Bonds vs. Immediate Annuities

[smiller]

 

Judging from other threads there seem to be a lot of new retirees (or almost-retirees) here so interested in how you've worked this one out...

 

Assuming that you have a portion of your portfolio dedicated to generating low-risk income, have you compared an immediate fixed annuity vs. low risk (government, high-grade corporate, etc.) bonds/bond funds? Bonds seem to be able to provide an income stream very close to an annuity while retaining personal control of the money. Annuities (again, just considering a garden-variety fixed immediate annuity here) OTOH provide virtually no risk and a slightly better return, and no onging management issues. The case for bonds seems to come down to how much you want to retain control of the funds and how much of a hit in return (vs. an annuity) you are willing to trade for it, but are there any other fundamental differences in the case where one is primarily interested in an income stream? Tax-wise they both seem to have their own advantages and disadvantages so I don't know if there is a clear winner there.

 

Thoughts?

[John Ranalletta]

Certainly don't have an answer, but will monitor this as well.

 

Questions: In the case of bonds,

• Are you considering building a ladder of maturities and buying upon expiration of each?
• What time frame would your ladder cover?
• Since you're comparing bonds to an annuity, are you planning to hold to maturity, thus disregarding any capital loss/gain due to interest rate vagaries?

[smiller]

Yes, a typical ladder strategy, intended to provide income throughout retirement (meaning over several decades, assuming fate plans on my being around that long.) These would be held to maturity and be high grade and government issues so I would expect low market/credit/default risks. Some inflation risk will always be there (except for TIPS, etc.) but that is ever-present.

[Deadboy]

Two issues come to mind

 

#1. Additional fees associated with annuities (because is it an insurance contract) tend to be much higher than those in mutual funds (that hold bonds).

 

#2. Loss of control is a big issue with an annuity once you begin the annuitization process (taking distributions from the annuity) as you are basically locked in to taking distributions in accordance with your contract and cannot take an emergency lump sum distribution for a sudden event unless you are willing to take a big penalty for doing this. Less than 5% of annuity holders ever bother to annuitize and instead use it as a vehicle to pass funds to their heirs (as it is really just an insurance policy).

[smiller]

Good points, but not all that applicable in my case. Variable annuities carry all sorts of ongoing fees but simple fixed immediate annuities normally don't (unless you incur a surrender fee or such), making them much easier to compare to each other and other kinds of investments. Loss of control is an issue, but normally one should use an annuity as only part of their portfolio, leaving other funds for emergency use if necessary. And passing unused funds to heirs isn't a particular concern in my case either.

 

But still, loss of control seems to be the crux of the decision. If I truly didn't care about that then an annuity would provide a higher return than bonds (when you include risk) and be a lot simpler to manage, as in no management at all. But I'm still hesitant about giving up control and am just trying to figure out whether that concern is really rational in my case, or if there are any other factors I'm missing.

[Patallaire]

If you are dealing in High Yield bonds vs an annuity there would be tax considerations on the growth and distribution of the bonds as well as more risk, that would not be handled the same on a fixed annuity. Also if you are buying a bond fund you really don't know what the risk will be going forward. The control issue can be mitigated by using short term period certain distributions {5Yr}. Interest rates are low on everything so you may not want to go real long on either investment.

 

Don't discount using a Variable Annuity as part of your solution, the product design, even with teh fees has some great features to it that take the downside risk out of the equation and allow you control. Talk to a specialist in retirement planning, it is a different approach than the accumulation planning you might be used to employing.

[eddd]

...But still, loss of control seems to be the crux of the decision. If I truly didn't care about that then an annuity would provide a higher return than bonds (when you include risk) and be a lot simpler to manage, as in no management at all. But I'm still hesitant about giving up control and am just trying to figure out whether that concern is really rational in my case, or if there are any other factors I'm missing.

 

I agree that that loss of control is critical to your decision.

 

I have one annuity, and for years I wished I hadn't purchased it, due largely to the inability to get my funds out and put them where they would have done much better. As it turns out now, the minimum rate they pay is WAY beyond anything I could make in any CD, money market, or bond fund. Of course when the insurance company offer that rate as the minimum, I'm sure they never thought things would get to where they are now. Since I've reach the maturity date, they've tried to get me to start taking out my money. Sorry, I'm riding this horse until something better comes along.

