Key Takeaways
- Bonds and fixed annuities can offer retirees a stable income but differ in their payment mechanisms: bonds are debt instruments, while annuities are based on contractual agreements with insurance companies.
- Fixed 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 fixed annuities offer better protection against rising interest rates and have the advantage of providing lifetime income.
How Fixed Annuities and Bonds Work
Both fixed annuities and bonds are known for their ability to provide stable returns with very low risk. These products can also generate an income stream, although they do so in different ways and are designed 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, on the other hand, are insurance products that send you payments based on contractual guarantees made by the issuing company. Fixed annuities are a type of annuity that earns a guaranteed interest rate for a specified period of time before maturing, at which point, can be converted into income payments.
Understanding the similarities and differences between bonds and fixed annuities can help retirees decide whether one — or a combination of the two — makes the most sense for them.
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®Principal Financial Analyst for Annuity.orgStephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.
How Fixed Annuities and Bonds Are Alike
Fixed annuities are the type of annuity that’s most similar to a typical corporate, municipal or government bond.
Both products are popular among conservative retirement investors for their principal protection and guaranteed growth. For fixed annuities and bonds, the security of the guarantee depends on the creditworthiness of the issuer. In every case, you need to decide how comfortable you are with the credit risk before you purchase.
Other similarities between fixed annuities and bonds include:
- Both are purchased with a lump-sum payment
- Both offer guaranteed payments for a specified period
- Both include a stated payment rate
- Both are considered safe investments with guaranteed returns of premium
- The main risk associated with both products is the risk of the issuer not being able to fulfill its obligations
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Fixed Annuities and Zero Coupon Bonds
You might compare fixed annuities to zero-coupon bonds, also called zeros. 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.
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Key Differences Between Fixed Annuities and Bonds
The main difference between fixed annuities and bonds is the nature of the relationship between you and the issuer. With a fixed 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.
Fixed 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 include an option 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.
Fixed Annuities Offer Tax Advantages
Fixed annuities grow tax-deferred, meaning you won’t owe taxes on the income the annuity generates until you start receiving payments. This can be advantageous as it leaves more money in the annuity’s account to compound interest over time, leading to better returns.
When you receive payments from a nonqualified fixed annuity, you’ll only pay taxes on a portion of each payment. This is because each payment from a fixed annuity is made up of both the interest earned and a return of your original premium. You only owe taxes on the interest earned.
Unlike fixed annuities, the income from most bonds is completely taxable. You’ll owe taxes on the entire amount of each payment you receive from the bond.
Bonds Are More Liquid
Fixed annuities are less liquid than bonds. Cancelling your policy or withdrawing earlier than the contract allows can result in penalties.
Bonds, on the other hand, can be bought and sold in a single day.
Fixed Annuities Offer More Protection Against Rising Interest Rates
While fixed annuities are less liquid, they provide more protection from interest rate risk. When you purchase a fixed annuity, you lock in a guaranteed rate for a certain period of time.
As interest rates fluctuate, the market value of bonds moves in the opposite direction. When interest rates rise, the value of bonds declines. Since fixed 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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Fixed Annuities Offer Lifetime Income
Bonds have fixed maturity dates. When the maturity date arrives, the interest payments stop and you receive the original principal back.
Fixed annuities, on the other hand, can be structured to provide guaranteed income for life. This makes them an effective tool for protecting against the risk of outliving one’s money.
A recent Annuity.org study found that nearly 30% of Americans aged 45 and up are concerned about outliving their savings in retirement. The guaranteed lifetime income that fixed annuities provide could be a significant benefit for retirement investors who share this concern.
Fixed Annuities Produce More Predictable Income Than Bonds
As bonds in a portfolio mature, their proceeds need to be reinvested. This would generate more income over time in a rising interest rate environment. 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, a fixed 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 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, while 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.
Which Is Right for You?
While fixed annuities and bonds have many similar features, they also have key differences. Both financial vehicles come with their own benefits and drawbacks. Carefully consider the pros and cons in light of your personal financial objectives.
Whether you decide to buy fixed annuities, bonds, or both, it is important to consider how they fit into your overall financial plan, taking important factors like Social Security into account.
Running different models can help you determine whether bonds or fixed 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.
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