July 12, 2019
In the long list of humanity's bad ideas, the creation of the annuity industry sits near the top. In my opinion, classic annuities, as sold by insurance and financial companies, are a horrifically bad investment, yet they are widespread, with almost a quarter trillion (that's a "t," as in "tomfoolery") dollars of new annuities sold in 2018 (1). Insurance industry annuities are difficult to understand, the fees are cleverly obfuscated, they lock up capital with expensive exit charges, and they often have complex tax ramifications. A properly constructed set of index funds generally can accomplish the same purpose. They are, in my view, a bottom tranche of the financial industry - you have to try hard to find a worse investment.
If someone tries to sell you an annuity, I have one piece of advice: run.
With all of those accolades, it is time to cue the United States Congress. Never seeing lobbyist money that is not attractively green, in May the House passed the Secure Act which will make it *easier* for financial firms to lace 401(k) plans with annuities. The Secure Act eliminates much of the legal liability on the annuity provider, paving the way for industry growth in retirement plans. You can read more about it here.
Notice above that I said "classic annuities as sold by insurance companies." The concept of an annuity, as opposed to an annuity product, is wonderful indeed. An annuity is a fixed sum of money paid each year, often for the remainder of an individual's life. That is inbound cash flow, something we like here at One Day In July. And there is a simple way of achieving it.
They're called dividends and interest, and they are the money that businesses and bonds pay their owners. When you wrap hundreds or thousands of them together in an index, you wash away the default risk on any one security, and reduce the risk in the financial instrument.
Dividends and interest are not guaranteed to rise, but historically, over time, they have. Looking at the second quarter dividend on the S&P 500 via a Vanguard ETF (2), the per-share payment rose from $1.01 in 2017 to $1.16 in 2018 to $1.39 in 2019 in the June quarter. That is over a 37% rise in just two years, and the investor didn't have to pay an insurance company 8% of his/her capital to buy it!
That rise is above average, but I encourage you to look at the column second from the right on this page at the NYU business school. You can see that the yearly dividend on the S&P 500 rose from $16.07 per share in 2000, to $53.61 in 2018. So regardless of the gain in the investment, the investor got an annuity each year, and in most years it rose. In fact, since 1960, it has only declined six times. And much of this annuity is taxed at the lower dividend tax rates.
This is the type of annuity you want as an investor: transparent, simple, inexpensive to own, tax-efficient, and liquid. You receive the benefits instead of an an insurance company.
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