 

 

[BFish]

Two issues come to mind

 

#1. Additional fees associated with annuities (because is it an insurance contract) tend to be much higher than those in mutual funds (that hold bonds).

 

#2. Loss of control is a big issue with an annuity once you begin the annuitization process (taking distributions from the annuity) as you are basically locked in to taking distributions in accordance with your contract and cannot take an emergency lump sum distribution for a sudden event unless you are willing to take a big penalty for doing this. Less than 5% of annuity holders ever bother to annuitize and instead use it as a vehicle to pass funds to their heirs (as it is really just an insurance policy).

 

In addition, income taken (generally in excess of your investment) from an annuity will be taxed at ordinary rates. As mentioned above, penalites, both inside the annuity and tax wise may occur at early withdrawal, depending on the circumstances. annuities passed on at death are also subject to potential rapid withdrawal and will be taxed at ordinary rates to the beneficiaries. I'm not dissing annuities, but merely pointing out the tax issues involved. i tend to agree with many of the other comments.

 

 

[smiller]

In addition, income taken (generally in excess of your investment) from an annuity will be taxed at ordinary rates.

But so will interest income from bonds so I don't see much difference there..?

[smiller]

If you are dealing in High Yield bonds vs an annuity there would be tax considerations on the growth and distribution of the bonds as well as more risk, that would not be handled the same on a fixed annuity. Also if you are buying a bond fund you really don't know what the risk will be going forward. The control issue can be mitigated by using short term period certain distributions {5Yr}. Interest rates are low on everything so you may not want to go real long on either investment.

For the purpose of my analysis I am only considering government or very high grade bonds and everything would be held to maturity so I believe risk would be fairly low (except for inflation but again that factor affects most any investment.) Using period-certain annuities is an interesting idea but I think the overall return would be considerably less that way, will have to run that and see...

[Lawman]

Yes, a typical ladder strategy, intended to provide income throughout retirement (meaning over several decades,

 

Seth,

In this environment, why would you consider locking in a very low interest rate for a very long time simply for a slightly better return for the very short term? If you think the risk/return makes sense here I think you should seriously reconsider..

 

[smiller]

In this environment, why would you consider locking in a very low interest rate for a very long time simply for a slightly better return for the very short term? If you think the risk/return makes sense here I think you should seriously reconsider..

Hi Billy. I'm not sure which investment you're referring to here, I assume the annuity since the purpose of a laddered bond fund is to not lock anything in for too long. Annuity rates are at an all-time low right now but they still compete favorably with ultra-safe bonds. Plus this investment is still a couple years out and interest rates (and thus annuity yields) will likely be higher by then.

 

Or maybe I'm missing your point... what is your specific concern? That bonds would provide a better return than a long-term annuity, or..?

[David]

Seth, you lost me on the comparable risk comment. The risk is unacceptable to me if the underlying guarantor is an insurance company, in spite of the "re" market out there. I believe the chance of one of the large dozen companies failing is real. We witnessed something very close to it six months ago.

 

Bond issuers are, too, but:

 

1) There are many more of those bodies, and the cascading effect isn't there to the same extent.

 

2) I think you're more likely to be made whole in a bond gone bad than an annuity gone bad.

 

An annuity (to me) is a house of cards and just another way to sell an insurance product. If you've maximized all your qualified options, I see a place for them. But otherwise, I wouldn't buy an annuity for any reason.

 

Of course the people who sell them on commission always disagree with me.

[T.M. Roe]

Oh David, you know how talk of impending business collapse makes me feel, well, a bit randy.

[David]

This is no time to change your name from Tom to Randy.

[T.M. Roe]

Tommy Downer is probably more apropo.

[smiller]

I think you're more likely to be made whole in a bond gone bad than an annuity gone bad.

Most states' guarantee associations provide protection against default up to $100,000 (varies by state but usually in that range) per contract. If you keep any individual annuity amount below this (i.e. buying multiple policies from different providers if you are annutizing more than $100k) then as far as I can tell annuities bought with such a strategy are virtually risk-free.

