Annuities Vs. Bonds: An Overview

Annuities and bonds are both popular options for investors who want to be assured of a steady income in retirement, but it's important to know how they differ.

  • An annuity is purchased by the investor in return for a regular payment that is guaranteed for life. Annuities are sold by life insurance companies.
  • A bond is an investment in debt that provides regular interest payments for a fixed period of time, at the end of which the principal investment is returned. Bonds are issued by corporations and governments.

Both investment products have their advocates and their detractors.

Annuities

An annuity provides a fixed income that the investor can never outlive.

The investor may purchase the annuity years before retirement. It will earn interest during the intervening years, and the investor has the option of contributing additional principal at any time in order to obtain a larger payment down the road.

The investor decides when to begin withdrawing the income, presumably at retirement. The amount paid monthly is based on the person's remaining life expectancy.

Key Takeaways

  • An annuity is purchased in return for a regular payment that is guaranteed for life.
  • A bond is a loan that provides regular interest payments for a fixed period of time, at the end of which the principal investment is returned.
  • Bonds generally pay a higher yield than annuities.
  • The exceptions are for annuity investors who live an extremely long life!

In other words, if the retiree begins receiving payments at age 60, and the insurance company calculates that person's life expectancy to be 80 years, the annuity might pay out 5% per year. The balance will be completely paid in 20 years. But the checks will keep coming even if the recipient blithely sails past 100.

While traditional life insurance provides protection from dying sooner than expected, an annuity protects a person who lives much longer than expected.

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

Advantages of Annuities

Annuities offer several distinct advantages. Chief among them are a guaranteed income for life and tax-deferred growth before retirement.

An investor can add to an annuity over time before taking distributions. Even better, that growth is not taxed until the money is withdrawn as income.

Annuities can come with high commission charges that are paid to the insurance agent and the company and eat into an investor's gains.

The period of time between when the annuity is purchased and when distributions are taken is called the accumulation phase. Any growth in the annuity during this phase is tax-deferred.

When the investor begins taking distributions, only the portion of the annuity balance that represents interest income is taxed, not the capital contributions by the investor.

Disadvantages of Annuities

Annuities can come with high commission charges that are paid to the insurance agent and the company and eat into an investor's gains.

Worse, most annuities contain "surrender charges" that penalize investors for withdrawing from an annuity during the first few years after buying it.

An annuity is not a good choice if estate planning is a priority. The investor is paying out a good portion of accumulated wealth in return for a steady income that dies with the investor or the spouse.

Finally, a fixed payment is not adjusted for inflation. We all hope to live a long life, but years of inflation can eat away at the buying power of an annuity.

Tax Considerations of Annuities

The tax treatment of annuities might be considered a downside. Rather than being taxed as long-term capital gains like 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% as of 2019; Long-term capital gains are taxed at 20%.

In addition, while the IRS taxes only the interest portion of an annuity distribution, it considers the first money withdrawn as interest. For example, a retiree whose annuity earned $10,000 in interest during the accumulation phase is taxed on the first $10,000 in distributions.

Bonds

High-quality bonds have long been a mainstay for conservative investors, offering 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.

As noted, that's the big difference between annuities and bonds: When you buy a bond, you get interest payments for a set period of time, and then you get your money back. It is, after all, a loan that the investor is extending to the corporation or government that issues the bond.

Advantages of Bonds

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 also cost less in fees and commissions than annuities.

For the investor, buying a bond is not a permanent decision, or even necessarily a long-term one. Bonds are issued for terms as short as three months or as long as 10 years. An investor who thinks bond rates may go up soon can buy a short-term bond and then re-invest the principal later, when rates may indeed be better.

There is little risk of loss of principal in bonds, but little risk is not the same as none. If a company goes bankrupt or a government defaults, the investor's principal can be lost.