Replace Bonds With an Income Annuity?

by | Feb 12, 2021 | Financial Planning

Should you consider replacing your bonds with an income annuity? A recent article in the WSJ discussed this very topic. The author’s point was that unless you die relatively young, an income annuity will give you more retirement spending power than bonds.

But is it accurate to say an income annuity will give you more than owning bonds?

It won’t surprise me if some folks are handed a copy of this Wall Street Journal article in the future, as a marketing piece. Most likely sent to them by someone selling annuities.

The case for choosing whether an income annuity is right in your situation won’t ever be answered by a newspaper article. You need to speak with your advisor to determine whether this insurance product is right for your situation.

To be clear – there are different types of annuities. This post will not cover deferred annuities. A deferred annuity is where you invest a lump sum upfront (or through a series of installments) and let the money compound over time. For all their bells and whistles, these insurance products are often the most expensive ways to invest.

Costs for all types of annuities can vary, so it makes sense to shop around and compare.

What is an income annuity?

An income annuity is designed to provide an income stream to the owner sooner, not later. But like most investments, you need to know what you own.

An income annuity is a promise from the insurance company you will receive a check, an income stream, each month for the rest of your life, and possibly till the end of a second life (a spouse).

We often describe an income annuity as a “trade.” The owner of an income annuity has essentially given up their asset for an income stream to cover the rest of their life.

For example, if you cash in a $500,000 portfolio of bonds in order to set up monthly income through an income annuity, know that your “asset” is now the promise, the guarantee from the insurance company the check will arrive each month.

You cannot “cancel the income stream” at some point down the road, and receive your principal back.

While insurance companies have a large capital base and a long track records, you still have to trust that the insurance company standing behind your annuity will come through each month. This arrangement has worked well for many. But, periodically, there may be stories of troubled insurance companies in the future.

It is possible the “income stream” received from an income annuity could offer a higher yield than what’s currently offered in the bond market. One reason for this may be because the insurance company will invest the money as they see fit, and may generate higher returns than individuals.

But it is also important to remember a portion of each monthly check contains your own capital being returned to you. Part of your distribution will not be taxed, since it is your own money coming back to you. This is how illustrations can show “higher returns” to owners of income annuities.

Another way to view an income annuity is to compare it to “purchasing a pension.” Essentially you would be trading assets for an income stream for the rest of your life. Moving forward, income annuities will become more available in retirement plans like 401k accounts. This is one more option to choose from as you consider your retiremet options with your advisor.

The Wall Street Journal article (link) displayed a comparison between a person taking a monthly income annuity versus building a “bond ladder.”

What is a bond ladder?

A bond ladder is constructed by investing so a portion of your bond portfolio comes due every year (or every two years, or five years, etc.). The bonds mature at regular intervals. This can provide a good alternative to purchasing an income annuity. Instead of investing “all the money” into “one bond” the investments are spread equally into the future, with different maturities.

The are several benefits to constructing a bond ladder.

  1. A portion of the money invested consistently comes due.
  2. As “steps” of the ladder mature, this money can be reinvested and capture current rates.
  3. You retain ownership of the asset. You have not “traded” your protfolio for a monthly check.

A bond ladder provides liquidity, in the event a need should arise. To be fair, as “steps” on the ladder come due each year, the rates that money will be reinvested could be higher or lower. But retaining ownership is a difference-maker. By keeping control of the asset, you have the ability to collapse the ladder in the event of a dire emergency, you can change strategies, you can change how the money gets invested (taxable vs. tax-free, securely or in high-yield bonds, etc.).

And in many cases, the cost of investing directly into bonds will be far cheaper than purchasing an income annuity.

The biggest problem in 2021 (as it has been for years) is the current low-rate environment. Unless you are wading into the “junk-bond” end of the bond pool, it’s been very difficult to generate any sustainable yields from bonds.

The options and flexibility with bond ladders, or any fixed-income approach, are not available if you give up control and trade the assets for a monthly check with an income annuity.

Nor will you find an income annuity is indexed for inflation. As the cost of living increases in most years, nearly all income annuities will not change their monthly payout.

One of the best examples around for an income annuity which IS indexed for inflation is social security. Your monthly social security check will get readjusted year by year, depending on any increase in the consumer price index (CPI), which is a gauge used to measure inflation.

Like an income annuity, deciding when to begin taking social security is also a personal decision. There is no “rule” which is the “optimal strategy” for decisions regarding when to take social security. There are several strategies. This is why we suggest speaking with your financial planner before making decisions.

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