[David]

I thought you were talking about bigger ones. Nevertheless:

 

difference between guaranty association protection and the protection e.g. of bank accounts by FDIC, credit union accounts by NCUA, and brokerage accounts by SIPC, is that it is difficult for consumers to learn about this protection. Usually, state law prohibits insurance agents and companies from using the guaranty association in any advertising and agents are prohibited by statute from using this Web site or the existence of the guaranty association as an inducement to purchase insurance(e.g. [5]). Presumably this is a response to concerns by stronger insurance companies about moral hazard.

--Wikipedia entry

 

Also, with an average commission of 6% (and as high as 12%), something's wrong with a product that pays it, in my opinion. It IS coming from the returns.

 

Plus, at one or both deaths the income stream disappears, which ain't that cool if you want to build it into your estate planning (i.e., heirs, as in me).

[smiller]

Well, size doesn't matter all that much because a $500,000 annuity can (and probably should) be purchased as five $100,000 contracts, etc. Guarantee association reserves may not equal the FDIC but it seems that it would take a fairly apocalyptic economic scenario for this to be a concern, i.e. even during last year's debacle nothing even close to such defaults occurred. And no doubt commissions and expenses come out of the returns, but on a comparative basis (all that really matters in the end) the returns between an annuity and high grade bond ladder per dollar invested are similar, and beyond that there's no control I have (other than avoiding either investment entirely, and I'm not sure what other vehicle(s) would be a suitable choice as an ultra-safe income source.)

 

But yes, when my wife and I are gone then the income stream ends and I am betting that won't happen before the principal is used up (and the insurance company is betting it will, which is why the return is higher than a straight investment.) But we have no children, plus upon our deaths there are other funds that will help salve my relatives' grief. You will have to fight along with them for it though.

 

But I'm not trying to argue with you or anyone, just saying that while annuities are the investment everybody loves to hate it seems that a preference between these two investment types has more to do with personal feelings than any negatives regarding a dollar-for-dollar returns or risk. An annuity's (again, referring to simple fixed products) advantages seem to have more to with less tangible qualities such as low risk and simplicity which have different values to different people, hence the differences in perceived value. But try as I might I can't come up with any purely objective reason why an annuity is a bad investment vs. other vehicles with the same goals, at least in my specific situation.

 

Crap, sometimes choice is a bad thing...

[Patallaire]

Wow! You have a real feel for annuities David! I would like to be able to get between a 6 and 12% payout for these fixed products, however, it is not even close. The guarantees for the products are State guarantees, not Association guarantees, the reserves are mandated to prevent the risk you feel you understand. In NY State there has never been a client who lost money as a result of an insurance company going under. The income stream does not need to end on one death, or both deaths, it is all in the design. I think you should stick to what you know, and refrain from giving absolute advise on a subject that you may only read about on the internet.

[philbytx]

Hey Seth!

Don't forget about Tax Free Muni's mate, especially the fine Texan variety However, they are being snapped up fairly quickly these days though

 

[T.M. Roe]

Now now folks, just because the world is about to come crashing down on our heads cant we all just get along?

[David]

Wow! You have a real feel for annuities David! I would like to be able to get between a 6 and 12% payout for these fixed products, however, it is not even close. The guarantees for the products are State guarantees, not Association guarantees, the reserves are mandated to prevent the risk you feel you understand. In NY State there has never been a client who lost money as a result of an insurance company going under. The income stream does not need to end on one death, or both deaths, it is all in the design. I think you should stick to what you know, and refrain from giving absolute advise on a subject that you may only read about on the internet.

 

Wikipedia disagrees with you on both counts. So I may very well be wrong, but if so, they are too. It's always great to know more than publicly vetted websites.

[Patallaire]

Wikipedia disagrees with you on both counts.

That is a sight that is written by people, perhaps like yourself, who don't know what they don't know! The "vetting" process is suspect as in this case, a blanket statement is picked up as fact when in fact it can not be fact. It gives a forum to place information and unless challenged it sticks, whoever posts they do it without anyone knowing who they are, here we are different. We know who you are!

