Introduction
An annuity is an investment with an insurance company that promises to pay you a regular income later on, often when you retire. This is often compared to (sometimes confused with) bonds.
The question most articles try to answer when it comes to annuities vs. bonds is which is better? The problem with trying to answer that question is that the answer really depends! It depends on the current age of the buyer. It depends on their current net worth. It depends if they’re married, divorced, re-married, it depends….you get the point.
What this article aims to do is merely give you the facts. For many people a both/and rather than an either/or type of solution may actually be best.
Below is a table of characteristics for both bonds and annuities with some concluding thoughts.
Annuity vs. Bond Characteristics
| Characteristic | Bond | Annuity | Discussion |
|---|---|---|---|
Definition | Debt securities issued by governments or corporations to raise capital, paying periodic interest and returning principal at maturity. | Insurance products designed to provide a stream of income, often used for retirement, with options for immediate or deferred payouts. | The biggest difference here is that an annuity is an insurance product, and a bond is debt issued to raise capital. |
Purpose | Investment for generating periodic interest income and potential capital preservation. | Primarily for generating regular income, typically used for retirement. | There’s some overlap here both are commonly used as periodic income and de-risking portfolios. |
Income | Fixed (for fixed-rate bonds) or variable (for variable-rate bonds), based on interest rate. | Fixed or variable income based on the type of annuity and payout options selected. | Very similar, something to consider here is that annuities will come with rate caps and more fees for the variable and index type. |
Risk | Varies by bond issuer; government bonds are lower risk, while corporate bonds can be higher risk. Interest rate risk, default risk, and inflation risk apply. | Low to moderate risk, depending on the type (fixed, variable, indexed). The insurance company’s financial health is a factor. | If risk is your primary motivating factor, government bonds (e.g., T-Bonds) may be your best bet. However, there are many well established insurance companies selling annuities today. |
Liquidity | Generally more liquid, can be sold before maturity, though market conditions may affect price. | Generally illiquid; early withdrawal can lead to significant penalties and surrender charges. | Here bonds may be much more attractive to the average retiree. |
Principal | Typically returned at maturity unless the issuer defaults. | Principal may be preserved in fixed annuities, but not in variable annuities. Surrendering early may result in penalties. | Again if you’re more risk averse, bonds may be the better choice, but again with risk comes more upside. |
Maturity | Fixed term, usually 1 to 30 years. | No fixed maturity; can be structured for lifetime or a set period of payments. | You have plenty of flexibility with bonds, however, they still no not match the flexibility and options available to you with annuities. |
Tax Treatment | Interest income is usually taxed as ordinary income unless held in tax-advantaged accounts. | Gains grow tax-deferred, and withdrawals are taxed as ordinary income (often taxed later in life when retired). | If you are trying to minimize your retirement income tax events, annuities may be the better option. Consult with a tax professional to determine how to maximize your individual retirement income plan. |
Growth Potential | Limited to interest payments (unless trading in bonds where market value can rise). | Potential for growth in variable and indexed annuities, tied to market performance, with some risk to principal. | Upside can be realized more so with annuities, but again higher risk and fees need to be considered. |
Payout Structure | Interest paid regularly (e.g., annually, semi-annually). Principal returned at maturity. | Payouts can be structured as a lump sum or as periodic payments (monthly, quarterly, annually). | Here again, we have the flexibility of annuities providing potentially more benefit to the retiree. |
Fees and Expenses | Low fees, often just transaction costs and management fees (for bond funds). | Can have high fees, administrative, and investment management fees (especially for variable annuities). | Care must be taken when shopping for annuities. Talking with a financial advisor will help you “do the math” to ensure you’re maximizing your retirement income. |
Death Benefit | None, unless a bondholder passes before maturity and it’s part of their estate. | Many annuities offer death benefits, allowing beneficiaries to receive payments or the remaining account balance. | Estate planning is essential for either bonds or annuities. With annuities, the death benefit riders may come with higher fees/costs. |
Inflation Protection | Limited inflation protection, unless inflation-adjusted bonds are purchased (e.g., TIPS). | Indexed annuities may offer some inflation protection, but fixed annuities do not. | For both of these options, the inflation protection is relatively limited. These are typically purchased to provide a stable/steady source of income. If retirement income is planned well, inflation can be mitigated. |
Customization | Limited customization, primarily focused on maturity and interest rate. | Highly customizable, with options for guaranteed lifetime income, death benefits, and inflation adjustments. | As previously seen, customization is seen more on the annuity side of the ledger. But with this flexibility come fees and costs. Always ensure you know exactly what the fees and costs will be. |
Suitability | Suitable for those seeking fixed income and capital preservation with moderate to low risk. | Suitable for retirees or those looking for guaranteed income over a long period, often with less focus on capital preservation. | Both/and thinking here can be useful. If you have the resources there is no reason capital preservation and the security of guaranteed income cannot both be planned for. |
Guarantees | No guarantees beyond issuer’s ability to repay. Bonds carry credit risk. | Backed by the insurance company’s guarantees, including potential lifetime income, though not insured by the FDIC. | With any investment comes risk. Government bonds are probably the least risky option between these two. And all though annuities are not FDIC insured they are oftentimes covered by state insurance commissions or other state regulatory bodies. |
Conclusion
Are annuities better than bonds? It depends. But a retirement income strategy utilizing a both/and approach should be able to get the best of both worlds. Retirement income planning can be daunting. But with the right investment product and good financial advice, ensuring a comfortable retirement and leaving a legacy should be well within reach many retirees.