Bonds Or Annuities: What’s The Best Way To Generate Retirement Income?
From: www.forbes.com
Many of us are familiar with and follow the “120 minus your age” investing framework. It says that you should subtract your age from 120 and invest that percentage in equities, putting the rest in fixed income. For example, a 50-year-old would be 70% (120-50) in equities and 30% (100%-70%) in fixed income. (Note that the rule used to be 100 instead of 120 but has since been revised due to increasing life spans.)
The rule-of-thumb is based on a couple of key concepts:
- Equities have higher potential return, but also higher potential risk, than fixed income.
- The younger you are, the greater your ability to take on risk and recover from adverse outcomes (market downturns).
- The older you are — and the closer you are needing to use your money in retirement — the less risk you should take.
So, as you age and get closer to retirement, you dial down your equity allocation as you move money to fixed income. The rule of thumb has its limitations, but in the absence of knowing more about someone, their risk tolerance, and their cash flows, it does a good job of guiding people towards the right investment mindset and outcomes. Most “Target Date” retirement funds work this way.
But today, I want to challenge one aspect of the rule of thumb, and that is that we got the type of fixed income wrong. It should be annuities, not bonds.
Should You Put Your Retirement Money in Annuities Instead of Bonds?
First, some definitions…
Bonds are corporate or government debt instruments. When you buy a bond, you’re lending a fixed amount of money to a corporation or public entity. In exchange, and based on their credit risk and the duration of the loan, they pay you a semiannual coupon followed by your money back at maturity. The value you’ll get from a bond is much more predictable than that from a stock because it’s defined unless (a) you decide to sell early, (b) the company defaults, or (c) the company cancels the arrangement early. Bond funds — which you’re more likely invested in than actual bonds — are portfolios of bonds.
Annuities, when purchased correctly, provide guaranteed income in retirement. You give money to an insurer upfront, and in exchange they promise you a steady amount of income each month starting at a predetermined date in retirement. It’s fixed for as long as you live and no matter what happens in the market. The amount of income you get each month depends on your age now, the age at which you start receiving income, your gender, and how much money you commit today.
The difference between annuities and bonds are as follows:
- Bonds provide interest (via coupon payments) and then return your principal at the end. Annuity payments on the other hand are a combination of interest and principal, making each individual annuity payment higher than a bond’s coupon but with no principal repayment at the end.
- Bonds have finite durations, after which you will need to reinvest your money in order to keep generating interest. Annuities continue providing income forever, made possible by the pooling of longevity risk across participants (known as mortality credits).
- Bonds can be sold such that you get your money back with a gain/loss based on how interest rates have moved since your purchase. Many annuities, especially those offering the most value, cannot be sold.
- Bonds are issued by corporations. Annuities are offered by insurance companies.
Both annuities and bonds could be considered members of the “fixed income” asset class. But because bonds are traded on the market like equities, they’re more commonly used. However, many experts argue that annuities are a better way to generate retirement income. Let’s take a look at some of their arguments.
