Comparing Annuities to Bonds
Because different types of bonds and annuities exist, it’s hard to make a broad comparison between the two financial strategies. Although annuities and bonds share some common elements, they are structured to achieve different outcomes.
One way to determine which option is better for providing reliable income throughout your retirement is to compare the types of annuities and bonds that are the most alike. Single premium immediate annuities and coupon bonds meet this description, so these are the types of annuities and bonds we’ll discuss.
How Annuities and Bonds Are Alike
To acquire an annuity or bond, you make a one-time, lump-sum payment to an issuer. In return, the issuer promises to pay you income for a set period of time. For annuities, the issuer is an insurance company. For bonds, it’s either the federal government or a big corporation.
Both annuities and bonds establish specific payment dates from the start. As soon as you acquire a bond or annuity, you know exactly when your payments will begin. You and the issuer agree on stated payment dates and the rate for payments upfront.
Another similarity between annuities and bonds is that the issuer guarantees payments. The riskiness of the guarantee is based on the credit worthiness of the issuer. In every case, you need to decide how comfortable you are with the credit risk of your initial purchase price.
Similarities between annuities and bonds include:
- Purchased with a lump-sum payment
- Issuer guarantees payments for a set period
- Specific payment dates
- Stated payment rate
- Credit risk
While annuities and bonds share these common factors, there are many ways in which they are different.
Read More: How to Diversify Your Portfolio
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What’s the Difference 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 to a contract. With a bond, you are a lender.
Annuity contracts are somewhat negotiable. Before you finalize an agreement, you can add benefits 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 indentures are not negotiable. The terms of a 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.
For example, if you invest $10,000 in a 20-year treasury bond with a 4 percent coupon (the stated rate of interest), you would earn $400 in annual income until the bond reaches maturity in 20 years. At maturity, you get your $10,000 back.
With an annuity, each payment includes a portion of your original premium as well as a return on that premium. This distinguishes annuities from bonds in two ways:
- Annuities typically generate more income than bonds of similar maturity purchased at the same time.
- Only the annuity’s return on investment is taxable; the premium portion of each payment is returned tax-free.
Bond income is completely taxable, so annuities typically generate higher after-tax cash flows. But there are tradeoffs.
Those higher payments come at the expense of liquidity. Annuities can be difficult to sell, and the secondary market for them is not as liquid as the market for bonds. Bonds can be bought and sold in a single day.
While annuities are less liquid, they provide a level of premium protection not found in bonds. As interest rates fluctuate, the market value of bonds moves in the opposite direction.
When interest rates rise, the value of bonds declines. Because annuities aren’t priced daily in an open market (as are bonds), they are much better than bonds at holding their carrying value. They also generate a more predictable cash flow.
Annuities Produce More Predictable Income than 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.
As bonds in a portfolio mature, their proceeds need to be reinvested. In a rising interest rate environment, you would generate more income over time. But if interest rates fall, your income would 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. The annuity owner doesn’t have that risk because payments are guaranteed for life.
Read More: Passive Income Streams
Which Is Right for You?
While annuities and bonds have many features that produce similar outcomes, they have key differences. In fact, both financial vehicles come in different types with unique risks. You must carefully consider those risks in light of your personal financial objectives. When in doubt, seek the advice of a qualified professional.
Whether you decide to buy annuities or bonds, it is important to model various what-if scenarios to help plan for contingencies. You should also take Social Security into consideration. Waiting to apply for Social Security benefits may help you maximize your retirement income.
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.
