Classic Question: Annuities or Bonds?

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By Don Taylor, Ph.D., CFA February 3, 2009

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Q: Dear Dr. Don,

I have been considering an immediate annuity, but was wondering what the benefit is over buying a long-term corporate bond or bonds with a similar yield.

Assuming I seek 30 years of income, it seems the annuity is implying something like a 4.5 percent to 5 percent yield. Wouldn't I be better off buying a corporate bond that yields a similar amount? That way, I'd still have the principal to spend at maturity in case I lived longer than planned.

Am I not taking the same default risk with either investment since the insurance company could go out of business just like any other company? And finally, are there tax reasons that would make an immediate annuity better?

— Laurence Longevity

A. Dear Laurence,

Yours is a classic question in retirement planning. To restate: "If you can invest at the same yield and the same risk as the immediate annuity, aren't you better off investing in the bonds versus buying the immediate annuity?"

For many the answer will be "no," but making it an apples-to-apples comparison is more difficult than just comparing the interest income from the bonds with the income from the annuity.

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In addition, getting the risk levels equal is nigh on impossible. State insurance commissions have reserve and other requirements that make an investment in an annuity from a highly rated insurance company safer than an investment in a highly rated corporate bond.

You purchase an immediate annuity with a lump sum and buy an income stream that lasts for your lifetime. The immediate annuity allows you to achieve a higher income stream than you could earn from living off the interest income paid by the bonds. That's because a straight life immediate annuity doesn't return principal when you die, and the annuity only lasts for your lifetime.

There are a multitude of options in how you structure the annuity. You can have it pay over your lifetime, over a joint lifetime or over a set time horizon. The payment can be indexed to inflation. There may or may not be a death benefit to a beneficiary. There may be a guarantee that you or your beneficiaries will at least receive in distributions the amount of money you have invested.

As soon as you start adding options, however, the value of the annuity payment declines because you have spent part of the purchase price to buy that option.

I used the annuity quote function on and assumed a $1 million investment for a 66-year old male. (The annuity calculator on is also recommended.) You can do your own calculation based on your age and the money you have available to purchase the annuity. The site will return almost two dozen different monthly payments based on typical annuity options.

I'm going to focus on the straight life annuity, which is the type of annuity that ensures a fixed income for the rest of the purchaser's life. The $1 million purchase secures a monthly income stream of $7,397. If you assume a 30-year life, it equates to a yield of roughly 8.4 percent (assuming the 66-year-old lives to 96). The longer you live, the higher the implied yield on the annuity.

A portfolio of 30-year, single-A rated corporate bonds isn't currently yielding in that ballpark. However, even if the two products were yielding a similar rate, the bonds are riskier than the annuities (for the reasons stated earlier).

I'm going to beg off on the tax discussion between the two investments and leave that to you and a tax professional. However, there's more to consider here than just taxes. Two other considerations are how the choice of an annuity versus the bond portfolio could impact your eligibility for Medicaid and potential estate-planning issues.

The bottom line is that the law of large numbers should allow an insurance company to pay a higher income stream on a single life annuity than you can earn off a similar amount invested in a high-quality bond portfolio.

This is true because the insurance company doesn't have to return your principal if you die sooner than expected, and dealing with a large pool of annuity owners means it can use mortality figures to estimate the average life of that pool to price the annuity.

Annuities are going to make the most sense for people who are worried about outliving their income and don't have a large retirement nest egg as a backstop.

Before signing an annuity contract, get a second opinion on the decision from fee-only financial adviser. The National Association of Personal Financial Advisors maintains a listing of fee-only advisers.

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