Annuities vs. Bonds: Key Retirement Investment Differences

Annuities and bonds are two financial products often used by investors who are seeking a steady stream of income in retirement. However, tax regulations, interest rates, lending systems, and maturity lengths for these products vary widely. Before you make any investment decisions, it’s important to know how they differ.

Annuities and bonds are popular ways for investors to generate an income stream. Both are considered members of the fixed income asset class. Bonds are more commonly used since they trade like stocks on the markets. Still, many financial experts argue that annuities are a better way to generate income in retirement because the payments typically last for life.

Understanding Annuities

Annuities are financial products that provide monthly, quarterly, or annual payments over a certain period, often as a guaranteed income for life. They are also:

• Primarily used as income for retirees
• Created and sold by life insurance companies

Annuities are long-term contracts with an insurance company. You invest money, either as a lump sum or over time. In exchange, you get income in the form of regular payments.

There are several types of annuities:

• Immediate Annuity: Payments begin as soon as you fund the annuity.
• Deferred Annuity: Payments begin at a later date.
• Fixed Annuity: Payments are predictable amounts that do not vary.
• Variable Annuity: Payments vary depending on how well the fund’s investments are doing.
• Fixed Indexed Annuity: Payments vary based on a specific index, such as the S&P 500.

With any type of annuity, you decide when to withdraw the income. Typically, that’s during retirement. The monthly annuity payment is based on several factors, including:

• Interest rates when you buy the annuity
• The amount of money you deposit
• Your age
• Your gender
• The length of time the payments are guaranteed

A retiree with an annuity can also elect a joint-life option that continues payments to a surviving spouse. The retiree’s monthly benefit amount will be lower to compensate.

While traditional life insurance provides protection if you die sooner than expected, an annuity protects you if you live longer than expected.

Pros and Cons of Annuities

As with any investment, annuities have pros and cons that should be considered before making any decisions.

Pros of Annuities

Annuities offer several distinct advantages. Chief among them is guaranteed income for life, even if you live past 100.

The period of time between when you buy the annuity and when you receive payments is called the accumulation phase. You can add to an annuity before taking distributions. Any growth in the annuity during this phase is tax-deferred. Even better, that growth is not taxed until you withdraw the money as income.

Cons of Annuities

Annuities often come with high sales charges and high annual expenses. Fees can be even higher if you have an actively managed fund or if you take out any special riders to increase your coverage. Adding to the high costs is the surrender fee if you withdraw funds from your annuity during the first few years after buying it.

Taxes on annuities may also be considered a downside. Rather than being taxed as long-term capital gains, as is most investment income earned over a long period, annuity payments are taxed as ordinary income.

For investors in lower tax brackets, the difference might not be very significant. For wealthy investors, it is a big consideration. The top tax bracket for ordinary income is 37%; long-term capital gains are taxed at 20%.

Understanding Bonds

Bonds are investments in debt that provide regular interest payments for a fixed period, and then the principal investment is returned. They are also:

• Used by all types of investors, including retirees
• Issued by corporations, municipalities, and governments

Think of a bond as an I.O.U. between you and a company, municipality, or government. You act as the lender, and the borrower (e.g., the company) pays you interest for the life of the bond. When the bond matures, you get your initial investment back.

High-quality bonds have long been a mainstay for conservative investors. They offer a steady, if relatively low, return along with a very low risk to the principal investment. In retirement, those payments of interest are often used as a supplement to income.

Pros and Cons of Bonds

Like annuities and other investments, bonds have perks and drawbacks.

Pros of Bonds

For the investor, buying a bond may not be a permanent decision, or even necessarily a long-term one. An investor who thinks bond rates may go up soon can buy a short-term bond and then reinvest the principal later, when rates may be better.

Bonds generally earn higher yields than annuities. The exception is that lucky person who lives to 100 or more. The lifetime guarantee of an annuity means an outstanding return on investment for the long lived.

Bonds are easy to buy and cost less in fees and commissions than annuities.

Cons of Bonds

Bonds provide income for a finite amount of time—not for life, like an annuity. You have to reinvest your money if you want to continue generating interest.

And while there is little risk of loss of principal in bonds, that risk exists. If a company goes bankrupt or a government defaults, the investor’s principal can be lost.

The Bottom Line

Annuities and bonds both offer a steady source of income. With annuities, that income can last for the rest of your life. Bonds, however, provide income for a specific amount of time—anywhere from three months to 30 years, or more. Of course, once one bond matures, it’s possible to reinvest your money in another bond so you can keep that income coming in.

There are many different types of bonds and annuities. Finding the right one for your retirement portfolio can be a challenge. When in doubt, consult with a qualified financial advisor who can make recommendations based on your personal situation.