Why Bonds are a Better Buy than Annuities

Retirement planning: Should I buy a bond or an annuity? 

How does one choose between an annuity and a bond or portfolio of bonds? Few investors realize that they can enjoy the security of an annuity with much higher income and total returns. This can be achieved with a low risk bond portfolio. There are many different types of annuities and bonds. For the purposes of this article, we’ll discuss the most commonly used structures for both types of products.

Annuities and bonds both pay you a predetermined cash flow for a given period of time. The annuity usually commits to pay you until the end of your life and the bond pays you until a pre established date (i.e. the maturity date). The annuity gives purchasers the comfort that they will get an “income stream for the rest of their lives”. However, this commitment is only as good as the creditworthiness of the issuing institution (i.e. the likelihood that the issuing insurance company will be around in 20 to 30 years). This is also true of the bond. The bond gives investors the comfort that they will get a consistent stream of income until the end of the contract (i.e. until the bond matures). Similarly, this promise is only as good as the company or entity issuing the bond. External Credit Ratings provide a reference guide for the safety of the issuing entities. Annuities are usually issued by insurance companies and AM Best is one of the most popular rating agencies for insurance companies. The company issues ratings that correspond to the safety and security of an insurance company. They are not foolproof, but they provide a standardized and simple way to assess the insurance company issuing your annuity. Similarly, Moody’s and S&P provide this service for many bond issuers. Think of the rating like a grade in school. AAA to A ratings represent exceptional to excellent performance; BBB is categorized as “good” and BB is “fair”. Anything B and below in this world is considered weak or poor. Be sure to check the rating of the insurance company or bond issuer.

The most popular annuities give you income “for the rest of your life”. However, as a percentage of your principal investment, the offering is not attractive. A sample of annuities on the local market delivered returns (as calculated by the IRR) ranging between 2% and 3% depending on the length of the life of the holder. Bonds can provide far more income. A portfolio of long term investment grade bonds can yield anywhere between 4% and 6% depending on the tenor. You may think that an extra 2% is negligible. However, if 2% is compounded over a 20 year period it increases your investment principal by roughly 50%.

You may think that a lower return is worth accepting if you get “income for the rest of your life”. However, this can also be achieved by selecting and managing a high quality portfolio of bonds. In fact, bonds allow you to take advantage of movements in the market that can grow the size of your investment. It is also very easy to leave a bond portfolio to other family members in the event of your death. There is no cost to doing so. In the case of annuities, a lower cash flow is usually offered for this flexibility. 

Bonds are also far more flexible than annuities. You can buy or sell them at any time and there are no onerous fees or broker imposed discounts that penalize you. For example, if you have an emergency and need liquidity, you can sell the bond and use the proceeds. In contrast, annuities are much more difficult (and sometimes impossible) to liquidate. The benefit of the annuity is limited to the cash flow it provides. Bonds on the other hand, preserve your principal AND give you a cash flow.

Which is better for me? This ultimately depends on your preferences. If you would like to maximize your return and income during retirement, a portfolio of high quality bonds will almost always be more attractive than an annuity.

Marian Ross is an Assistant Vice President of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm