Annuities and Bond Ladders: Are They Comparable?

Financial professionals say that comparing annuities with bond ladders is apples to oranges. I agree. An annuity is a contract that you make with an insurance company. It is sold as a “product”. It should not be thought of as an investment. Annuity income is a return of principal and the income earned on that principal. A bond ladder is an investment portfolio. It can be created by an individual or by a financial advisor. A bond ladder[1]returns interest only. The principal is returned when a bond matures or is sold.

Clearly, an annuity and a bond ladder are not the same thing. But there are similarities.

  • In each case, you invest a large sum (i.e. principal).
  • The objective is the same for both – replace income lost after you’ve retired.
  • Returns are expressed as yields (percentages).

Definitions aside, let’s s assume that you are recently retired and you have a sum of money that you want to convert into an income stream. Assume that you have already balanced and invested your portfolio including equities. You could buy an annuity (assume an immediate annuity), invest in a bond ladder or perhaps both.  In this context, I view annuities and bond ladders alternatives. The question then is should you purchase an annuity, build a bond ladder or do both?

To answer that question, let’s take a look at some of the pros and cons of annuities and bond ladders.

Here are some of the pros of annuities.

  • There is no annual contribution limit such as in an IRA or 401K (e.g. for deferred annuities).
    • Money can be paid into an annuity over time or just one time.
    • Annuities, including investment returns, grow tax free until the time that payments begin (annuitization).
  • There is a vast array of annuity products (including fixed rate, variable rate and indexed). This increases the chances that you will find an annuity that suits your needs.
  • Provides a steady stream of income for life.
  • Annuity income will be greater than what you will receive from a bond ladder because the annuity is returning part of your principal whereas a bond ladder only returns interest.
  • Professional money management.

Now, here are some of the cons.

  • High fees including sales commissions and high annual fees.
    • The annual total of these fees can be 2%, 3% or even more.
  • Expensive surrender charges which are intended to keep you in the contract.
  • Inflation risk for immediate fixed rate annuities.
  • Potential loss of principal if you should die.
  • While annuities are very safe, there is some default risk.
    • I actually lost 80% of the money that I had invested in a company called Executive Life. After many years, I received 20% back.
  • Tax consequences
    • Investment gains are taxed at ordinary income rate instead of capital gains rate.
    • Heirs of a death benefit will inherit the original investment cost basis instead of the inheritance cost basis step-up (and therefore pay higher taxes).
  • Churning – sales person moves you into a different annuity which earns them more commission.
  • Buy backs – insurance companies sometimes try to buy back contracts of annuities that are underperforming (for them). This can leave an annuitant who agrees to the buy-back terms, with less advantageous options going forward.
    • I recently provided some input to someone who was offered a buy back. I suspect that the complexity and opaqueness of the communications from the insurance company was intentional. It is difficult to figure out what is in your best interest.
  • Market risk for indexed or variable annuities.

Next, let’s take a look at the pros of bond ladders.

  • Investor has control over makeup of the ladder including duration (number of years), rungs (number of bonds), risk (type and rating), and return (target yield).
  • A bond ladder adjusts to prevailing interest rates by replacement of a maturing bond with one that is at the far end of the bond ladder’s duration (e.g. replacement bonds come in at the higher range of the yield curve).
    • For example, Bond A, whose principal is $10,000 and yield is 1.5%, is part of a 5 year duration bond ladder. If Bond A matures next month, you can invest the $10,000 in a Bond B which matures in 5 years and yields 3.0%.
  • Constant maturing of bonds provides liquidity.
  • The investor retains control over the principal. Bonds mature on schedule and can be sold in the secondary market if necessary.

And here are some of the cons.

  • Requires ongoing active management or oversight.
  • Bond default risk.
  • Since a bond ladder only pays interest, more credit risk may need to be taken in order to increase the yield in order to meet objectives.
  • Potential loss of some principal if a bond has to be sold before maturation.
  • Reinvestment risk during periods of falling interest rates.
  • Bonds are purchased from brokers or dealers as opposed to stocks which are purchased from an exchange. Therefore bond purchase transaction costs are not transparent or consistent. (Therefore buying should be done on the basis of yield.)

OK, so now that we have better understanding of both, let’s look at some possible decision criteria to consider.

Question Answer Implies
Are you a DIY money manager? Yes

No

You may prefer a bond ladder

You may prefer an annuity

Is retaining control over your principal important to you? Yes

No

You may prefer a bond ladder

You may prefer an annuity

Do you anticipate living beyond the average? Yes

No

You may prefer an annuity

You may prefer a bond ladder

Are you concerned about leaving an inheritance? Yes

No

You may prefer a bond ladder

You may prefer an annuity

Do you understand how bonds work? Yes

No

You may prefer a bond ladder

You may prefer an annuity

Do you have concerns about the sales aspect of annuities and their complexity? Yes

No

You may prefer a bond ladder

You may prefer an annuity

Can your portfolio’s diversification objectives be further met by holding both? Yes You may want to hold both

 

For me the choice was straightforward. I chose to invest in a bond ladder. I am a bit put off by the sales and marketing aspect of annuities, of giving up control over my principal and the future effect of inflation on a fixed rate annuity. However, if I had to buy an annuity, here is how I would approach it.

  • Define my objectives by working up three use cases.
    1. Purchase an immediate annuity to cover non-discretionary expenses. The goal of this use case is to lock in a guaranteed income to keep a roof over my head and the lights on despite whatever is happening in the market, the economy and the geo-political arena.
    2. Purchase an immediate annuity to cover “the gap”. The goal of this use case is to generate enough additional income to pay my monthly expenses. The gap is the difference between other monthly income (such as Social Security and pension benefits) and monthly expenses.
    3. In lieu of Long Term Care Insurance,  purchase a deferred annuity that starts payments 15 – 20 years in the future.
  • Decide which use case(s) to fund.
  • Conduct research on types of annuities by insurer and current yields.
  • Come up with a range of how much principal it will take to fund the use case.
  • Meet with a financial advisor and select the annuity that meets my objectives.

Here’s some metrics regarding my bond ladder. In general, fixed income yields are low because we are in a protracted period of extremely low interest rates. However, at some point (likely this year) interest rates are going to rise. To take advantage of rising rates, I limited my ladder to just 5 years as opposed to say 10. My objective is to replace low yielding bonds with higher yielding bonds. Another way of looking at it is that I avoided locking in very low interest rates for 5 additional years by not opting for a 10 year ladder. My bond ladder is currently yielding 3.9% – not great, but not all that bad especially when you look at money market rates. They are S&P rated from A1 (upper medium grade) to AA+ (high grade). They are considered investment grade. My ladder has 8 rungs (individual bonds) in it.

To wrap up, here are the key take-aways from this article.

  • Annuities and bonds are different. They are not equivalents.
  • However, depending on the situation, you might end up viewing them as alternatives.
  • An annuity is a sales product which means that whoever is selling it, has an incentive to do so.
  • In return for lifetime income, you generally relinquish your principal when you buy an annuity.
  • Annuities are mature, stable products and many people find them attractive.
  • Bond ladders require more active management and generally return less than an annuity because they only return interest.
  • Bond ladders allow you to retain control over your principal.
  • Bond ladders can adjust to the interest rate environment and inflation.
  • Whether you choose an annuity, a bond ladder or both depends upon the depth of your financial background, your asset allocation strategy and your money management style.

Please feel free to share your thoughts on this subject.

Note: the information contained in this article is not offered as advice or guidance. It’s purpose is illustrative – not instructive or prescriptive. As always, consider seeking professional advice when it comes to your financial decisions.

[1] The comparison with annuities works best with a bond ladder rather than a bond mutual fund. Bond ladders vs. bond mutual funds will be explored in a future post.

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6 Responses

  1. Dot says:

    Hi Ed, thanks for the info on bond ladders vs. annuities. This is very timely as I am looking at converting some of our portfolio to one or both of these instruments. I enjoyed the stories too!

  2. tedcarr654 says:

    Hi Dot, good luck on your research. I’m confident that you will work out a solution that suits you!

  3. Sandy says:

    Ted, this was a helpful analysis of the two alternatives. Like you, I come down on the side of bond ladders. Couple of questions:
    1) why 8 rungs?
    2) did you initially set up the ladder with equally-spaced maturities on the 8 bonds?
    Thanks!

    • tedcarr654 says:

      Hi Sandy, my target is to have 2 rungs per year – one in each half. Initially I had nine rungs across 5 years with year 1 having only one rung since we were in the second half of the year. Years 2-5 had
      two rungs each for a total of 9. I am now in the process of increasing my rungs from 8 to 10. I opted for two rungs per year for several reasons: some level of diversification and default risk mitigation;
      ease of management; and the low rate of interest rate changes. Perhaps when we enter a time of interest rate change acceleration, I may increase the number of rungs.
      The “height” of my ladder was not precisely spaced. However, the ladder was evenly spaced if you measure it by 1/2 year increments, i.e. with a maturity happening within a 6 month window instead of a given month.
      I know that you have done a lot of research on bonds and annuities and are very comfortable with bonds. Thanks for sharing your experience!

      • Sandy says:

        Ted, what resource(s) did you find most helpful for researching the appropriate bonds for your ladder?
        Thnx, Sandy

        • tedcarr654 says:

          I use Fidelity’s website: Research -> Fixed Income & Bonds. I use it to find individual bonds as well as to construct trial bond ladders. When I do select a bond,
          I place a call to Fidelity’s Fixed Income department to review my choice with them. Fidelity is very strong in this area and I have found the website and their
          representatives to be invaluable. Please feel free to share how you conduct your research.

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