Saving for retirement can be very difficult because of longevity risk — that is, the chance that you might live long enough to outlast your savings.

The traditional solution has been an annuity, which transfers the longevity risk to an insurance company and pays you an income for the remainder of your life.

However, annuities have a hidden drawback: They lock in the interest rate prevailing when you buy them. At present, that makes them a lousy deal.

Luckily, we have a better strategy that’s simple to employ and can ensure income for years to come…The strategy is pretty straightforward: buying dividend stocks and waiting for rates to improve.

You see, not only do low interest rates adversely affect annuity rates, but the longer low rates persist, the worse the effects get. That’s because insurance companies use a mix of historic and projected returns when setting annuity rates. When rates stay down for more than six years — as at present — the interest rate swaps used by the insurance companies run off and interest rates get steadily worse.

Low interest rates affect annuity rates in two ways. For immediate annuities, they reduce the amount of annuity purchased for each $100,000. For deferred annuities, their effect is even more pernicious, because their compounding effect extends throughout the deferral period.

Thus, at present, an annuity purchased at age 60 to run from the annuitant’s 80th birthday (a common solution to the problem of longevity risk) is an especially bad deal. If interest rates are lower than the expected rate during the deferral period, then the annuity purchaser is receiving a negative real return on his purchase.

Mediocre Return and the Effects of Inflation

Brokers have gotten around the interest rate problem in recent years by offering investors variable annuities, in which the initial premium is invested in stocks or other investments, and the annuitant is paid a return depending on the return of the investments.

In general, these don’t solve the longevity risk problem, since the fund may be drawn down if the annuitant lives a long time. In addition, the commissions involved are generally high; you’re better off investing directly in no-load mutual funds, which give you the same investments with lower fees.

A typical annuity calculation today, given by Vanguard, shows a 65-year-old male purchasing an annuity of $1,000 per month for $167,105. Given today’s life expectancy for a 65-year old (19.2 years), that gives us an internal rate of return of 3.5%.

Needless to say, with inflation running around 2% per annum (the yield spread between 30-year fixed rate Treasuries and 30-year TIPS, a measure of expected inflation, is currently 1.9%), that’s not a very interesting yield.

Meanwhile, a deferred annuity of $1,000 per month that ran from your 80th birthday would currently cost you $47,976, according to Vanguard. That looks like a better deal — except that, with 2% inflation, the $1,000-per-month annuity beginning in 2030 would by then be worth just $743 per month.

Invest Wisely in the Meantime

Protection against longevity risk will always be necessary. However, rather than choosing a dismal annuity, retirees should employ a hybrid strategy: investing in dividend stocks now and waiting for interest rates to rise, so that annuity rates improve.

Investors can easily find high-quality dividend stocks paying more than 3.5% and hope that, in five years, annuity rates will have improved enough to make either an immediate or deferred annuity attractive.

For this strategy, you should choose stable dividend stocks that have some inflation protection. For instance, a consumer goods company with a broad-based market position is more attractive than a bank or tech company.

Beyond that, it’s important to ensure that the dividend exceeds the 3.5% yield on the annuity and keeps up with inflation over the next few years, so that the principal is available to invest in an annuity once interest rates are more favorable.

For starters, I’ve identified three companies that appear especially suitable for purchase and holding over the interim period before an annuity is selected.

• GlaxoSmithKline (GSK) is a global pharmaceutical company with worldwide operations, a broad base, and a $100-billion market capitalization. The stock yields 5.7%, far better than an annuity that could be purchased now.

• McDonald’s (MCD) is, as everyone knows, a stable worldwide business. Like GSK, it’s not over-dependent on the U.S. economy, and its stock currently yields 3.6%.

• Unilever (UN) is a global consumer products company with special concentration in Europe. That’s important, because Europe – a major oil importer – can be expected to benefit from lower oil prices. At the moment, UN stock yields 3.8%.

All three of these companies are stable global businesses that are more or less inflation-proof – thus ideal for retirement investors as an alternative to an annuity.

Good investing,

Martin Hutchinson