In my last article I showed you why annuities could be the pension industry’s next accident waiting to happen. The fact is that another bout of inflation could make mincemeat out of your pension.
Even if you’ve squirreled away a million in your pension – and let’s face it most people haven’t – you may get as little as £30k p.a. income from this fund with an annuity. And if inflation gets out of control, that £30k could start to look pretty lousy. I’d like to show how you could get a much better deal.
Please do bear in mind that this is my personal opinion. If you’re planning on making changes to your retirement plan, you should get some specific financial advice first.
But I have to say that I won’t be buying an annuity policy before I absolutely have to.
Why you can’t trust a ‘guaranteed income’
The dangerous thing about an annuity is that once you’ve signed up, there is no way out. Your hard-earned pension is all bundled up in this one insurance policy. And you are badly exposed if inflation takes off. So rather than purchasing an annuity at the earliest possible date (55 as the law stands), I’d hold off.
I think investing your cash in a basket of income stocks until you have to buy your annuity (currently by the age of 77) could be a safer bet. That’s because over time businesses raise their prices along with inflation. That means profits should keep up too.
There is one major snag with stocks though. And that is that profits aren’t guaranteed, which means that dividends aren’t guaranteed either. We need look no further than BP, or RBS for a reminder of that.
Annuities, on the other hand, do at least give a guaranteed income. But what good is a guaranteed income, if its value gets massacred by inflation? It appears to be a very high price to pay. It’s the dilemma we face. Go for inflation busting dividends, or an annuity with a guaranteed income?
It all comes down to what you feel is the bigger risk: Inflation, or suspended dividends? Even with the risk of some missed dividends, I’d rather go for stocks. I reckon that stocks have got a secret weapon that’ll maintain dividends over the long run.
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Dividends don’t just keep up with inflation – they should outpace it
The dividend you get from a stock is only half the story.
Look at the electricity sector for example. Today the sector yields 5%, and the dividends are twice covered – i.e. the businesses only pay out about half of their earnings. Technically that means that profits could halve and they could still pay out the dividend from earnings.
But more importantly it means that the company is using half of its profits to reinvest in growing the business. They could use the cash to acquire other businesses, or to invest in new projects to enhance future returns.
So not only have you got inflation protection, but you’ve got growth on top of that too. How on earth can annuities compete with that? Bearing in mind an annuity only pays out about 6% and many stocks pay the same, surely this is a no-brainer?
But there remains one concern for investors.
Why income will see you through thick and thin
The stock market can take you on a rollercoaster ride. And not everybody likes a rollercoaster, especially as they get older.
But if you’re looking for an income, then the value of the shares shouldn’t bother you. It’s what one of my colleagues at MoneyWeek, Stephen Bland, keeps telling me: “I haven’t got a clue where the FTSE is going and I couldn’t care less”. As far as Stephen is concerned, there is only one thing worth caring about: dividends.
If you buy an annuity, that’s all you see too – your cheques arrive each month. You don’t get a valuation of whatever investments the insurance company happens to be holding. All you need to worry about is the yield on your initial investment.
The key with using stocks for income is to make sure you spread your assets around to get a diversified high yielding portfolio. That way, if some stocks miss, or reduce dividends, then others should be growing theirs.
On Monday I mentioned that the insurance companies behind annuities could actually end up as the big winners if inflation makes a comeback. And afterwards, Stephen pointed out to me that he just wrote about one of the major insurance players in his Dividend Letter.
The basic point is this: it is probably a far better idea to buy shares in the annuity provider than buy an annuity itself.
So how do you go about it?
Two steps to avoiding the annuity massacre
My first piece of advice is to hold off on buying a policy until you really have to. For a start, I’m hoping that the government will do away with this wretched obligation to spend your personal pension on an annuity. They’re certainly making all the right noises at the moment. They’ve already increased the age at which you have to buy the policy to 77.
It is true that you run the risk of annuity rates falling even further and if Government doesn’t remove annuity legislation, you could end up worse off.
But with interest rates practically at zero and with 30yr gilts paying a pitiful 4%, it’s hard to imagine how much lower annuity rates can actually go.
In the meantime, I think you should also start scoping out some decent high yielding stocks. The utilities sector is an obvious place to start and BP not withstanding, I still reckon oil is a sector worth getting exposure to.
But income investing is really Stephen’s area. He has been pursuing his strategy of picking high yield blue chip stocks for years. And it seems to be working out for him.
So I’ve been poring over the Dividend Letter over the last couple of days. I think that if we see another bout of inflation, then high yielding income stocks could be the best protection available.
And Stephen has a great system for building long term income. Click here to find out more about what Stephen has to say.
• This article was first published on 27 October in the free investment email The Right side. Sign up to The Right Side here.
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