Annuities vs. Bonds: What’s the Difference?
The question of annuities vs. bonds can send many investors on a wild goose chase. You might think that it’s just a matter of understanding a few terms, but there are actually many distinctions between them when it comes to investing. To create a successful investment portfolio, it’s important to understand the difference between annuities and bonds and how to use them as part of your overall strategy.
What Are Annuities?
An annuity is a long-term investment option that is sold by insurance companies, typically as a means to provide guaranteed income in retirement. It is an agreement between the investor and insurance company wherein the investor pays a lump sum or makes periodic payments in exchange for a guaranteed income stream, usually in retirement. There are a variety of annuities to consider including deferred, immediate, indexed and variable annuities.
Deferred Annuity:
A deferred annuity allows individuals to save for retirement on a tax-deferred basis, meaning that the earnings on the account are subject to taxes when they are withdrawn. This type of annuity is designed to help individuals build a retirement nest egg that they can access in later years when they are retired and no longer actively bringing in income.
Immediate Annuity:
An immediate annuity works in a similar way to a deferred annuity, with the key difference being that it allows the investor to start receiving an income stream soon after making an investment. The investor will pay an insurance company a lump sum and in return, the insurance company will provide the investor with an income for a set length of time (often for the rest of their life).
Indexed Annuity:
Indexed annuities are a type of deferred annuity that protects your principal from losses due to a decline in the market while still allowing you to participate in some of the upside potential. This type of annuity will invest your principal in a combination of fixed assets and indexed assets.
Variable Annuity:
A variable annuity is a type of deferred annuity that gives you more control over how the money is invested with the understanding that your earnings may vary. This type of annuity gives you access to a selection of underlying investments, such as stocks, bonds, money market funds and mutual funds, that are chosen by you and allocated among several subaccounts.
What Are Bonds?
Bonds are debt investments typically issued by governments and corporations to generate funding, in exchange for regular interest payments. Bond investors are essentially lending money to the issuer with the expectation that they will receive repayment of their principal plus interest at maturity.
Government Bonds:
Government bonds (also known as Treasuries) are secured debt that are considered a safe investment as they are backed by the full faith and credit of the U.S. government. This means that the U.S. government guarantees the promised payments. Government bonds typically come in the form of treasury bills (maturity <1 year), notes (maturity>1 year but <10 years), and long-term bonds (maturity>10 years).
Corporate Bonds:
Corporate bonds are debt securities issued by corporations to raise capital. They are typically secured by the issuer’s assets, such as cash, inventory or real estate. Corporate bonds tend to offer higher yields than government bonds, however, they are considered to be riskier since the issuer is not always able to make its payments.
Municipal Bonds:
Municipal bonds (also called munis or tax-exempt bonds) are debt securities that are issued by cities, states or other local governments to fund their various operations. These bonds are typically exempt from federal taxes as well as taxes in the state of issuance, making them a popular choice among investors. This type of bond is usually classified as either a general obligation or revenue bond depending on how the principal and interest are repaid over time.
The Difference Between Annuities and Bonds
When comparing annuities and bonds, the key distinguishing factors are the structure of the investment and the characteristics of the returns. Annuities are designed as a long-term investment and provide guaranteed income while allowing the investor to defer taxes. Bonds on the other hand, are debt investments that provide regular interest payments with maturity values structurated upon the terms of the respective bonds.
Taxation Differences
Annuities offer tax deferred growth, meaning that the money invested does not have to have income taxes due on it until the money is withdrawn. With bonds, the income taxes on interest paid is due at the time of payment unless the bond is a municipal bond which is exempt from federal taxes as well as taxes in the state of issuance.
Inflation Considerations
Annuities are a great way to hedge against inflation while bonds may not be able to provide this same protection in a declining market. Annuities offer investors the opportunity to purchase a product which has an underlying value that is linked to the consumer price index or other creative investment vehicles, allowing you toInflation adjust the income generated from your annuity over time.
Interest Rate Sensitivity
Both annuities and bonds have interest rate sensitivity but in different ways. When interest rates increase, it puts downward pressure on the price of fixed annuities, as these contracts contain an interest rate guarantee and the investor is being paid a guaranteed rate of return that is lower than the current rate being offered in the market. On the flip side, when interest rates decrease, it puts upward pressure on the price of bonds due to the higher yield they offer.
Risk Profile
The risk profile between annuities and bonds is also different. Annuities offer predictable income, however their value depends on the performance of the underlying funds. In other words, if the investments held in the annuity decline in value, you may experience losses. Bonds, on the other hand, provide a predictable interest rate and repayment of principal at maturity but carry the risk that the issuer is not able to make the payments in full.
When deciding between annuities and bonds, it is important to consider your investment objectives, risk tolerance, time horizon and tax situation. Annuities may provide greater potential for growth and can offer predictable income in retirement. Bonds, on the other hand, offer a fixed rate of return with a known repayment at maturity but the investments are subject to default risk. Ultimately, the best decision will depend on your individual situation.
