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Understanding SCHD vs Annuities
Choosing between SCHD (a dividend-focused ETF) and annuities for retirement income involves understanding fundamental differences in how these investment vehicles work, their risk profiles, and their potential benefits.
Key Differences at a Glance
SCHD offers growth potential and liquidity but with market risk, while annuities provide guaranteed income with less flexibility. Your choice depends on your risk tolerance, need for guaranteed income, and legacy planning goals.
About SCHD as Income Source
The Schwab U.S. Dividend Equity ETF (SCHD) tracks the Dow Jones U.S. Dividend 100 Index, focusing on high-quality companies with strong dividend records. As an income source, SCHD offers:
- Growing Income Potential: SCHD has historically increased its dividend payments annually, with a 5-year average growth rate of approximately 11.44%.
- Capital Appreciation: Beyond dividends, the underlying assets can appreciate in value over time.
- Liquidity: You can access your principal at any time by selling shares.
- Legacy Value: Remaining principal can be passed to heirs.
- Market Risk: Both dividend payments and principal are subject to market fluctuations.
"SCHD focuses on quality dividend stocks with strong fundamentals and consistent dividend growth, providing a balance between current income and future income growth potential."
About Annuities as Income Source
Annuities are insurance products designed to provide guaranteed income streams. When considering annuities for retirement income:
- Guaranteed Income: Fixed annuities provide predictable payments regardless of market conditions.
- Longevity Protection: Some annuities pay for life, eliminating the risk of outliving your money.
- Higher Initial Rates: Often provide higher initial payout rates compared to dividend yields.
- Limited Liquidity: Access to principal is typically restricted or subject to surrender charges.
- No Growth Potential: Fixed annuity payments generally don't increase over time (unless you purchase inflation riders).
- Limited Legacy Value: With standard annuities, payments cease upon death with no remaining principal.
"Annuities convert a lump sum into guaranteed income, offering protection from market risk and longevity risk, but typically without growth potential or access to principal."
Income Growth Analysis
One of the most significant differences between SCHD and annuities is how income changes over time. This analysis explores the trajectory of income from both sources and the implications for retirement planning.
SCHD's Growing Income Stream
SCHD's income typically starts lower but grows over time due to:
- Underlying Dividend Growth: Companies in SCHD have historically increased their dividends annually, with top holdings averaging 7-10% annual dividend growth.
- Reinvestment Potential: If not drawing all income, reinvested dividends further accelerate income growth.
- Index Rebalancing: SCHD's methodology replaces underperforming companies with stronger dividend growers during annual rebalancing.
Historical Perspective: From 2012 to 2022, SCHD's dividend payment per share grew from $1.07 to $2.46, representing a compound annual growth rate of approximately 8.7%.
This growing income stream provides an effective hedge against inflation, as retirement expenses typically increase over time. For retirees with a longer time horizon, this growth can significantly outpace fixed income alternatives in later years.
Annuity's Fixed Income Stream
Standard fixed annuities provide consistent income that:
- Starts Higher: Initial payout rates are typically higher than dividend yields (often 1.5-3% higher).
- Remains Constant: Payments don't increase over time (unless you purchase a cost-of-living adjustment rider at additional cost).
- Loses Purchasing Power: Due to inflation, the real value of fixed payments decreases over time (approximately 3% annually with average inflation).
Inflation Impact: A $50,000 annual annuity payment would have the equivalent purchasing power of just $27,687 after 20 years with 3% annual inflation.
While annuities provide income security and peace of mind, the erosion of purchasing power over a long retirement can be significant. For retirees concerned about inflation, this is a major consideration when comparing to dividend growth investments like SCHD.
Income Break-Even Analysis
When comparing SCHD to annuities, there's typically a "crossover point" where SCHD's growing income stream surpasses the initially higher annuity payment. Understanding this timeline is crucial:
| Time Horizon | Typical Crossover Period | Cumulative Income Advantage | Recommendation |
|---|---|---|---|
| Short (5-10 years) | SCHD may never cross over | Annuity provides more total income | Consider annuity for maximum short-term income |
| Medium (10-20 years) | 7-12 years | Mixed, depends on growth rate | Split approach or base decision on other factors |
| Long (20+ years) | 8-15 years | SCHD likely provides more total income | SCHD offers better long-term income potential |
The break-even point varies significantly based on:
- Initial Yield Difference: The gap between SCHD's dividend yield and annuity payout rate.
- Dividend Growth Rate: Higher growth rates in SCHD dividends lead to earlier crossovers.
- Inflation Environment: Higher inflation makes the growing income from SCHD more valuable.
Principal Preservation and Access
Beyond income considerations, how your principal is preserved, accessed, and eventually transferred can significantly impact your retirement strategy and legacy planning.
SCHD: Maintaining Access and Growth Potential
With SCHD, your investment retains several important characteristics:
- Liquidity: You can sell shares at any time if you need additional funds beyond the dividend income.
- Growth Potential: The underlying value of your SCHD shares can appreciate over time, potentially growing your principal.
- Market Risk: Your principal is subject to market fluctuations, which could temporarily or permanently reduce your investment value.
- Full Control: You maintain complete control over your assets, allowing you to adjust your strategy as needs change.
- Legacy Planning: Any remaining SCHD shares can be passed to heirs or charitable organizations.
Historical Principal Growth
From 2011 to 2022, SCHD's share price grew from approximately $28 to $75, representing a compound annual growth rate of about 9.4% (excluding dividends).
Annuities: Sacrificing Access for Guarantees
With standard income annuities, your principal considerations include:
- Surrender of Principal: With traditional immediate annuities, you exchange your principal for the income stream with no ability to reclaim it.
- Limited Liquidity: Most annuities have restricted access to principal or significant surrender charges for early withdrawal.
- No Growth Potential: Your principal doesn't grow inside a fixed annuity.
- Protection from Market Risk: The value of your contract is not affected by market downturns.
- Limited Legacy Options: Standard annuities end at death, though riders can provide death benefits at additional cost.
Annuity Variations
Some annuity types (variable, indexed, or fixed with withdrawal provisions) offer more access to principal but typically with lower payout rates or additional fees.
Case Study: The Value of Liquidity
Consider a retiree who invested $500,000 in SCHD in 2012. By 2020, the portfolio had grown to approximately $850,000. When faced with unexpected medical costs of $100,000, they could sell a portion of their SCHD shares while continuing to receive income from the remaining investment.
With an annuity, they would have been limited to the fixed income stream with no ability to access additional funds from their initial investment.
Risk Considerations
Different risks accompany each income approach, and understanding these can help you build a strategy aligned with your risk tolerance and needs.
| Risk Factor | SCHD | Annuity |
|---|---|---|
| Market Risk | High - Both principal and income subject to market fluctuations | None - Payments guaranteed regardless of market performance |
| Inflation Risk | Low - Growing dividends help offset inflation | High - Fixed payments lose purchasing power over time |
| Longevity Risk (outliving your money) |
Moderate - Depends on withdrawal rate and market performance | None - Lifetime annuities pay until death |
| Liquidity Risk | Low - Can sell shares anytime | High - Limited or no access to principal |
| Counterparty Risk | Low - Diversified across many companies | Moderate - Dependent on insurance company's financial strength |
| Sequence of Returns Risk | High - Early market downturns can permanently impact portfolio | None - Payments unaffected by market timing |
| Interest Rate Risk | Moderate - Some impact on dividend stocks | High - Locking in rates during low interest environments |
Market Volatility Impact
Market volatility affects SCHD and annuities very differently:
SCHD During Market Stress
During the March 2020 COVID-19 market crash, SCHD experienced:
- Share price decline of approximately 35%
- Some companies reduced or suspended dividends
- Overall dividend reduction was relatively modest compared to broader market
- Recovery to pre-crash levels took approximately 8 months
This illustrates both the risk (temporary principal loss) and resilience (dividend stability) of SCHD during market stress.
Annuities During Market Stress
During the same period, fixed annuity owners experienced:
- No change in scheduled payments
- No impact on annuity contract value
- Complete insulation from market volatility
- Peace of mind during market uncertainty
This stability illustrates the key psychological benefit of annuities during market downturns - elimination of market stress and uncertainty.
Sequence of Returns Risk
For retirees taking withdrawals from investments, the sequence of market returns can dramatically impact long-term outcomes. Annuities eliminate this risk completely, which is particularly valuable during the early retirement years when portfolios are most vulnerable to permanent damage from withdrawals during market downturns.
Tax Considerations
The tax treatment of income from SCHD versus annuities differs significantly and can impact your after-tax income and overall strategy.
SCHD Dividend Taxation
SCHD dividends receive favorable tax treatment in taxable accounts:
- Qualified Dividend Treatment: Most SCHD dividends qualify for lower long-term capital gains tax rates (0%, 15%, or 20% depending on income).
- Tax Location Flexibility: SCHD can be held in taxable accounts (for tax-advantaged dividends) or tax-advantaged accounts (for tax-deferred or tax-free growth).
- Capital Gains Control: You control when to realize capital gains by deciding when to sell shares.
- Step-up Basis: Heirs receive a step-up in cost basis at death, potentially eliminating capital gains tax on appreciation.
Example
A retired couple in the 22% federal tax bracket might pay only 15% on qualified dividends from SCHD, resulting in effective tax-advantaged income.
Annuity Taxation
Annuity payments follow different tax rules:
- Exclusion Ratio: With non-qualified annuities (purchased with after-tax dollars), part of each payment is considered return of principal (tax-free) and part is considered earnings (taxable as ordinary income).
- Ordinary Income: The earnings portion of annuity payments is taxed at ordinary income rates, which are typically higher than qualified dividend rates.
- Tax-Deferred Growth: Inside the annuity, earnings grow tax-deferred until distributed.
- No Step-up: Annuities do not receive a step-up in basis at death.
Example
With a $500,000 non-qualified annuity and a 20-year life expectancy, approximately $25,000 of each annual payment would be tax-free return of principal, with the remainder taxed as ordinary income.
Tax-Efficient Strategy
For optimal tax efficiency, consider:
- Holding SCHD in taxable accounts to benefit from qualified dividend treatment
- Using annuities purchased within IRAs or with pre-tax dollars when appropriate
- Consulting with a tax professional to model after-tax income scenarios based on your specific tax situation
Strategic Implementation Approaches
Rather than viewing SCHD and annuities as mutually exclusive options, many retirees benefit from strategic combinations that leverage the strengths of each approach.
Hybrid Income Strategy
Combine both SCHD and annuities to create a comprehensive income plan:
- Use annuities to cover essential expenses (housing, healthcare, food)
- Use SCHD dividends for discretionary spending and growth
- Adjust the allocation based on your risk tolerance and income needs
Example: 60% of retirement assets in SCHD for growth and rising income, 40% in an annuity for guaranteed baseline income.
Laddered Approach
Create a time-segmented strategy:
- Use SCHD for long-term growth and future income needs
- Purchase deferred annuities that begin payments at different future dates
- Match income sources with anticipated expenses at different life stages
Example: Purchase a deferred annuity at age 65 that begins payments at age 75 when healthcare costs typically increase.
Longevity Insurance
Use SCHD as primary income with annuity protection for advanced age:
- Invest primarily in SCHD for growth and income during early retirement
- Purchase a deferred income annuity (longevity insurance) that begins payments at advanced age (85+)
- Protect against outliving your assets
Example: Allocate 10-15% of retirement assets to a deferred income annuity starting at age 85, using SCHD for income until then.
Bucketing Strategy
Organize retirement funds into time-based buckets:
- Short-term bucket: Cash and fixed income for 1-3 years of expenses
- Medium-term bucket: Partial annuitization for years 4-10
- Long-term bucket: SCHD for growth and increasing income beyond 10 years
Example: Structure investments to match when you'll need the money, with guaranteed income covering specific time periods.
Adapting to Personal Situations
| Scenario | Recommended Approach | Rationale |
|---|---|---|
| Retiree with pension covering basic needs | Higher allocation to SCHD (80%+) | Pension provides income security similar to an annuity; SCHD adds growth potential |
| Retiree with no pension or other guaranteed income | Consider 30-40% in annuities | Creates income floor for essential expenses while maintaining growth potential |
| Conservative investor highly concerned about market risk | Higher allocation to annuities (50%+) | Reduces anxiety about market fluctuations while securing income |
| Investor focused on maximizing legacy | Higher allocation to SCHD (70%+) | Maintains growth potential and control of assets for eventual transfer |
| Early retiree (before age 60) | Start with SCHD, add annuities later | Annuity rates improve with age; maintain flexibility during early retirement |
Real-World Scenarios
These case studies illustrate how different retirees might approach the SCHD vs. annuity decision based on their specific circumstances and goals.
Case Study 1: Early Retirement Focus
Meet James & Maria (Ages 58 and 57)
- Retirement savings: $1.2 million
- Goals: Early retirement, travel while young, maintain flexibility
- Risk tolerance: Moderate
- Life expectancy: Family history suggests longevity
Their Strategy:
James and Maria allocated 85% of their portfolio to SCHD and other dividend growth investments, with 15% to a deferred income annuity that begins payments at age 80. This approach gives them:
- Maximum flexibility during early active retirement years
- Growing income to offset inflation over a potentially long retirement
- Protection against outliving their assets in very old age
- Ability to adjust withdrawal strategy based on market conditions
"We wanted the best of both worlds – growth potential and flexibility now, with guaranteed income later when we might need it most."
Case Study 2: Security Focus
Meet Robert (Age 68)
- Retirement savings: $800,000
- Goals: Predictable income, minimize financial stress
- Risk tolerance: Conservative
- Other income: Small pension ($15,000/year) plus Social Security
His Strategy:
Robert allocated 40% of his portfolio to an immediate annuity and 60% to SCHD and other income-focused investments. This approach gives him:
- Guaranteed income floor covering essential expenses
- Growth potential to offset inflation with remaining assets
- Reduced anxiety about market volatility
- Simplified financial management
"After the market crash of 2008, I knew I wanted some guaranteed income. But keeping a portion in SCHD helps me feel I'm not missing out on market growth and dividend increases."
Finding Your Balance
The optimal balance between SCHD and annuities depends on your:
- Income needs and timing
- Risk tolerance
- Desire for control vs. simplicity
- Legacy goals
- Other income sources
- Health status and longevity expectations
Use the calculator above to model different scenarios and see how they might work for your specific situation.
Frequently Asked Questions
What is the primary advantage of SCHD over annuities?
SCHD offers growth potential in both income and principal, plus liquidity and control over your assets. The dividends typically grow over time, helping offset inflation, and you retain access to your principal.
What is the main advantage of annuities over SCHD?
Annuities provide guaranteed income regardless of market conditions, eliminating market risk and the possibility of outliving your money (with lifetime annuities). They offer higher initial income rates and peace of mind through predictability.
Can SCHD dividends be relied upon in retirement?
While generally reliable, SCHD dividends are not guaranteed. The fund focuses on companies with strong dividend histories, but dividends can be reduced during severe economic downturns. However, SCHD's diversification across multiple dividend-paying companies helps mitigate this risk.
How do interest rates affect the SCHD vs. annuity decision?
Rising interest rates typically allow insurance companies to offer higher annuity payout rates, making annuities more attractive. However, rising rates can temporarily pressure dividend stock prices. The prevailing interest rate environment should be considered when deciding between these options.
Is it possible to combine SCHD and annuities effectively?
Yes, many financial planners recommend a balanced approach that uses annuities to create a guaranteed income floor covering essential expenses, with SCHD and other investments providing growth potential, inflation protection, and funds for discretionary spending.
How does inflation affect each income approach?
Standard fixed annuity payments remain constant, losing purchasing power during inflation. SCHD dividends have historically grown over time, often exceeding inflation rates, which helps maintain purchasing power throughout retirement.
What happens to my investment if I die early?
With standard immediate annuities, payments typically cease at death with no remaining value (though survivorship options are available at a cost). With SCHD, the full value of your investment passes to your heirs or estate.
At what age should I consider annuitizing some assets?
Annuity payout rates increase with age, so many advisors suggest waiting until at least age 70-75 for partial annuitization if appropriate for your situation. This allows more time for investment growth while securing higher income rates later.