Key Takeaways
- Bonds and annuities can both offer a stable income for retirees but differ in their payment mechanisms: bonds are debt instruments, while annuities are based on contractual agreements with insurance companies.
- Annuities provide more flexibility and tax advantages, generating potentially higher income than bonds due to mortality credits and tax treatment on returns.
- Bonds are more liquid, but annuities offer better protection against rising interest rates and have the advantage of providing lifetime income.
How Annuities and Bonds Work
Bonds and annuities are both investments popular for their ability to provide a consistent and stable rate of return. While each product can create a steady stream of income, they do so in different ways and are structured to achieve different outcomes.
Bonds are debt instruments that represent loans you have made to the issuer. You receive cash flow as interest payments during the life of the bond, and later the return of your principal when it eventually matures. Annuities, meanwhile, are insurance products that send you payments based on contractual guarantees made by the issuing company.
Understanding the similarities and differences between bonds and annuities can help retirees decide whether one — or a combination of the two — makes the most sense for them.
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It is not a question of either or, but a question of how much in each. Annuities and bonds have a place in most investors’ retirement income plans. There is no reason investors need to forgo either product’s advantages when they can have both. Utilizing the greater liquidity of bonds for shorter-term savings is important. Leveraging the security of lifetime income is essential. There is a place for both, and such a portfolio will be greater than the sum of its parts.
Stephen Kates, CFP®Founder of Clocktower Financial ConsultingStephen Kates is a Certified Financial Planner™ and personal finance expert specializing in financial planning and education. Stephen has expertise in wealth management, personal finance, investing and retirement planning.
Comparing Annuities to Bonds
Before comparing bonds and annuities, it’s important to know that there are many types of each product.
For example, there are many types of bonds issued by local, state and federal governments. Corporations can also issue them.
- Coupon Bonds
- Coupon bonds generally pay interest every six months and return the principal value when the bond matures.
- Zero-Coupon Bonds
- Zero-coupon bonds do not make regular interest payments. Instead, they are sold for a discount and you receive all interest and principal at maturity.
- Municipal Bonds
- State and local governments issue municipal bonds, also called muni bonds. The interest is tax-free income at the federal level. If you live in the same state where the bond was issued, there’s a possibility that it could also be exempt from state-level taxes.
- Floating Rate Bonds
- Floating rate bonds have a variable interest rate that fluctuates based on movements of a base rate.
- U.S. Treasury Bonds
- U.S. Treasury bonds are issued by the federal government and are often considered the safest type of investment.
Common Types of Bonds
As with bonds, there are many types of annuities. Since each issuer offers different contract provisions, each type may differ between issuers.
- Immediate Annuity
- Immediate annuities begin payments immediately upon purchase (or within one year).
- Fixed Index Annuity
- Fixed index annuities offer returns tied to the performance of a market index, such as the S&P 500.
- Deferred Annuity
- Deferred annuities don’t begin making payments until some time in the future.
- Variable Annuity
- Variable annuities fluctuate based on the performance of underlying investments.
- Fixed Annuity
- Fixed annuities do not fluctuate, instead offering a fixed rate of return.
Common Types of Annuities
Read More: How To Diversify Your Portfolio
How Annuities and Bonds Are Alike
Because different types of bonds and annuities exist, it’s hard to make a broad comparison between the products. Therefore, for illustration, we’ll choose a bond and an annuity that are most similar: single premium immediate annuities, or SPIAs, and coupon bonds. They are both popular for their ability to provide reliable income throughout retirement.
To acquire a SPIA or coupon bond, you make a single lump-sum payment to an issuer. In return, the issuer promises to pay income for a set period. For annuities, that issuer is usually an insurance company. For bonds, it’s either the federal, state or local government — or a corporation.
Both annuities and bonds establish specific payment dates from the start. With both, you’ll know exactly when your payments will begin and how much they’ll be. You and the issuer agree upfront on stated payment dates and the rate for payments.
Another similarity between annuities and bonds is that the issuer guarantees payments. The security of that guarantee depends on the creditworthiness of the issuer. In every case, you need to evaluate and decide how comfortable you are with the credit risk before you purchase.
Both annuities and bonds:
- Are purchased with a lump-sum payment.
- Offer guaranteed payments for a set period.
- Have specific payment dates.
- Include a stated payment rate.
- Include some credit risk.
While annuities and bonds share these common factors, there are also many ways in which they are different.
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Annuities vs. Zero Coupon Bonds
You might compare fixed annuities to zero coupon bonds, also called zeros. As previously mentioned, zero coupon bonds do not pay interest at regular intervals as coupon bonds do. Instead, investors purchase zeros at a steep discount and receive the bond’s face value at maturity.
Zero coupon bonds have a longer maturity period than other types of bonds, sometimes fifteen years or longer. Because of this, zero coupon bonds are better suited to saving for long-term goals like retirement. Similarly, fixed annuities have a long accumulation period because they are designed for retirement savings.
