostly because they’ve been “sold” an annuity not understanding the purpose of an annuity or how it works.

An annuity is a contract between you and the insurance company that says the insurance company will pay you a certain stream of income over a future period of time.  In exchange, you must give that insurance company a lump sum of money OR agree to make a series of payments up front during what’s referred to as an accumulation phase.  In other words, give me your money and I guarantee you’ll get (most) of it back in the future. 

Put in such stark terms, it’s reasonable to believe many buyers wouldn’t pull the trigger on an annuity purchase, but they do because they don’t understand what’s happening.  The annuity contracts require you to pay some form of commission up front, baked into the deal so you can’t see it of course, AND then hang additional management fees on top of that, for the life of the annuity.  These commissions and management fees seriously degrade your “investment”, which isn't likely to be high quality to begin with, but hey, it’s supposed to be a “guaranteed” income stream over time, right?

There are multiple flavors of annuities e.g., fixed, variable, hybrid, life certain, etc.  However, they are all designed specifically to favor the seller in aggregate.  If not, nobody would sell them, right?

Given this background, here are 9 reasons I believe dividend stocks beat annuities.

1)    Commissions:  If you buy a stock with a solid history of dividend payments, you’ll do so for only a few dollars at a time through most brokerages.  Let’s say you buy $10,000 of a div stock through Fidelity.  You’ll pay anywhere from $5 - $10 to do so.  However, if you contract for an annuity of $10,000 with an insurance company, you could pay commissions in the 3-7% range or $300 - $700.  The cost to get into the annuity is 30x to 140x times higher than it is to get into the stock.

2)    Management Fees:  Once you buy a dividend stock, you pay no management fees for the privilege of owning it.  On the contrary, the annuity is likely to charge you a relatively substantial fee each year to “own” the annuity.  Management fees are often on par with those of managed mutual funds.  If managed mutual funds charge 1% to 3% per year, that's about what you can expect from an annuity.

3)    Surrender Fees: If you buy a dividend stock today and discover in six months that you need the money, you can sell the stock and pay the commission which is only a few bucks through most brokerages plus taxes on any gains (if there are any).  However, if you buy an annuity today and discover in six months that you need the money, you’ll pay a hefty surrender fee.  For instance, assume your annuity had a 7-year surrender period and you withdrew your money in six months.  Your surrender fee is likely to be 7% of your annuity ($700 on a $10,000 annuity).  If you need your money out in three years your surrender fee drops to 4% of your principle corresponding with four years left in the surrender period.  This $400 still a hefty chunk.  Under these conditions you won’t avoid the surrender fee until you’ve passed the seven-year mark on the annuity.  What's worse, some annuities have surrender periods up to 10 years.

4)    Risk: Annuities are mostly sold by insurance companies.  Insurance companies can go out of business like any other firm.  If you have $10,000 to invest and put it all into an annuity you’ve put all your eggs into a single insurance company basket.  While it’s possible to spread your annuity funds among a few insurance carriers, it’s much easier and more economical to spread your $10,000 investment across several dividend aristocrats or champions, at lower cost and with less complexity.  Spreading your investment funds across several investments diversifies away much of your investment risk while putting all your money into an annuity through one insurance carrier doesn’t.  We may explore the probability behind risk diversification in a later post.

5)    Complexity:  It’s easier to understand what AT&T, General Motors, IBM, or Microsoft do as businesses, but it's tough to understand the nuances of a variable annuity vs a life certain product, particularly when offered by different carriers much less the underlying investment structure.  The clarity and ease of understanding that comes with investing in a dividend stalwart vs an opaque annuity makes it easier to determine where your money’s going, how you can get it back, and when.  The rules of dividend stock investment are more user friendly than the rules of annuity selection.  Considering the costs associated with annuities, who needs the complexity on top of it?

6)    Cash Flow: Annuities are sold as vehicles providing a “guaranteed” stream of income over a period of time.  In exchange they take a large bite out of the principle in commissions and fees, then lock up your money through high surrender fees for prolonged periods.  Dividend stocks also offer a stream of income (not guaranteed however) in exchange for which you don’t get gouged with high fees or be forced to lock up your money.  While the annuity stream may provide a larger periodic payment than the dividend stock, it does so by returning a portion of your original principle along with a small investment return.  If you want the same effect with your dividend stocks you can get it by taking the dividend stream while selling a small portion of your underlying portfolio and doing so without any of the large annuity fees.

7)    Incremental Investments:  Annuities require either a large, lump sum payment up front or substantial monthly payments during an accumulation period.  This means you have to start out with a lot of cash or a healthy stream of disposable income.  If you don’t have either of these, then an annuity is out of the question.  However, you can start saving for your future with much smaller investments in total or even smaller monthly contributions e.g., $25 when investing in high quality dividend stocks.  Furthermore, you make those investments on your schedule, not on an insurance company’s.  This allows you to take smaller, cautious steps when starting to save for your future.

8)    Fiduciary Requirements: Up until 2016 or so, agents selling annuities did not have to act with fiduciary responsibility in selling an annuity.  In other words, they were allowed to sell customers whatever would pay the highest commission to the agent irrespective of whether or not the product was in the buyer’s best interest.  When the Department of Labor (DOL) enacted fiduciary requirements, annuity sales began to plummet since agents had to take responsibility for the products they sold and they didn't want to be responsible for a bad apple.  Annuity News even documents the decline.  Unfortunately, the Fifth Circuit Court has overturned that DOL ruling to allow agents to once more sell whatever pays them the greatest commission (see notes above about annuity commissions).  However, the registered investment advisor through whom you are most likely to make your dividend stock purchases is required by the Securities and Exchange Commission to act with fiduciary responsibility when selling stocks.

9)    Investment Visibility:  When you buy an annuity, you’re buying a pig-in-a-poke, blue sky, swamp land in the Everglades, a bridge to nowhere, or who knows what else.  You don’t really get to see or understand the underlying “investments” the annuity provider is putting your money into.  If you buy dividend stocks, however, you can readily see how and what they’re doing.  There is a universe of news, stock, advisory, and regulatory filings you can dig through to gain visibility to your dividend investment.  No such galaxy of resources is available to you for an annuity.  Unless you enjoy losing coins in a couch, it’s nearly always better to see where your money’s going and what it’s doing when it gets there.

If you’ve been keeping score on that original 10,000 dollar investment you put into an annuity, you lost $300 to $700 in up-front commissions, plus another $100 - $300 in fees the first year (plus a similar amount every year thereafter).  This means you’re behind the investment curve by $400 - $1,000 just for signing up.  And if you have an emergency in the first year requiring you to gain access to that money, you’ll lost another $700 - $1000. 

In a worst case scenario, you’re down $2,000 with an annuity before the year’s over.  Granted, that should be the extent of it unless the insurance carrier goes out of business.  Then you lose the lot.  On the other hand, if you put $10,000 into dividend stocks spread across 3 to 5 flavors you’re out about 50 bucks in brokerage fees and that’s it.  It’s possible you could lose the entire $10,000 in a catastrophic market meltdown, but if all 5 of your dividend champions went to zero in a single year, we’ve probably all got a lot more to worry about than market losses.  We’ll be living in mud huts wondering if we’ll ever see the sun again.  

The probability of taking substantial loses with an annuity is, from my perspective, much higher than the probability of suffering a significant setback with a handful of solid dividend payers.  You may have a different take and that’s ok, but at least there's an alternative to consider.

In the next post, I’ll explore the reasons Dividend Stocks Beat Real Estate Investments.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.