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Comparing Annuities to Bonds

By Bob Carlson on January 24, 2013

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Can you build a bond portfolio that does a better job providing secure retirement income than an immediate annuity?

Economists and many financial advisors believe some portion of a retiree’s portfolio should be placed in immediate annuities. These are the annuities that pay a regular income for life or the joint life of the owner and a spouse. Immediate annuity payments can be either fixed or inflation-adjusted.

Only a small portion of retirees follows this advice. Four reasons generally are given for the reluctance to buy annuities. The most frequent reason is that people don’t want to relinquish control of part of their nest eggs. Related to that is that the annuity is inflexible; the owner often can’t withdraw additional income in a year when it’s needed. Another reason: Many people don’t want to forego the potential to earn higher returns should a new bull market emerge. Finally, with an immediate annuity there’s nothing left for your heirs.

These are reasons not to put your entire nest egg into an immediate annuity. But they shouldn’t override the reasons to include an immediate annuity as some portion of your retirement assets. Most of us need to have a secure floor on your income for life and to transfer the risks of a long life and poor returns to the insurer.

Can you avoid these risks by purchasing long-term bonds instead of an annuity? The question is addressed in a study by Michael Edesess that was published recently on Advisor Perspectives.com.

Bonds initially appear to have the upper hand, because you won’t be paying the costs embedded in an annuity. Edesess estimates that at recent prices, a fixed annuity has an expected return of 1.5% while an inflation-adjusted annuity’s expected return is -1.9%. Though bonds have extremely low yields now, the yields on long-term bonds are higher than expected returns on annuities. But only the long-term bonds yields are competitive with annuities. The traditional strategy of laddering bonds of different maturities offers expected returns well below those on annuities right now, says Edesess.

To compare owning bonds to immediate annuities, Edesess sought to answer the question: What would happen if a person were to buy a 30-year treasury bond and spend the interest plus sell the bond piecemeal to generate annual income equal to the annuity payouts? How does that compare with using the same amount of money to purchase an annuity?

The results would be comparable over 30 years if interest rates were stable. Comparing a fixed annuity to a nominal treasury bond, after 30 years there would be less than a year’s income left in the treasury bond. Comparing a 30-year Treasury Inflation-Protected Security (TIPS) to an inflation-indexed annuity, the TIPS lasts only 27 years. So, for a 65-year-old the nominal treasury would last to age 95 and the TIPS would last to age 92. If you don’t think there’s much of a risk of living past 95, the treasury bond alternative looks feasible.

The picture changes, however, when interest rates rise over the years. That’s because the value of the bond will fall when rates rise, so more of the bond will have to be sold each year to generate the same income. When yields rise from a recent 0.4% to 0.9% on the TIPS over the next 10 years, the TIPS bond lasts only 25 years. If the yields rise only one percentage point, the bond lasts only 23 years. If the rate on the nominal bond rises one percentage point, the bond lasts only 25 years. If the nominal bond yield rises two percentage points (which still would leave the yield below the 40-year average), the bond lasts only 21 years.

Another factor to consider is income taxes. When the assets that would purchase either the annuity or bond are held in an IRA, there aren’t tax differences. The distributions from the IRA will be taxed as ordinary income unless they represent after-tax contributions.

But there are differences outside the IRA. In a taxable account, part of each annuity payment will be tax-free until you’ve recovered the initial investment in the annuity, which will occur when you reach life expectancy. One estimate is that about 75% of the annuity distributions will be non-taxable until life expectancy is reached. After that, all the distributions are fully taxable. For bonds, the interest will be taxed as ordinary income, and sales of the bond are tax-free unless interest rates fall and the bond is sold for more than its cost. But in the early years, more of the payout will be interest, so Edesess believes there will be less tax deferral with the bond. But the tax-free portion of those payouts will grow over time.

The bottom line is you aren’t likely to be able to duplicate the safety and certainty of an immediate annuity’s guaranteed income. If market yields increase, you might be able over time to increase the return from bonds above what you’d receive from an annuity. But to do that you have to take the risk that things don’t turn out well and you lose money. To earn secure, guaranteed lifetime income, it’s tough to beat an immediate annuity. For that security you give up some flexibility and control of your assets plus the potential of leaving a legacy to the next generation.

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  1. avatar
    Hong Chen Reply May 5, 2013 at 6:12 PM EST

    there are two ways to address the inflation concerns with Treasuries-based annuity: (1) construct annuity out of TIPS, or (2) construct annuity with Treasuries with a “built-in” inflation assumption. For example, if you expect inflation for next 10-years to be 2%/year, you can build a Treasuries portfolio with annuity-like cash flows that increase 2%/year.

    Treasury-based annuity has two benefits over carrier based annuity: (1) government credit quality – at current Berkshire annuity rate, one pays about 0.15%-0.30% a year more than a treasury-based annuity for a lesser credit; (2) liquidity – the invested treasury portfolio sits in one’s IRA account and they can be sold at market price any time.

    • avatar
      Hong Chen Reply May 7, 2013 at 1:18 PM EST

      Here are 5/6/2013 yields for Berkshire’s SPIA and the comparable DIY Treasury-based annuities at various number of annual payments:

      payments BK / DIY
      7 0.35% / 0.74%
      10 0.66% / 1.15%
      15 1.05% / 1.69%
      20 1.66% / 2.07%

  2. avatar
    Hong Chen Reply May 5, 2013 at 5:05 PM EST

    If you are interested in comparing term certain, immediate fixed rate annuity against treasuries, I can construct a treasuries portfolio that matches exactly the desired annual cash flows and the portfolio will be sitting in your broker account and you do not need to part your money to a insurance carrier. I use this method to fair value Berkshires EZQUOTE for these types of annuities and find one can save up to 0.3% for a 10-15 year trade, using the DIY version.

  3. avatar
    Rachel Summit Reply January 31, 2013 at 3:07 PM EST

    This is a great comparison! I’m always trying to promote using a portion of one’s savings for an annuity at Annuity FYI, rather than your entire retirement savings. Thanks for sharing the results of Mr. Edesess’ study.

  4. avatar
    J Lockwood Reply January 24, 2013 at 10:09 PM EST

    Who would want to buy bonds at all-time low interest rates? And I fully realize that you could say the same thing about buying annuities in an all-time low interest rate environment, but at least they can provide a contractual lifetime income. I am certain that the next 10 years annuities will see the largest influx into annuities than at any other point in history. Whereas bonds will hit all time highs in being unpopular. Check out this blog about the GAO recommending annuities for boomers – http://blog.annuitythinktank.com/gao-recommends-annuities/ But I guess only time will tell…