Dividends versus Annuities: Why dividends are still important

Annuities

Annuities are a type of retirement investments offered by insurance companies. It remains popular among investors who want a stable and steady income stream for retirement.

Through a super fund or a life insurance company, one can invest in an annuity and choose the type of payments. Annuity tenure depends on the type of product, which could be fixed or for the rest of your life.

You must be between 55 and 60 for using super to invest in annuities. An annuity can be bought in joint names, allowing for splitting tax and transfer of fund to the survivor when a partner is deceased.

Annuity investor decides the amount to be received when buying the annuity, and the annuity income increases each year by indexation with inflation or a fixed percentage.

Share market performance does not affect annuity returns, which makes annuities a stable retirement income vehicle. Meanwhile, an account-based pension is invested in shares, bonds and other asset classes, giving better growth and investment performance, but market performance impacts the returns.

Annuities have a lot of advantages and disadvantages too.

Advantages of Annuities:

• Low-risk fixed income stream irrespective of markets.
• Suitable for risk-averse retirees.
• Annuities bought through super, after age 60, are tax free.
• Indexed annuities protect from the inflation risk.
• Annuities can be for a lifetime as well.

Disadvantages of Annuities:

• You cannot choose the investment mandate
• As interest rates are low, annuities would yield low.
• Funds are locked in the annuity until the time it ends.
• Lump sum withdrawals are not possible in annuities usually.

Since there are many types of annuities on the show for retirees, they should know the pros and cons of each type of annuity. Investing in an annuity could have major implications for the tenure of the product.

Fixed term: Such annuities are offered for a defined period of time, which could range from 1 to 50 years, and some products are offered for your lifetime until the time you die.

Payment: You would need to choose the type of payment frequency, and it could be monthly, quarterly, semi-annually or annually. A higher frequency of payments may diminish your returns.

Withdrawal: Although annuity products are designed to be held until maturity, some products may provide you with withdrawal features. However, the early withdrawal is likely to come at a cost.

Indexed: This type of annuities protects a person from rising inflation. In such annuities, payments are adjusted for the Consumer Price Inflation – it could impact the cost of annuity and value of initial payments.

Dividend stocks

Dividend stocks are companies with a solid history of paying a dividend. Some of these companies tend to grow their dividends as earnings of the business improve overtime.

In the meantime, the companies may lower dividends as earnings deteriorate due to various reasons, including recession, investment decisions, growth opportunities, and large legal liabilities.

Dividends by a business are dependent on various factors. Main factor that impacts the dividend paying capacity of the business is cash flow – cash flows of a business are very crucial for the going concern of the business.

A deterioration in cash flows of the business does not only raises concerns for creditors but for financiers and shareholders as well. When cash flows of the business are facing stress, it is likely to create challenges for the management to meet the near-term obligation, including dividends.

Since COVID-19 has disrupted the cash flows and caused a sudden stop to the cash flows of the businesses that have been closed forcibly, the companies are actively pursuing strategies to preserve cash for survival through delaying/cancelling dividends, raising capital, cutting on expenses, etc.

Investment and growth pursued by a business also impact the dividend paying capability of the companies. As the capital/cash is utilised in making investment decisions or reinvestments, the residual cash may not be enough to declare a dividend to the shareholders.

Small companies generally fall in this category as such businesses have to capture market share, scale up revenues, develop and innovate. Therefore, the dividend expectations from high growth, cash burning business should be lower, as these businesses are investing/reinvesting to become a large business.

Indebtedness of the business also impacts the capability to pay dividends as companies with large debt piles need to pay interest on the debts, which reduces cash that could be paid to shareholders in the form of dividends. At the same time, when businesses have low or no debt, it allows to disburse a higher level of cash to the shareholders.

Corporate tax rates also play an important role in delivering shareholder returns. As companies pay higher taxes, level of the cash left with them is usually low, thus the level of residual cash left for other obligation is relatively lower.

Why are dividend stocks important in your portfolio?

Dividends are also returns that are generated by the investments. When the earnings of the business are growing, chances of growing dividends are higher. Dividend investors should be very careful when picking dividend stocks and consider the sustainability of the dividends.

It is believed that the traditionally defensive sector like healthcare, consumer staples and telecommunications have sustainable dividends. However, investors should consider the health of the business, emphasising on the ability to pay dividends.

Dividend stocks not only generate a return through income, but the share prices may also appreciate over time as the companies grow and become even larger organically or inorganically.