Can you build a bond portfolio that provides better retirement income security than an immediate annuity?

Economists and many financial advisors believe some portion of a retiree’s portfolio should be placed in immediate annuities. There are a lot of types of annuities out there, so let’s be clear. We’re talking here only about annuities that pay a regular income for life or the joint life of the owner and a spouse after you deposit a lump sum with the insurer. Immediate annuity payments can be either fixed or inflation-adjusted.

Only a small portion of retirees follows this advice. Four reasons generally are given for the reluctance to buy annuities. Most people don’t want to relinquish control of part of their nest eggs. Giving up control seems to be the major objection to annuities. Related to that is that the annuity is inflexible; the owner often can’t withdraw additional income in a year when it’s needed. You receive the fixed annual payments and nothing more. Another reason: Many people don’t want to forego the potential to earn higher returns should a new bull market emerge. Finally, with an immediate annuity there’s nothing left for your heirs.

These are reasons not to put your entire nest egg into an immediate annuity. But they shouldn’t override the reasons to buy an immediate annuity with some portion of your retirement assets. Most of us need to have a secure lifetime floor on our income for life. It’s also advisable to transfer some of the risks of a long life and poor returns to the insurer.

Can you avoid these risks by purchasing long-term bonds instead of an annuity? The question is addressed in a study by Michael Edesess that was published on Advisor Perspectives.com.

Bonds initially appear to have the upper hand, because you won’t be paying the costs embedded in an annuity. Edesess estimates that at recent prices, a fixed annuity has an expected return of 1.5% while an inflation-adjusted annuity’s expected return is -1.9%. Though bonds have extremely low yields now, the yields on long-term bonds are higher than expected returns on annuities. Only the long-term bonds yields are competitive with annuities. The traditional strategy of laddering bonds of different maturities offers expected returns well below those on annuities right now, says Edesess.

To compare owning bonds to immediate annuities, Edesess sought to answer the question: What would happen if a person were to buy a 30-year treasury bond and spend the interest plus sell the bond piecemeal to generate annual income equal to the annuity payouts? How does that compare with using the same amount of money to purchase an annuity?

The results would be comparable over 30 years if interest rates were stable. After 30 years, there would be less than a year’s income left in the treasury bond. Comparing a 30-year Treasury Inflation-Protected Security (TIPS) to an inflation-indexed annuity, the TIPS lasts only 27 years. So, for a 65-year-old the nominal treasury would last to age 95 and the TIPS would last to age 92. If you don’t think there’s much of a risk of living past 95, the treasury bond alternative to an immediate annuity looks feasible.

The picture changes, however, when interest rates rise over the years. That’s because the value of the bond will fall when rates rise, so more of the bond will have to be sold each year to generate the same income. When yields rise from 0.4% to 0.9% on the TIPS over the first 10 years, the TIPS bond lasts only 25 years. If the yields rise only one percentage point, the bond lasts only 23 years. If the rate on the nominal bond rises one percentage point, the bond lasts only 25 years. If the nominal bond yield rises two percentage points (which still would leave the yield below the 40-year average), the bond lasts only 21 years.

Another factor to consider is income taxes. When the assets that would purchase either the annuity or bond are held in an IRA, there aren’t tax differences. The distributions from the IRA will be taxed as ordinary income unless they represent after-tax contributions.

But there are differences outside the IRA. In a taxable account, part of each annuity payment will be tax-free until you’ve recovered the initial investment in the annuity, which will occur when you reach life expectancy. One estimate is that about 75% of the annuity distributions will be non-taxable until life expectancy is reached. After that, all the distributions are fully taxable. For bonds, the interest will be taxed as ordinary income, and sales of the bond are tax-free unless interest rates fall and the bond is sold for more than its cost. But in the early years, more of the payout will be interest, so Edesess believes there will be less tax deferral with the bond. But the tax-free portion of those payouts will grow over time.

The bottom line is you aren’t likely to be able to duplicate the safety and certainty of an immediate annuity’s guaranteed income with bonds. If market yields increase, you might be able over time to increase the return from bonds above what you’d receive from an annuity. But to do that you also have to take the risk that things don’t turn out well and you lose money. To earn secure, guaranteed lifetime income, it’s tough to beat an immediate annuity. For that security you give up some flexibility and control of your assets plus the potential of leaving a legacy to the next generation.