There is a lot of good information as well as mis-information and opinions on the web pertaining to annuities, they are neither right or wrong for everyone, it is through the planning process that we make that determination, is it good or not, does it create the desired outcome, what is the strength of the company, what might it be going forward, are the clients risk tolerences met, does the client understand the solution and is it right for them, that is how we determine its application, not through internet opinions.

You know better, David!

[David]

Pat, don't take all this so personally. Wikipedia is not out to get you and (usually, from what I can tell) has no agenda other than fact. If they've got the whole article wrong and you're smarter than the author and the editors, you should contact them and volunteer as an editor so that they can get their facts straight.

 

Meanwhile, it's probably the better sort of help to Seth if the personal slams stay out of the thread, by me or you. Happy New Year!

[Tom R.]

Ahh yes, the age old debate; whether to annuitize or not to annuitize.

 

I have been performing investment product due diligence, and advising financial advisors on the relative merits of various options, for close to twenty years. Fixed immediate annuities are under utilized in my opinion. That said, probably some of the best advice I have rendered in the past twenty years is to avoid all or nothing thinking. Frequently, the “best” investment for an individual or couple is a combination of investments. Immediate annuities can do things that a bond or bond portfolio will not, and vice versa.

 

Most prospective immediate annuity buyers fail to pull the trigger due to the loss of control of principal. However, if your goal is to maximize income, and you are not as concerned with leaving the asset to heirs, depending on the age of the proposed annuitant(s), it can be difficult to replicate the level of income from an annuity without taking significantly more risk.

 

Also, one significant yet little-known benefit of immediate annuities is their treatment for those in need of long term care (nursing care). In many states (and this is a state specific issue), the asset or money that is used to purchase the immediate annuity is then no longer treated as an asset for Medicaid qualification purposes. That can be a huge advantage for planning purposes.

 

If annuitized over two lives, the income stream from the annuity will be available for the surviving, non-institutionalized spouse. When held as a bond or bond portfolio, the Medicaid rules frequently require “spending down” or liquidating assets to pay for care, which means the income from the asset is gone and not available to the non-institutionalized spouse. This can have a dramatic, negative effect on cash flow for the survivor.

 

Feel free to pm me if you like.

 

[smiller]

Thanks for your comments Tom. As a matter of fact the Medicaid spend-down issues did occur to me and as far as I can tell most states would not require you to surrender an annuity. You would have to fork over the payout during the spend-down process but afterwards (a grim thought) the surviving spouse would continue to receive payouts instead of being left with nothing. Well, not nothing since it appears that many states do allow the survivor to keep something, perhaps $100k, but $100k and an annuity would be better in the unfortunate case of it coming to that.

[markgoodrich]

Interesting topic. I've never seriously considered annuities, due to two concerns: fear of inflation and fear of the underwriting company disappearing. How does one overcome these two issues when looking into the future several decades?

 

TIPS were going to be my bet against both, but I didn't heed my own advice, and rather than buy the bonds themselves I bought into a TIPS fund; rates now are hovering around zero. If TIPS rates begin to go back up, I'll likely get out of Treasury and Muni funds and buy the TIPS direct from the gov't.

 

Seth, in another thread in this forum I suggest purchasing ESPLanner Plus (no connection); it will allow you to see what all the various scenarios you're considering will do to your consumption over your lifetimes. You can fiddle variables until you go blind.

[smiller]

Interesting topic. I've never seriously considered annuities, due to two concerns: fear of inflation and fear of the underwriting company disappearing. How does one overcome these two issues when looking into the future several decades?

As was touched on earlier in the thread virtually every state oversees a guarantee association that will cover insolvency of an individual insurer, usually to a maximum of $100,000. So if you split annuities into this amount or smaller you are generally protected. But it's notable that such failures are exceedingly rare as required reserves are high, in fact as far as I'm aware an individual actually losing principal in states with a guaranty fund is virtually unheard of. Nothing is ever certain about the future but a financial catastrophe severe enough to cause massive failure would probably decimate any other investment you might have first. Bottom line, annuity contracts have their pros and cons (as we have been discussing) but as far as I can tell safety really isn't an issue in any practical sense.

