Annuities and bonds are popular options for investors who want to be assured of a steady income in retirement. But before you make any investment decisions, it's important to know how they differ

Key Takeaways

  • An annuity provides an income stream for a certain period or for life.
  • With a bond, an investor lends money and gets regular interest payments for a fixed period; then, the principal investment is returned.
  • In general, bonds pay a higher yield than annuities—but that's not always true.

Annuities vs. Bonds

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 last for life.

  • Financial products that provide monthly payments over a certain period, often as a guaranteed income for life
  • Primarily used as income for retirees
  • Created and sold by life insurance companies

Bonds, on the other hand, are:

  • Investments in debt that provide regular interest payments for a fixed period, and then the principal investment is returned
  • Used by all types of investors, including retirees
  • Issued by corporations, municipalities, and governments

What Is an Annuity?

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, and they can be broken down based on when the payments start:

  • Immediate annuity. You make a lump-sum, one-time payment to the insurance company, and it promises to pay you for the rest of your life, or for some other period. As the name implies, an immediate annuity starts to pay as soon as you fund it. Generally, you buy this type of annuity if you're at or near retirement and you want a consistent income.
  • Deferred annuity. These are similar to immediate annuities, except the income stream doesn't start until some later date chosen by the "annuitant" (that's the investor). In general, investors buy this type of annuity if they want to save money on a tax-deferred basis.

Annuities are also broken down depending on how your payments are calculated:

  • Fixed Annuity. These provide regular periodic payments.
  • Variable Annuity. These provide different payments depending on how well the investments in the fund are doing.
  • Fixed Index. The payments are based on the changes of a certain 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

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

Annuities: Pros and Cons

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

Pros

  • Income for life, no matter how long you live.

  • Tax-deferred. You don't pay taxes until you withdraw the funds.

  • Guaranteed rates with fixed annuities. The payout from variable annuities depends on how the investments perform.

Cons

  • High fees. Upfront sales charges and annual expenses can add up.

  • Lack of liquidity. If you take an early withdrawal, you may owe a steep surrender fee.

  • Withdrawals are taxed as ordinary income.

Advantages of Annuities

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

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.

Disadvantages 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.

Annuity taxes may also 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%.

What Is a Bond?

Think of as 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 then bond matures, you get your initial investment back, too.

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.

That's the biggest 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. Annuities often pay for the rest of your life, no matter how many years that is.

Bonds: Pros and Cons

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

Pros

  • Predictable income for a certain amount of time.

  • Generally earn higher yields than annuities.

  • Easy to buy. You can buy bonds through your broker or on the TreasuryDirect website.

Cons

  • Unlike annuities, the income is for a finite amount of time.

  • Default risk. The company or municipality could stop making payments.

  • Fewer options than annuities for how and when to receive interest earnings.

Advantages of Bonds

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 30 years (and sometimes even longer). 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 also cost less in fees and commissions than annuities.

Disadvantages 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.

The interest rate in effect when you buy an annuity has a big effect on your future payments. In a low interest rate environment, some investors may wonder if it's better to wait for higher interest rates before they buy an annuity. Maybe, maybe not.

Before deciding, consider how long you plan to delay the income from the annuity. If it's far out, the insurance company would have time to grow your premium at a higher interest rate—and would likely pay more. If it's close, there's no real advantage to waiting.

There are many different types of bonds and annuities. Finding the right one(s) for your retirement portfolio can be a challenge. When in doubt, consult with a qualified financial advisor who can make recommendations based on current interest rates, your age, your risk tolerance, and your time horizon.