How Not To Compare An Annuity To A Bond

How Not To Compare An Annuity To A Bond

My elderly uncle is convinced that annuities are better than bonds because the annuity will not only pay more on a monthly basis than a similar bond investment but would also keep paying over the remainder of his lifetime. While that’s true, it doesn’t tell the whole story. I’m writing this article to share a more accurate way of comparing the two.

Because there are so many annuity variants, not to mention bond types, we’ll compare a basic single life single premium immediate annuity (SPIA) for a 65 year old male to a ten-year U.S. Treasury bond to keep the comparison apples-to-apples as closely as possible. For those unfamiliar with these investment vehicles, the SPIA in this example returns a guaranteed monthly payment for the rest of your life primarily based on three factors: (1) the amount of principal you contribute upfront, (2) your age, and (3) current interest rates. The Treasury bond pays a guaranteed amount of interest twice yearly, also based on current interest rates, but only for ten years, at which time your original principal is returned.

The key difference between the two is that you get the principal back piecemeal over time with the annuity but as a lump sum during the year the bond matures. That’s the main reason why annuity payments are higher; they include interest and principal rather than just interest. The other important difference is that the annuity rate is locked in for your entire lifetime, while bond investing requires you to purchase another bond whenever the current one matures at that year’s prevailing rate, and so on. So in our example your annual income from the bonds could change every ten years.

To make the comparison I calculated the break-even age at which each investment returns the same amount of money. And to keep the analysis simple I did not assume any reinvestments or compounding of returns. Using interest rates as of this writing – 2.12% for the ten-year Treasury and 6.44% for an SPIA I found on – the break-even age turns out to be age 88. In other words, a 65 year-old male investing $100K would have accumulated by age 88 the same amount of principal & interest (about $148K) either way. If he dies at an earlier age, he would have done better buying the Treasury bonds. If he survives past age 88, the SPIA would have turned out to have been preferable.

The assumption that bond interest rates did not change for 23 years in the above comparison is pretty unrealistic in today’s low interest rate environment.  Assuming that rates rise from 2.12% to 4.12% over the first ten years and then remain constant would be somewhat more realistic. In that case the break-even age would grow to about age 96. A retiree would need to live an extremely long time before the money collected from that annuity would exceed the return on investment from a series of ten-year Treasury bonds.

This analysis did not take taxes into account nor the fact that the annuity guarantee – which is backed by the insurance company issuing it and secondarily by a consortium of insurers called the National Organization of Life and Health Insurance Guaranty Associations – is not as strong as that of the Treasury bonds. Regardless, it suggests that when interest rates are rising annuities become less competitive with bonds except for very long-lived individuals.

This is not to say that annuities are a bad investment. SPIAs in particular can provide increased peace of mind for retirees with a low risk tolerance and few other sources of guaranteed income. What’s important is to make sure you understand in detail how your investment choices actually work in order to make better informed decisions.

I hope my uncle is reading this.

2 Responses

  1. Alan Silverstein says:

    My previous analysis of Social Security deferral versus break-even ages was up-ended by essays pointing out that it’s incomplete to think of Social Security as merely a pension plan, it’s also a lifetime income insurance policy. I wonder if the same applies here, because an SPIA comes with at least a nominal lifetime guarantee.

    • Artie Green says:

      As mentioned there are those for whom an annuity would be psychologically valuable as a lifetime income insurance policy. But there’s an implied perception that the lifetime guarantee will result in more income for longer-lived individuals. The point of the article is to show that may not be true in a rising rate environment when compared to (relatively equivalent) safe alternatives. With Social Security, the decision is different. The only choice is when to start. The lifetime guarantee is the same regardless of your choice and there are no alternatives from which to choose.

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