 

Regarding inflation, that is a risk of a fixed annuity. One way to handle this is to maintain some money in a stock portfolio to augment fixed income investments (you should never put everything in one basket anyway), or another option is an inflation-adjusted fixed annuity. With the latter you get lower payments up front but they will increase over time.

 

Seth, in another thread in this forum I suggest purchasing ESPLanner Plus (no connection); it will allow you to see what all the various scenarios you're considering will do to your consumption over your lifetimes. You can fiddle variables until you go blind.

Hmmm... maybe just until I need glasses...

[FLrider]

Bond funds don't allow you to "control" maturity. If you can't control maturity, you can't control interest rate risk, or market price variations due to changing interest rates.

 

Bond funds charge operating expenses which can significantly reduce yield. So, unless you need expertise related to the sector bet (High Yield or International Bonds for example, you probably shouldn't use a bond fund. Just buy the individual bond.

 

Immediate annuities can be a great source of cash flow for the risk averse, just remember that part of your "return" is actually your own money coming back to you. The Internal Rate of Return (IRR) on immediate annuities is NOT as competitive with other fixed income investments of a similar duration, held to maturity.

 

Pat is correct. I've been in the business for over 30 years. I have never seen ANY immediate annuity product that pays the agent a 6 - 15%+ commission. That doesn't mean there aren't deferred annuities which can ultimately be "annuitized", thereby providing a lifetime income stream. I HAVE seen insurance companies offer commissions in EXCESS of 15% to the agent to sell these policies.

 

My advice is to find a professional advisor who doesn't have an axe to grind and have them help you. You are not talking about investing nickles here. This isn't the time to DIY.

[Tom R.]

Creating sustainable streams of income that are; "safe", hedged against inflation, treated kindly by the taxing authorities, and, cannot be outlived, will be the holy grail of the investment advice giving business in the decades to come. As I said earlier, a combination of investments is often best.

 

On the other hand, for a younger retiree, a systematic withdrawal plan from a globally diversified balanced mutual fund with a tilt towards income could serve as a core holding. Although the study is a little dated, for some interesting reading and a hint at a safe withdrawal rate, try a Google search for "Trinity Study".

[smiller]

Creating sustainable streams of income that are; "safe", hedged against inflation, treated kindly by the taxing authorities, and, cannot be outlived, will be the holy grail of the investment advice giving business in the decades to come.

Yeah, that's it! I want me one of those...

 

On the other hand, for a younger retiree, a systematic withdrawal plan from a globally diversified balanced mutual fund with a tilt towards income could serve as a core holding.

Yes, that strategy (systematic withdrawals from a diversified combination of mutual funds) is attractive in its simplicity and liquidity, not to mention the potential of much higher gains than super-safe alternatives. The downside of course is the potential of experiencing another year like the last sometime during retirement, and if that retirement period is several decades then the chance becomes substantial -- and certainly not something I would prefer to experience. OTOH, if one keeps several year's emergency living expenses in cash and can thus avoid having to liquidate investments while they are down then that would seem to mitigate a lot of that risk.

[Tom R.]

This morning's episode of Consuelo Mack's Wealthtrack on PBS featured a notable advisor and two journalists who endorse using immediate annuities. The episode should be available for viewing soon on www.wealthtrack.com.

 

The concept of using an immediate to fund the first five years of retirement was discussed. This would address one of the shortcomings of using a systematic withdrawal plan for retirement income.

[jaytee]

Of course the people who sell them on commission always disagree with me.

 

I sell them on commission and I disagree with you -- see? we agree!!!

 

While I do sell them and have for 15 years or so they are not my main source of income which is managing a thriving tax practice. I can say that I have had more clients bitten by bonds than by annuities. In fact of the few hundred annuities that my clients own (less than half of them sold by me), *not a single client* has lost a dime in the fixed rate products. I even have clients with annuities from AIG and not only have they not lost anything, their renewal terms are stil lquite reasonable.

 

In my mind state guarantee associations make fixed rate annuities more safe than anthing short of a US treasury.

 

We already know that the insurance companies are "too big to fail" and there is virtually no chance the governemnt will let al lthe retirees (main annuity clients) take a bath if one does fail. Witness AIG.

 

While you may have an axe to grind with insurance companies in general I think you are off base in your analysis of comparable risk.

 

JT