Annuities vs. Bond Ladders

Which is better for generating reliable income: an immediate annuity or a bond ladder? I’m asked that frequently these days, and the frequency increases as more Baby Boomers inch closer to their post-career years.

First, let’s define terms. A bond ladder is constructed by purchasing a portfolio of bonds that mature in different years. The simplest ladder is invested equally in treasury bonds that mature over each of the next 10 years. Each year, one tenth of the original portfolio matures.

You earn interest on the bonds each year, which is used to pay your expenses. When the interest isn’t enough income, you take some principal from the bond that matures during the year. Then you reinvest the rest of the principal in a treasury bond that matures in 10 years.

The bond ladder reduces interest rate risk. You won’t permanently lock in today’s low interest rates. If rates rise, the principal of maturing bonds is reinvested at the new, higher rate. Also, since you hold the bonds to maturity, you don’t worry about having to sell a bond below your purchase price after interest rates rise. With a bond maturing each year, you always have a source of extra cash from the maturing bond.

Bond ladders can be more sophisticated than this. Money managers who specialize in building them will use more than treasury bonds. They’ll match bonds with your income needs and risk tolerance. They’ll also look for what’s selling at relative discounts when it’s time to reinvest principal from maturing bonds. Some money managers use complicated computer algorithms to build a bond ladder portfolio.

Don’t use bond mutual funds to implement a bond ladder. Bond funds don’t mature and don’t hold bonds until maturity. When interest rates rise, a bond fund loses value. When you need to tap principal to pay expenses, the bond fund might be worth less than you paid for it. If interest rates rise steadily, you’ll have what professional investors call a permanent impairment of capital. You’ll lose principal that you can’t get back. To implement a bond ladder, you buy individual bonds and hold to maturity.

Immediate annuities are simpler. You pay a lump sum to an insurer, and it promises to send you scheduled payments for life. You can buy an inflation-indexed annuity or fixed annuity. You also can cover the joint life of you and your spouse or other beneficiary. I’ve discussed immediate annuities in detail in past issues of Retirement Watch, and the discussions are available in the Annuity Watch section of the Archive on the members’ web site.

So, which is better for you, the annuity or the bond ladder? You should know that bond ladders and immediate annuities aren’t true alternatives to each other. They don’t have the same goals and aren’t interchangeable. In a sense, comparing them is more like comparing apples and oranges than comparing different apples.

An annuity provides a guaranteed lifetime income stream. You give up other benefits (liquidity, potentially higher returns, leaving a legacy) in exchange for the secure lifetime income.

A bond ladder isn’t a lifetime income product. It’s a bond investment strategy. There’s no guarantee you won’t outlive the money or that it will provide adequate, secure income. In fact, you know that income from the bonds will change over time as interest rates change and bonds mature. You can’t outlive an annuity, but you can outlive a bond ladder.

You shouldn’t view immediate annuities and bond ladders as an either/or choice. Instead, you need to evaluate your goals and net worth and determine how best to use the two tools.

Most people should seek an immediate annuity first. The annuity provides a safe, guaranteed floor of lifetime income. After Social Security, any pension, and an immediate annuity establish your guaranteed retirement income, consider alternatives for your other funds.

Some people shouldn’t consider alternatives beyond the immediate annuity. They have enough money to buy annuities that will meet their lifetime spending needs and little or nothing beyond that.

When you’ve achieved adequate income security, consider a bond ladder for part of a diversified investment strategy that allows you to achieve other goals, such as leaving a legacy for loved ones, charity, or both. You have flexibility with a bond ladder that you don’t have with an annuity or many other income investments. A bond ladder comes close to guaranteeing no permanent loss of value from rising rates, and over time it lets you take advantage of rising rates and inflation. 

Analysts disagree whether a bond ladder is cheaper than an annuity or other forms of income investing. It’s hard to tell, because many costs are built into an annuity rather than separately stated. Also, there are many ways to implement a bond ladder. You can do it almost cost-free by purchasing treasury bonds direct from the treasury. Or you could use an advisor to build a custom ladder using different types of bonds. The cost would depend on the advisor’s fee and the efficiency of the bond purchases.

The choice between an annuity and a bond ladder really is a false choice. They’re not true alternatives. When you have enough assets relative to your needs that you feel financially secure, you might not want any amount in immediate annuities. When your priority is having a lifetime of secure income, you might put all or most of your portfolio in annuities. Many people fall between these two situations. They’ll put a portion of their portfolios into immediate annuities and invest the rest. They should consider whether a bond ladder should be used for a portion of that portfolio to supplement the annuity and diversify the portfolio.