Today we’re going to look at a comparison of annuities vs bonds. As always, when the subject of securities products are discussed here, this content is for informational purposes only and is in no way a recommendation to buy or sell any type of security product.
What is a Bond? An Overview
Simply put, a bond is a contractual debt obligation that makes a series of payments on a series of predetermined dates. There are all types of bonds. There are muni bonds, corporate bonds, treasury bonds, green bonds, international bonds, bond ETFs, convertible bonds, and bond funds.
Corporations and government entities issue bonds to raise capital, and then they pay interest on that money to the bondholders for a specific amount of time. At the end of that term, you get the principal back.
So in a lot of ways, investment grade bonds act just like a bank CD or even a Multi-Year Guaranteed Annuity because they protect your principal based on the creditworthiness of the issuer to pay the interest back, and then return your principal.
But that’s really where the similarities end.
Risks Associated with Bonds
Most people think bonds are a risk-free way to earn interest, but they would be mistaken that bonds do not come with risk. You can absolutely lose money with bonds. Even in high-grade bonds, and most people don’t know that. Here are some of the most common risks that you may come across with bonds that you may not be aware of:
Risk #1: Call Risk
Call risk is basically where the bond issuer has determined that they can get a better deal somewhere else. When your bond is called, the issuer will give you your money back, and the interest payments will stop. That could cause you to have to go back into the bond market and look for another bond to purchase.
Risk #2: Reinvestment Risk
The second risk is the reinvestment risk, which is just a continuation of the call risk.
For example, let’s say that you have a bond that’s paying you 6%. But because interest rates have dropped, what the bond issuers will do is call the bond and then you will be forced to go back into the bond market to purchase something new at a lower rate.
Let’s say the new rate on bonds has dropped to 3%. Now that interest rates have changed, and the going rate on a new bond is only 3% versus the original 6% you were getting, your interest has been cut in half.
So either your growth rate was cut in half, or the income you were depending on has been cut in half.
I think we’re going to see a lot of this in the near future. When bond rates start to drop here pretty quickly you’re going to see a lot of people scrambling and trying to figure out how to replace or match the interest they were getting from the original bond.
Risk #3: Credit Risk
Credit Risk refers to the creditworthiness of the bond issuer to repay the money.
The bonds that will pay the highest interest rate are known as high-yield bonds, (aka junk bonds). And you’ll see some junk bonds mixed in with some of these larger bond funds.
Risk #4: Marketability Risk
Technically, you can sell your bond if you want your money back.
This is an interesting comparison to annuities because everybody always freaks out that the annuity has surrender charges, but what do you think bonds and stocks have?
You might say, “Bonds don’t have surrender charges. Stocks don’t have surrender charges.”, but here’s what I mean by that.
If you have a 10-year bond and you need the money back, how much can you sell that bond for? You have no idea. Because it all depends on what the market is doing at that point.
For instance, if you currently hold a bond that is paying 3%, and interest rates have gone up to 5%, how many people do you think will pay full value for your bond that’s only paying 3% when they can get a new bond that’s paying 5%?
There probably are not going to be a whole lot of people interested in purchasing that. And if they do, they’re going to buy it at a loss to you. And if you have to sell it at a loss, couldn’t that be considered a surrender charge?
At the end of the day, the only thing that matters is what will be the value of the asset when you need your money back.
With stocks and bonds, nobody knows what their value will be for sure in the future. Annuity companies are some of the only, if not the only institutions that will show you your worst-case scenario at any point in the future during your term. That worst-case scenario is provided to you in the illustration listed under, “Minimum Guaranteed Surrender Value”.
Risk #5: Bond Fees
Someone is getting a fee on that bond that you purchase. The advertised rate that you may be seeing probably will not be the actual interest rate that you will receive.
I believe the only exception to that rule is if you purchase a treasury bond directly from the government’s website.
Scenario-Based Comparison: Annuities vs Bonds
Bonds are a very broad subject because of the variation of bond types available. The point for me here is not to do a microscopic evaluation, but to give you a 30,000-foot view of how bonds compare to annuities.
I’ve said this before, but the only way to do a fair comparison is to ask yourself the question, “What is the purpose of my money?”
Using Annuities vs Bonds for Growth
Most of the time with bonds, you have to take that interest rate every six months. There are exceptions known as Z bonds, or zero coupon bonds, that do allow you to defer the interest throughout the term of the bond.
And just to keep things simple, we’ll do comparisons with treasury bonds right now because that’s going to be the safest category out there.
At the time of this writing, a 10-year treasury is paying about 4. 5%. Compare that with a 10-year Multi-Year Guaranteed Annuity that’s paying 6%.
At the end of that 10 years, a $100,000 Treasury bond at 4. 5% would be worth just over $155,000.
That’s not bad for a risk-free investment!
However, the annuity would be worth just over $179,000.
That’s 15% more growth by just using the annuity. You can have an agent set this up for you with nothing out of your pocket because we get paid directly by the annuity company.
Using Annuities vs Bonds For Interest Payments & Income
The second reason someone may want a bond is to have interest payments to supplement their income while preserving the principal.
With bonds, you’re going to be paid semi-annually based on the interest rate that you’re earning.
For example, if you have a $100,000 bond paying a 5% interest rate twice a year, you will get a check for $2,500 twice a year.
That’s not a bad thing at all. However, most people do not live their lives on a semi-annual basis.
They’re not used to getting just chunks of money like that.
They were used to budgeting on a monthly basis because that’s how they got paid when they were working, and that’s how they are getting their social security and/or pension income.
With the annuity, there are companies out there that will start paying you the interest in the first month. And we can set that up to automatically be put into your checking account every 30 days.
Your principal is preserved throughout the length of the term, then you receive all the money back, this is all done with no fees or expenses out of your pocket.
But you may ask, “Marty, won’t the principal be eaten up if I use the income annuity?”.
The answer is, yes. So that could make you think that using the bond is a better alternative because the principal will be preserved.
That’s true, but now you’re putting yourself at that reinvestment risk mentioned above because nobody knows what the rates will be in the future.
And even with the way interest rates are right now, it will still take a lot more money to create the same amount of income from a bond than it would with an income annuity.
For example, you could get a 10-year treasury at 4.5% that would pay you $4, 500 for every $100,000 that you allocate to the bond portfolio.
However, right now, a 65-year-old couple can get a guaranteed 7% payout rate on an income annuity…forever.
Here’s an example:
Let’s say we have a 65-year-old couple who has $500,000 saved for retirement and they want to play it super safe. Their advisor recommends a bond portfolio.
They need $20,000 per year in addition to their social security to cover living expenses.
If they were to use the bonds, it would take $444,000 to create $20,000 per year. This only leaves them $56,000 liquid to use for other investments.
But if they use the income annuity, it would only take $286,000 to create $20,000 in income, leaving them $214,000 liquid for other investments.
They could put that extra money into the market to help offset inflation for the rest of their lives and/or have a really nice emergency fund.
I keep hammering on the same point, but I always come back with this question: “What is the purpose of your money?” That’s the key.
In this podcast episode of “Annuities vs Bonds – Which is Better”, I go deep into the numbers and case studies for each of the things you just read about on this page. I highly recommend giving it a watch or a listen if you’re currently comparing annuities to bonds.
If you’d like to get a direct and personalized ‘annuities vs bonds comparison’, just click the schedule button at the top of this page, and we can look at your situation together to come up with the solution that best suits your situation.