This was originally a letter that I wrote to my mother. She had been planning on investing in an annuity and, not knowing much about them, I thought I’d investigate.
Below is the letter I sent to her.
Annuities
Like we discussed this morning, there are some downsides to annuities. From my research, and from what I gather, annuities are basically like buying insurance for your investments. From the variety of things I’ve read, annuities are only really suited for a small minority of folks.
Annuities are good for folks who are concerned that their savings won’t last them until the end of their lives. The insurance company who is issuing the annuity, is betting that you won’t live to use the money you’ve put into the annuity. I don’t know the specifics of your annuity, but typically speaking, when you die, they keep the money in the annuity and issue a small death benefit.
The other thing that annuities do is that they are designed theoretically to preserve wealth. This is accomplished my setting a cap of how much you can withdraw, as well as collecting large fees upfront and over time to compensate themselves. What this means is that if the market does poorly in a year, (from what I can remember from your annuity documentation) you can only withdraw 3% of the balance for that year. However, if the market does well another year, the most you can take out (after 10 years of course…) is 6%. All of the market gains are collected by the annuity company, and your “balance” isn’t really yours. If you want to ever take out your balance, they charge high fees to withdraw and you are only pegged at a low average appreciation.
The reason I think an annuity may not be a good match for you is that you have a variety of sources of income. You don’t necessarily need to be worried about your principle. You have large investments in real estate that you earn income from, as well as a diverse market portfolio. If the market has a bad year, you would still have passive income from rents to fall back if needed as well as your other less risky liquid investments.
Ultimately, this is why I don’t think annuities are for you. You don’t need insurance for your investments. I believe in your case, there are plethora of other ways you can preserve wealth besides paying high fees to a company whose business model is based on robbing you of the gains the market provides you with the illusion of security.
Other Options For Investing
Broad Market
For Molly and I, investing in a broad market index fund is the best way for us to build our wealth. We invest with Vanguard using the Vanguard Total Stock Market Index Admiral Shares (VTSAX). You get exposed to over 3600 top stocks in the market and with only a .04% expense ratio, it’s one of least expensive funds in existence. Since its inception, this fund has been earning an average 6.7% per year since 2000 and 16% annually since 2009. There are plenty of broad market index funds from other companies, it just happens that I chose Vanguard for us.
Dividend Growth and Lifetime Income
Since you are aiming more to preserve wealth, there are other options that allow you more liquidity and far less expense. You could go with a dividend appreciation fun, which tracks all the largest companies with dividends (VDADX). This has only been in existence since 2013, but so far it has returned over 10% annually since its inception. This also has a low expense ratio at .08%.
For a greater focus on high yield dividends and income from dividends you could allocate funds VHYAX which earns a 3.6% dividend distrubution.
You also have the option of investing in more conservative wealth preservation funds. These funds give you the peace of mind that your principle will always be growing at a steady rate. A good example of this is the Vanguard Life Strategy Income Fund (VDSIX). Since it’s inception in 1994 this fund has earned consistently 6%. It invests in 80% bonds and 20% stocks. This would be one of the most conservative ways to maintain your assets and beat inflation.
REIT Index Funds
Also just food for thought, I recently found this fund which I thought was interesting. It allows you exposure to the owning real estate without the hassle of dealing with people. You get paid a large dividend, plus you get the earnings and growth of the fund. VGSLX since it’s inception in 2001 has earned 10% annually and pays a 4% dividend on top of that. It has a very low expense ratio at 0.12%.
My Recommendation
I think one of the best ways to preserve your wealth is to keep more of it for yourself. With today’s investing tools and broad market index funds being so inexpensive and widely available, as well as safe and reliable, anything actively managed, to me at least, is giving your gains to someone else. Certainly there it is worthwhile having someone keep an eye on your money for you, and for the right person that can be extremely helpful. However, if, like you mentioned with your annuity, that you’re going to put money in there and not touch it for 10 years, with that type of time horizon, it would be foolish not to let that work for you in the market for 10 years vs. have the insurance company take the gains that would have been yours for themselves.
I think if I were in your position, I would look into a combination of low cost funds to distribute money to. If you are indeed not planning on touching money for 10 years, perhaps put that to work in the market with VTSAX.
If you want the money in the market, but want to take an income from it, maybe consider a dividend growth fund and live on the dividends.
As an example, perhaps it makes sense to have 40% in the market, 30% in bond funds, and 30% in dividend growth funds. That gives you exposure and safety across wide blocks of the economy. Your money will still grow, but will also be protected should the market experience a correction or recession.