The worse annuities get, the better dividends look.
Just because something has fallen sharply, doesn't mean it can't fall even further. Just look at annuities. Rates keep on falling and falling and falling.
Every time Mervyn King, magician to the Coalition, conjures another slab of virtual money, he forces down gilt yields, which in turn forces down annuity rates.
With the Bank of England recently printing another £50 billion of electronic money, and another £50 billion expected by November, it's hard to say when annuities will finally bottom out.
Rising life expectancy only makes things worse, as that annuity pot has to cover more ground. More than one million pensioners have been trapped in annuity hell since the financial crisis struck.
The incredible shrinking annuity
Most financial advisers will tell you that an annuity is still the starting point for your retirement income. It gives you the certainty you need in retirement, by paying a regular income for as long as you live. Your annuity is never going to run out. That kind of security is not to be sniffed at.
Unfortunately, annuity rates have a nasty stench about them these days. By shopping around, a 65-year old man with a £100,000 pension pot could buy a level annuity worth at most £5,700 a year, according to Hargreaves Lansdown Pensions.
If he wanted that annuity to rise with inflation, his starting income would shrink to a mere £3,500. And if he needed a joint life annuity, to cover his wife or partner, it would shrink further.
Once he buys that annuity, he can't switch if he spots a better rate. This is for life. Nor can he get his hands on any of the capital. It has gone for good.
Hell is for heroes
Luckily, you don't have to buy an annuity when you retire. There is an alternative, and right now, it looks heroic by comparison. Which is just what you need in these hellish times.
Instead of using that £100,000 to buy an annuity, you could invest it in a spread of dividend-yielding shares instead. That could generate income of £4,000 to £5,000 a year, and you get to keep your capital as well.
Better still, the value of your capital will rise in future, if stock markets rise. And so could your income, as the underlying companies hike their dividends.
That's slightly less than the annuity income, but of course, you still have your capital.
If that £100,000 is sitting in a pension, you could do this by investing in a drawdown plan. If you hold that money in an ISA, you have even more flexibility.
Feel the yield
There are plenty of tempting dividend-paying blue chips to choose from right now. GlaxoSmithKline (LSE: GSK) and Sainsbury's (LSE: SBRY) both yield more than 4.8%. Legal & General (LSE: LGEN) and Standard Life (LSE: SL) yield more than 5%. BAE Systems (LSE: BAE) and SSE (LSE: SSE) yield around 6%. Aviva (LSE: AV) yields over 8%.
There is nothing hellish about those yields. In fact, they're quite heavenly.
Long division
Staying footloose and fancy-free is riskier than plighting your troth to an annuity, of course. If you invest in dividend-paying stocks, even solid blue chips, neither your income or capital is secure.
The good news is that this isn't an either/or question. You could invest, say, half your pension in an annuity, and half in a portfolio of dividend-yielding stocks.
You could further balance your risk, by splitting your annuity between a level and index-linked income, to balance that higher initial income against valuable protection against inflation.
Zeros and heroes
Hargreaves Lansdown (LSE: HL) has produced figures looking at what would have happened if you invested £100,000 in equity income 20 years ago.
The answer is that lots of nice things would have happened. By now, you would have received total income of £131,500. Better still, your capital will have risen to a pleasant £240,000.
In 2011, you would have received £6,000 income. True, this is much less than the £14,000 a year you would have got from an annuity, but no annuity pays that kind of return these days.
The worse annuities get, the better dividends look. They are the heroes of the current investment world, and are likely to stay that way, even after annuity rates stop falling. Whenever that is.
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> Harvey holds shares in Aviva, Glaxo and Invesco-Perpetual Income. He doesn't own any other investment mentioned in this article. The Motley Fool owns shares in Hargreaves Lansdown.