Because fixed annuities and zero coupon bonds do not pay out regular interest payments, both products have no reinvestment risk. Reinvestment risk refers to how you might reinvest the interest received from a coupon bond. The risk is essentially that rates will have fallen by the time you can reinvest the interest.
Zero coupon bonds and annuities do not carry this risk. Because the zero is holding onto the interest it accumulates, that interest compounds at the same rate. The process is similar to how fixed annuities accumulate growth: compounding annually until the annuity’s term elapses.
Key Differences Between Annuities and Bonds
The main difference between annuities and bonds is the nature of the relationship between you and the issuer. With an annuity, you are a party in a contractual agreement defined by an insurer. There is also a contract involved with a bond, but you are the lender.
Annuity Terms Are More Flexible
Annuity contracts are somewhat negotiable. Before you finalize an agreement, you can add benefits through the selection of contract riders or modify some of its provisions. For example, you can include life insurance and name beneficiaries. The contract’s term is also flexible, although most annuities are written to provide lifetime income for the buyer.
Bond contracts, called indentures, are not negotiable. There are many bonds to choose from, with varying rates, term lengths, and risks. However, once you choose one, the terms of that bond can’t be modified. As a bond investor, you loan money to the issuer on the issuer’s terms. In return, you receive a fixed rate of interest for the life of the bond as stated in the contract.
For example, if you invest $10,000 in a 20-year treasury bond with a 4% coupon (the stated rate of interest), you would earn $400 in annual income until the bond reaches maturity in 20 years. At maturity, you would get your $10,000 back.
Annuities Offer Tax Advantages
With an annuity, each payment includes a portion of your original premium and a return on that premium. Annuities also benefit from the fact that the insurance company can pool their risk. This distinguishes annuities from bonds in two ways:
- One major advantage of annuities is their capacity to experience tax-deferred growth. This encompasses dividends, interest and capital gains, all of which can be completely reinvested as long as they are held within the annuity.
- Annuities can be categorized as either Qualified or Non-Qualified, with income from Qualified Annuities, including those within IRAs, subject to regular income tax, while Non-Qualified Annuities are taxed solely on the investment returns, and the premium payments are returned to the holder untaxed.
However, the income from most bonds is completely taxable and doesn’t benefit from insurance pooling.
Bonds Are More Liquid
Annuities are less liquid than bonds. Canceling your policy or taking withdrawals earlier than the contract allows can lead to penalties.
Bonds, on the other hand, can be bought and sold in a single day.
Annuities Offer More Protection Against Rising Interest Rates
While annuities are less liquid, they provide more protection from interest rate risk. As interest rates fluctuate, the market value of bonds moves in the opposite direction.
When interest rates rise, the value of bonds declines. Since annuities aren’t priced daily in an open market like bonds are, they are better at holding their value compared to bonds.
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You Get Your Principal Back When Bonds Mature
Perhaps the biggest hurdle for investors when it comes to purchasing an income annuity is that it often means giving up your premium permanently, although you can include a return of premium rider or death benefit.
However, the same isn’t true for bonds because the principal is returned at maturity.
Annuities Offer Lifetime Income Protection
Bonds have fixed maturity dates. When the maturity date arrives, the interest payments stop and you receive the original principal back.
Annuity payments can be structured to continue for the rest of your life. This makes them an effective tool for providing protection from the risk of outliving your money.
Annuities Produce More Predictable Income than Bonds
As bonds in a portfolio mature, their proceeds need to be reinvested. In a rising interest rate environment, this would generate more income over time. But if interest rates fall, your income will be lower. One risk you take as a bond investor is that interest rates might not remain at a level necessary to generate your desired income.
However, an annuity owner doesn’t have that risk because payments are guaranteed for life. For this reason, they tend to produce more predictable income than bonds.
According to 2023 data from Charles Schwab, 10-year certain annuity payouts for both men and women yielded higher results compared to those of corporate bonds.
Researchers David Blanchett and Michael S. Finke determined that bond investors had to invest more money than annuity owners to generate a given amount of income. Their study found that bond investors had to invest approximately $25 for every dollar of income earned. Annuity owners paid less than $19 for each dollar earned.
According to the study’s findings, it would take more than $2.5 million in bonds to generate $100,000 in retirement income. To earn that same amount from an annuity would require a premium of only $1.88 million. Importantly, the annuity guarantees that income for life. That’s not the case with bonds.
Which Is Right for You?
While annuities and bonds have many similar features, they also have key differences. Both financial vehicles come in various types, each with its own unique risks. Carefully consider those risks in light of your personal financial objectives.
Whether you decide to buy annuities or bonds, it is important to consider how they fit into your overall financial plan by taking important factors, like Social Security, into consideration.
Running different models can help you determine whether bonds or annuities will create the optimal mix of retirement income, capital appreciation and wealth preservation for future generations. When in doubt, seek the advice of a qualified professional.
Editor Malori Malone contributed to this article.
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