Retirement income can come from numerous sources, including your employer’s 401(k) plan, an individual retirement account and taxable brokerage accounts. Bonds and annuities can also help create regular income, but they work in different ways. That’s because one is a debt instrument and the other is an insurance policy. Understanding the differences between the two will highlight the strengths of each one.
Bonds vs. Annuities: The Basics
The first step in evaluating bonds and annuities as an investment tool is understanding what they are and how they work.
A bond is an IOU, a debt. When you buy bonds, you’re essentially loaning your investment dollars to another entity for a set period. For example, cities and towns can issue municipal bonds to fund public works projects. Investors buy the bonds and the city or town uses that money to pay for things like road construction or improvements to public water systems. Bonds can also be issued by other entities, such as the federal government or some of its agencies to raise funds. Corporations also issue bonds.
Each bond specifies how long the investor will hold the bond, what interest rate will be paid on specified “coupon dates” to investors while they hold the bond and when the bond matures. If the investor holds the bond until its maturity date, they’re repaid the face value of the bond.
Bonds, which can be held directly or in a fund, are considered a type of fixed-income investment since the interest income is usually a fixed amount and the payments occur on a predictable schedule.
An annuity, on the other hand, is an insurance contract. Annuities can be purchased from insurance companies, financial advisors and other individuals. There are many different ways an annuity can be structured, but, generally, they’re designed to provide an income stream.
For example, you may purchase a deferred annuity at age 50, with payouts from the annuity beginning at age 65. From age 50 to age 65, you make regular premium payments toward the annuity. This is called the accumulation phase. Then at age 65, you begin receiving monthly payments from the annuity. This is called the distribution phase.
Depending on how the annuity is set up, you may receive these income payments for a set period or for the rest of your natural life. You may also have the option to pass on your annuity payments to a spouse or another beneficiary when you die. An annuity can also be immediate, rather than deferred, meaning that the payments begin within one year of purchasing it.
Like bonds, annuities can earn interest. Specifically, you can choose between:
- Fixed annuities, which earn a fixed interest rate
- Variable annuities, which earn a variable rate based on their underlying investments
- Indexed annuities, which seek to match the performance of a stock market index or benchmark
Fixed annuities tend to be the least risky option, while variable annuities are typically at the higher end of the risk scale.
Pros and Cons of Bonds for Retirement Income
- Returns are predictable, potentially making it easier to plan your retirement budget.
- Bonds could offer better rates of return compared to the rate of return for an annuity.
- It’s possible to diversify across different types of bonds, i.e. corporate bonds, municipal bonds, government bonds and agency bonds.
- Bonds are relatively easy to purchase.
- Municipal bonds are tax-exempt.
- Income payments only last for a set schedule, until the bond reaches maturity.
- Bonds are not risk-free; if the entity issuing the bond defaults, you could lose interest payments and your initial investment.
- Bond prices and yields fluctuate as interest rates change.
Bond prices and interest rates move in opposite directions. So if interest rates rise, bond prices fall and vice versa. Those movements, along with rising or falling inflation, can directly affect the performance of bonds you own.
Pros and Cons of Annuities for Retirement Income
Like bonds, annuities have advantages and disadvantages. Here’s what you need to know about their strengths and weaknesses.
- Annuities can provide guaranteed lifetime income for yourself and your spouse.
- Fixed annuities can offer a predictable rate of return, while indexed or variable annuities can pay higher returns to investors who are willing to accept more risk.
- Annuity are tax-deferred, meaning you won’t pay taxes until you begin taking distributions.
- Annuities can come with high fees that bonds typically lack.
- You may have to pay a surrender charge or an early withdrawal tax penalty if you take money from the annuity before the distribution phase begins.
- Because there are so many types of annuities, they can be difficult to understand.
Annuities can generate income for life, which can be reassuring if you’re concerned that you haven’t saved enough in your employer’s plan or IRA, or you’re worried about Social Security benefits being less than what you expected.
The Bottom Line
Bonds and annuities provide income, but they do so in different ways. Whether to include one or the other in your retirement portfolio depends largely on your income goals, risk tolerance and what other sources of income you’ll be able to rely on. You might lean toward one over the other, but keep in mind that it could also make sense to incorporate both into your investing and retirement planning.
- Consider talking to a financial advisor about the merits of bonds vs. annuities for retirement income. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Get to know the different types of bonds and their comparative performance profiles. With annuities, be aware that there are many different types so it’s imperative to understand how they differ. Check the full range of fees you might pay for annuity so you can weigh the cost against potential returns.
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