Comparing Bonds and Income Annuities for Retirement

• Bonds and income annuities are important financial assets for retirement, both typically used for those looking for low-risk investments
• An income annuity offers a guaranteed lifetime retirement income floor that reduces market exposure and insures against the possibility that you will outlive your money
• Bonds may be a good investment option for people interested in safer and predictable investment returns who also want to maintain liquidity

There is a well-known axiom for investing that people should hold stocks for riskier, but potentially higher, returns on investments and bonds to achieve safer, more conservative returns. As you age, you should increase the amount of bonds and decrease the amount of stocks in your portfolio. One commonly used formula for this is to invest (120-age) percent of the portfolio in stocks. This model of preparing for retirement is sufficient in providing a framework for investing, but it falls short when it comes to preparing for retirement. That’s because retirement doesn’t just require saving and investing, but also forces you to have a plan for how you’ll spend that money. The portfolio allocation framework that’s limited to stocks and bonds doesn’t help you figure out how to spend your money and neglects the risk that you may outlive your money, and thus the value that many people place on having a stable retirement income.

In the 21st century, your retirement savings should include a mix of stocks to grow your portfolio, bonds to balance out the stocks and provide liquidity, and income annuities to provide guaranteed lifetime income you can’t outlive. Bonds and income annuities can both fulfill the conservative or safer part of your retirement portfolio, but they serve different purposes. Let’s take a closer look at both bonds and income annuities to understand the role each should play in your retirement planning.

How Does a Bond Work?

At its core, a bond is a loan taken out by an institution with you, and other investors, as its creditor. In exchange for the upfront money investors provide, the bond issuer (institution) promises to payback the investor(s) at a later date with a fixed payment structure. To make it worthwhile for the investor giving up his/her money, the bond issuer will do more than just pay the investor back — they’ll return the money, plus interest.

A typical payment structure includes a predetermined semi-annual interest payment, called a coupon, followed by the principal (investment) repaid at the end (maturity) of the bond. Bonds are normally issued for as little as a few months and up to 30 years (in some rare cases, bonds can be issued for up to 100 years). Bonds are often standardized in units of $100 or $1,000, where for $X upfront the issuer promises to pay $100 or $1,000 in Y years, as well pay the investor $Z every six months until that time. The variables of X, Y and Z influence what is called the bond’s yield-to-maturity, or yield, which is the percentage return that the investor receives if they were to hold onto the bond for its entire duration. It’s this structure, where the investor receives regular coupon payments, that makes bonds attractive for retirement. Those payments act as a source of income for the retiree.

In addition to managing the risk that the bond issuer may default, investors have to manage the risk that the bond may lose its value. Because the bond’s payment terms and structure are fixed at inception, the bond is sensitive to changes in market conditions, such as interest rates. The “time value of money” says that a dollar today is worth more than a dollar tomorrow, with interest rates indicating the rate at which a dollar loses its value. Rising interest rates exacerbates this relationship between a dollar today and a dollar in the future, such that the bond's future payoffs are worth less money in today’s dollars. Since higher interest rates mean that the bonds payoffs of are worth less money in today’s dollars, the “value” or price someone would be willing to pay you for your bond is lower. How much the price of the bond decreases depends on the duration of the bond, or how much the bond has until maturity.

In addition, you are likely to face a scenario where a bond’s duration isn’t long enough to cover your whole retirement horizon. That means you’ll likely have to purchase new bonds during retirement to replace some of the expiring bonds in your portfolio. This creates reinvestment risk, as market conditions when you must reinvest part of your bond portfolio could be worse than they are now. While some level of reinvestment risk is unavoidable in your portfolio, income annuities can play a role in minimizing that risk.

How Does an Income Annuity Work?

An income annuity is a lifetime income guarantee that you purchase from an insurance company as a way to reduce the risk that you run out of money in retirement. An individual purchases an income annuity from an insurance company by providing upfront payment(s) in return for guaranteed, lifetime income starting at retirement, which could be now or sometime in the future. Many value the safety and stability of a guaranteed income stream, since they don't have to worry about the stock market, bond rates, or how long they will live, making it easier to manage their retirements. For more information on the types of annuities, please follow this link.

Income annuities are able to provide a guaranteed, stable lifetime income stream by pooling longevity risk. While no one knows how long they’ll live, data can tell us how long people on average will live. With this information, an insurance company can offer a guarantee by pooling risk across an entire population in a way that an individual cannot do for themselves. When you purchase an income annuity, you are not buying a regular investment that will generate interest for a set amount of time. Instead, you’re buying an insurance contract that provides you with income forever, no matter how long you live.

The insurance company provides a quote for how much income they can give you based on how much you put in, how old you are, your gender, and when you want income to start. Since you don’t know how long you’ll receive income for ahead of time (since it’s based on how long you live), it can be hard to come up with a “return” or “yield” like you’re used to seeing with bonds. You can only do this for specific life expectancies, such as “if I live to X, I’ll make Y%.” Typically, the return assuming you live to life expectancy is similar to that of a highly-rated bond.

But, the real value in the income annuity is what happens after life expectancy, when you keep receiving money that, if you had just had a bond, wouldn’t be there. This is the effect of pooling risk, and is known in the industry as “mortality credits.”

Your income payment from the income annuity can be broken down into three pieces: (1) returning the principal you put in, (2) interest earned from the investment, and (3) mortality credits. This third piece is made possible for those that outlive their life expectancy by using the money not needed by those who didn’t.

Like with bonds, insurance companies have ratings. The promise they’re giving you is only as good as their ability to back it. The creditworthiness of income annuity providers is rated on a spectrum with the safest being rated A++ and the riskiest rated as D (read more about rating methodologies of one agency, A.M. Best here). At Blueprint Income, we strongly believe that people should only purchase income annuities from reputable, well-rated insurers. To make sure the lifetime guarantee is valuable, we only offer income annuities from insurers rated A or better from A.M. Best. Most are A+ or A++. Learn more about purchasing an income annuity by consulting our quote tool:

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Comparing Bonds and Income Annuities

Income annuities provide a retirement income floor and serve as insurance against the possibility that you will outlive your money in retirement. In addition, because payments in income annuities are predetermined, annuitants are immune from stock and bond market fluctuations, providing a useful hedge against future volatility.

Bonds provide investors with a stable and predictable return on an investment, making them a core conservative part of a retirement portfolio. While they do have the benefit over income annuities of providing liquidity, or access to one's funds, they fall short when it comes to longevity risk and reinvestment risk.

Using a traditional “return-on-investment” framework to compare income annuities and bonds is impossible to do ex-ante because we don’t know how long the annuitant will live for. Instead, it may be more productive to think of bonds as a way to conservatively earn market gains in your portfolio and use income annuities to hedge or de-risk your portfolio.

Bond and Income Annuity Features and Risks

 

Considering the different features and risks of bonds and income annuities outlined in the table above, there’s a place for both of them in your retirement portfolio.

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