Posted on 14 July 2010
By Mark Miller
Guaranteed retirement income has become a hot topic in the wake of the 2008 market crash, with financial planners and government policymakers alike looking for ways to reduce retiree exposure to equities and boost sources of guaranteed income.
Much of the buzz has focused on the humble single premium income annuity (SPIA), which offers regular monthly payments for life in return for an upfront lump payment to an insurance company. An SPIA can be a solid strategy for insuring against longevity risk–the risk of outlining your money. At a recent financial planners’ conference, a parade of speakers rose to sing the praises of the SPIA, and the Obama Administration has been pushing for regulatory changes that would encourage employers to offer annuities at retirement as part of their benefit plans.
But Charlie Farrell isn’t buying into the income annuity hype. Farrell is a principal at Northstar Investment Advisors and author of Your Money Ratios: 8 Simple Tools for Financial Security (Avery, 2009). He offers this criticism of income annuities: “Giving up your life savings to an insurance company is a high-cost way to get a modest amount of additional income. It’s also risky, because an insurer can go out of business.”
Farrell agrees that income is the name of the game. But he generates it for clients by constructing portfolios composed of top-rated bonds and high-dividend stocks. These high-income portfolios produce income streams that are highly stable–although not guaranteed–and that act very much like an annuity. But owners retain control of their assets, the risk is diversified among numerous bonds and stocks and the portfolio can match or outpace inflation.
Diversification is key to the strategy. Farrell argues that buying a single annuity–or even spreading your dollars across annuities from more than one provider–is akin to putting all your eggs in a single basket. In this case, you’re relying on that basket to generate monthly payments for the rest of your life. He admits that an income annuity contract offers a strong guarantee, but argues that all bets are off in the event of an industry-wide meltdown of the type we almost had in the 2008 financial crisis.
“A one-off failure of an insurance company wouldn’t be a problem, since the industry would absorb the contracts. But if you get a system-wide meltdown, no one can absorb it. So you might be better off with bonds and high-yield stocks from a variety of industries–you’re not concentrated 100 percent in finance.”
The income-producing portfolios are modeled on the Farrell-Northstar Retirement Income Index, which is composed of top-rated corporate and government debt, and high dividend stocks. Farrell and his partners at Northstar look for equities across a broad range of industries that maintain and increase dividends to outpace inflation (3 to 8 percent) and that offer meaningful current dividend yield (2 to 5 percent).
“Inflation is the biggest risk you need to manage in retirement,” Farrell says. “You don’t know what inflation rate you’ll see during retirement, but even at a modest inflation rate of 3 percent you need double what you started with in the income you receive every year.”
Dividends offer a good inflation hedge, since corporate management tends to make payouts that grow at the rate of inflation or more. Farrell doesn’t even care much if the equities appreciate; if they do, that’s icing on the cake. “We’re interested in the yield on the initial cost of your investment, since current yield is fluctuating constantly,” he says.
Here’s an example of how the Northstar income-producing portfolio compares with an immediate annuity. Let’s say a 65-year-old couple has $1 million in retirement assets. Investing that sum in an annuity with joint and survivor benefits from a top-rated insurer would produce about $63,000 per year in payments for the rest of their lives.
Northstar would invest that $1 million in a portfolio split 50-50 between stocks and bonds, with the stock dividends starting at about a 3.5 percent initial yield, with about 6 percent growth annually. If you started this program at age 55, total income at a typical retirement age of 65 would be about $54,000, and $78,000 by age 75–substantially higher than the annuity payments.
A couple of caveats:
–An income-producing portfolio like this works best for investors who get started a good 10 years ahead of retirement. “You don’t know where interest rates or the stock market will be in the year you retire, so you subject yourself to a lot of random outcomes if you stay in stocks for their appreciation,” Farrell says. “With this approach, you start building years before you need it–it’s like building a little business that yields cash flow down the line.”
–This isn’t something average investors should try to manage on their own. One drawback to the Northstar model is that it’s not something most people should attempt without help from an advisor. “Retirement income is complicated, whether it’s our strategy or someone else’s,” Farrell notes. “It’s the most complex part of retirement planning because you’re working with a fixed pool of capital and you’re trying to hit specific distribution targets annually over a 30-year period.”