Investing for income is different from investing for growth. The pure growth investor doesn’t care much about dividends. In fact, many growth investors look to avoid dividends (outside of retirement accounts), because A.), dividends are taxable, and B.) if the stock management thought they could reinvest capital back into the company at higher than market rates of return, they’d probably want to do that, rather than pay a dividend, depending on their corporate charter.
That’s all well and good – but you need to be able to keep food on your table and a roof over your head now, and not at some theoretical point in the future (that may never arrive, since growth stock companies occasionally do go bust!)
If you are relying on your investment portfolio to generate income to live on, though… and an income that’s going to be reliable, no matter what the stock market does. The consequences of a bear market early in a retirement, when you have no choice but to pull your living expenses out of a stock-heavy portfolio even when prices are low – can create a devastating chain reaction from which your portfolio many never recover.
I’m not speaking so much to those with tens of millions of dollars to your name. I’m sure you’ll muddle through somehow – and tax mitigation is a big part of your strategy, anyway, in many cases. You may not want to maximize income.
But for the lower-to upper-middle classes, who’ve had to try to save money for retirement through the bear markets of the 1970s, 2000 and 2008, and are now faced with the lowest interest rate, lowest-dividend environment in living memory, you’re going to need every break you can get.
So what tools are out there to maximize income?
The Lifetime Income Annuity
The lifetime income annuity is the pure income play. You give a chunk of your nest egg – or the whole thing, in some cases – to an insurance company. In return, you get a contract saying the insurance company will pay you X amount per month or per year for as long as you live. You can also elect to spread the payments out over the lifetime of yourself and one other person. Normally, it’s the spouse (though I’ve seen grandparents set up a lifetime annuity to give a small check to a beloved grandchild or grandchildren every year at Christmas time for as long as that child lives, long after grandma is gone. Which is neat to be able to do!)
The income is partially taxable – you pay income tax on the fraction of the income attributable to the growth of whatever you put in – and you spread that tax out over your expected natural life.
The big advantages to the lifetime income annuity are the guarantees – you are guaranteed not to run out of income for as long as you live (as long as the insurer remains solvent, that is!). There’s nothing else that will provide you that guarantee and put it in writing.
The other advantage, from an income point of view, is the concept of mortality credits. These credits enable older annuity buyers to get a much higher payout on a given lump sum than interest rates would allow.
Here’s how it works:
Imagine four elderly women in a knitting club. They make a pact: They’ll each put $100 in a cookie jar, and vow to get together in one year and enjoy the money. This they do, except that one of the ladies dies. Each of the three ladies now gets $133.33. That money didn’t make a penny of interest, but all the survivors got a 33 percent return on capital! For not doing anything except being alive!
Lifetime income annuities work the same way: Those who die ahead of actuaries’ expectations subsidize the incomes of those who survive.
Typically, these annuities will often come with a return of principal guarantee – if you die before you receive back an amount equal to what you paid in, your heirs will receive the difference in an annuity death benefit. You can also buy an inflation benefit, though it will reduce your starting income level substantially.
Lifetime income annuities always seem to be going on sale – next year. All things being equal, the payout on LIAs increases with age – since, on average, your premium contribution plus interest gets paid back to you over a shorter period of time. So if you commit to a large lifetime income annuity, you’re committing yourself to a lower payout for life.
This is particularly disadvantageous in todays’ low interest rate environment. Yes, you get paid a payout rate, not strictly an interest rate. Every payment back to you contains a partial return of principal (non-taxable.) But with interest rates so low, you are locking yourself into a very modest return – one that could improve markedly if you hold on for a year.
Lastly, assets in a lifetime income annuity don’t get passed on to your heirs. Once you commit to a lifetime income annuity, it’s pretty much lost to your family, except via any return of premium at death guarantees.
This is pretty much the real estate equivalent of the lifetime income annuity. Except that instead of sending an insurance company cash, you transfer to them the title to your home. You go on living in the house, and they send you income. How much? That’s a function of how long you are expected to live and the value of your equity in the home.
These are similar to LIAs, in that you do have a guarantee of lifetime income. The insurance company gets its money after you pass on, when they sell the house. Normally, you need to be at least age 62 to qualify.
More on these in an upcoming post. Before you commit to one of these, though, look carefully at the precise terms of the contract. If you have to live in a nursing home temporarily, can the reverse mortgage company come in and seize your home while you’re not living in it? The AARP and the Department of Housing and Urban Development have both put out useful consumer guides.
Both the LIA and the reverse mortgage are powerful options for increasing or maximizing income – without taking on market volatility. For some people they are just the ticket. But there are significant downsides and caveats to each of these products as well.
Tips: Read the fine print on these contracts before you sign. Both lifetime income annuities and reverse mortgage programs are commitments, and are very difficult or impossible to unravel later if you change your mind.
Be careful about changing any plan in which income is guaranteed for a plan in which your income is not guaranteed.
Consider the needs of your heirs and dependents, too, after your death. If they are entirely dependent on your wealth and your ability to earn, then you’ll want to look at some alternatives.
One technique: Just buy a lifetime income annuity big enough to cover your basic expenses. That way, you can reap the benefits of long term investment, avoid committing your entire portfolio to a low-interest rate environment and less-than historically-average payouts, and you can sleep well at night knowing that no matter what the market does, you still have the basics covered.
Remember that these products are sold, not given away. The salesman almost always gets paid if you buy and doesn’t get paid if you don’t. A good fee only planner can go over the advantages and disadvantages for each plan in your case, without any conflict of interest.