As you near or enter your golden years, a reliable, sufficient, income stream to live on becomes ever more valuable. Alas, with pensions disappearing, this goal is harder to achieve than it used to be. You'll need to weigh the pros and cons of a variety of options.
The most reliable incomes are guaranteed -- and that's what you get in immediate annuities from insurance companies. You fork over a big wad of money, and they promise to pay you a certain sum each month. For example, a 65-year-old man with $200,000 can buy an annual income of around $15,000 for life.
The upside is obvious -- peace of mind -- but consider the downsides before signing up. For one thing, you'll likely spend a big chunk of our nest egg, only to receive less than you'd like. That $15,000 per year isn't a lot of money, unless you also have Social Security payments and additional savings or income.
Right now, bad timing has further tarnished these annuities. Current interest rates remain extremely low, meaning that policies will offer you less than they would in higher-rate environments. A recent Wall Street Journal article noted that while a 65-year-old woman can draw about $7,000 annually via a $100,000 policy, she would have netted close to $9,000 a decade ago, and $11,000 a generation ago.
Finally, there's inflation. Even if you're satisfied with what you'll reap from your annuity, the buying power of the payouts will shrink over time. If inflation sticks to its historic average of about 3% annually, the purchasing power of a $10,000 annual payout today will be cut almost in half in 20 years! If inflation is higher than average, the result could be much worse.
The dividend alternative
Due to all these concerns about annuities, it makes sense to look at strong dividend payers as alternatives. The WSJ article notes that investment returns for average retirees buying annuities amount to just 1% to 3% per year. It's certainly easy to beat that with dividends.
The following big names not only offer dividend yields topping 3%, but are also apt to increase those payouts over time, very likely staying ahead of inflation:
Five-year avg. annual dividend growth rate
Data: Motley Fool CAPS.
Still, dividend payments are just not as reliable as annuity payments. Sometimes big companies we can't imagine going out of business do go out of business -- think of Enron or Lehman Brothers. Even companies that remain steadily in business can disappoint us. General Electric
Today, a company such as Annaly Capital
Mitigate those risks
Clearly, whether you go with annuities or dividends (or other investments), there are risks and trade-offs -- all of which can be mitigated.
Spend all your annuity money now, and you risk interest rates going up, leaving you kicking yourself. Instead, consider laddering your purchases, perhaps spending a third of your annuity wad now, a third in three years, and the final third three years later. If you're willing to accept a lower initial payout, you can also buy an annuity with an inflation-adjustment feature.
With dividend-paying stocks, you can reduce your risk by not overexposing yourself to any one sector, and by looking for the healthiest companies you can find.
Finally, consider simply saving more aggressively and accumulating a bigger nest egg. It will buy you bigger annuity payouts and/or more dividend-paying stocks and will serve you better in retirement.
One way or another, you can build your own pension.