Bonds vs. Annuities

Summary

Bonds and annuities both offer stable income, but one is considered an investment while the other is a contract with a life insurance company.
Bonds are investments with governments and corporations that offer capital preservation and modest income.
Annuities are contracts with an insurance company that provide guaranteed income. They’re considered a retirement vehicle and are subject to penalties for early withdrawals.
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What are bonds?

Bonds are an investment with modest, guaranteed income payments while you hold the bond.

Essentially, you lend money to a government or corporation (the issuer of the bond) to finance a project. The issuer pays you interest at regular intervals, and when the bond matures, you’ll receive your principal back.

Yields can be modest, but bonds are typically easy to sell on the secondary market if you’re not interested in holding them until maturity. Some bonds may offer tax savings.

Advantages of bonds:

Capital preservation: Bonds are a safe investment option for preserving capital while earning modest returns.
Modest income: Bonds may pay a modest income amount, typically bi-annually, which can help supplement income in retirement.
Better diversification: Adding bonds to your portfolio helps diversify your portfolio and hedges against market turmoil that causes stocks to fluctuate.
Tax savings: Municipal bonds offer federal tax savings, and federal bonds aren’t taxed at the local level.

Disadvantages of bonds:

Default risk: The issuer of the bond could default, and you won’t receive a payment for your investment.
Interest rate risk: Rising interest rates pose a risk to bonds. When interest rates rise, investors are able to earn higher yields from newer investments, and the value of your bonds may fall.
Inflation risk: Inflation can pose a risk for bond investors due to the fixed interest rate. Since interest payments for bonds are more conservative and remain unchanged until maturity, inflation could outpace your returns.
Possible liquidity issues: Though many bonds are easily traded, some are more difficult to sell than others, especially if your bond is close to the maturity date or has declined in value.

What are annuities?

Annuities are a contract between you and an insurance company offering guaranteed income in retirement. You can make either a lump-sum payment or a series of payments to receive disbursements under the contract.

There are different ways annuities can be set up, and the payout depends on your age, sex, whether you want income for life or for a set period of time, and whether you include a spouse on the policy. Annuities have some advantages and disadvantages to consider.

Advantages

Low risk: Annuities are contracts with an insurance company and don’t experience market risk as stocks do.
Guaranteed income: Annuities are designed to provide you with guaranteed income in retirement and peace of mind.
Guaranteed rate: You’ll earn a set rate on a fixed annuity that won’t change.
Tax-deferred growth: Annuities offer tax-deferred growth. You won’t pay until you receive income in retirement.
Spouse can be included on an annuity: You can customize an annuity in many ways, including adding a spouse to the policy who would receive benefits upon your death.

Disadvantages

Complex: Annuities are difficult to understand. There’s a lot of fine print, and it’s hard to set up a product like an annuity without knowing how long you’ll live.
High fees: It may be difficult to see exactly how much you’ll pay for an annuity, since many costs are folded into the contract.
Highly illiquid: Once you give your money to an insurance provider for an annuity, it’s difficult to get back out, and there are steep penalties for doing so.
Lower returns: Annuities aren’t known for growing your money. The strength lies in their security, with the tradeoff being higher returns.

What are the similarities between bonds and annuities?

Bonds and annuities share some common traits, as outlined in the chart below.

	Bonds	Annuities
Returns	Modest	Varies
Capital preservation	Yes	Yes
Risk	Low	Low
Time horizon	Long-term, but can be sold on the secondary market.	Long-term.
Income	Income is paid at the coupon rate (interest payment), often semi- annually.	Income is paid at a set rate, which is determined by your contract, initial investment amount, age, and interest rate.

Returns

Both bonds and annuities offer modest returns at a set rate for the duration of ownership. However, they’re structured differently. Bonds pay interest at the market rate until maturity (or until sold). Annuities offer a contract rate determined by factors such as your age, sex, and whether you receive income for life or for a set period of time.

Capital preservation

Both bonds and annuities are ways of preserving capital. You can receive your entire invested amount back when a bond matures.

Annuities are a slightly different way to ensure you don’t outlive your savings. With an annuity,

Risk

Both annuities and bonds are considered low-risk investments. Large governments and corporations back bonds, while large insurance companies back annuities.

Time horizon

Annuities and bonds both have a longer time horizon. Once you invest in an annuity, you can’t easily get out of it and will likely hold onto it until your death.

Bonds can have a long horizon; however, you can also sell bonds on the secondary market, making them much more liquid than an annuity.

Income

Both bonds and annuities provide income. The income from a bond is the coupon rate, while the income from an annuity is the amount guaranteed in your contract.

What are the differences between bonds and annuities?

The differences between bonds and annuities distinguish them from one another and can help you decide which to invest in.

	Bonds	Annuities
Source	Governments and certain corporations.	Insurance companies.
Types	Treasury, corporate, municipal, mortgage-backed securities, etc.	Fixed, variable, indexed, hybrid, etc.
Fees	Lower (and sometimes no) fees.	High and typically incorporated into the annuity's total cost.
Tax treatment	Interest payments are taxed as regular income.	Annuities are treated as retirement vehicles and are penalized if taken out early. In retirement, taxes on annuities usually depend on whether you already paid taxes on the amount contributed.
Complexity	Easier to understand than annuities.	Complicated insurance products with extensive fine print.

Source

Bonds generally originate from government and corporate sources (though brokerages sell them). Insurance companies typically sell annuities.

Type

The different types of bonds you can invest in are defined by who the issuer of the bond is (federal, municipal, and corporate, for example). These can include U.S. Treasuries, municipal bonds, corporate bonds, mortgage-backed securities, emerging-market bonds, agency bonds, and more.

When it comes to annuities, the different types are defined by how they’re set up. The three main types include fixed, variable, and indexed.

Fees

What you’ll pay for a bond vs. an annuity is far different. Annuities are a contract, and the fees are generally baked into the total cost. Annuities do have high administrative costs and pay high commissions to the agent who sold the annuity. Bonds, on the other hand, have low costs.

Tax treatment

Income from bonds is taxed as ordinary income, and if you sold the bond for more than you paid for it, you’ll also pay capital gains.

Annuities are more complex when it comes to taxes, and depend on your age and whether you contributed pre- or after-tax dollars to the annuity.

Complexity

Annuities are a more complex investment to understand than bonds, in part because of the large amount of fine print you’ll have to read and sign. They’re also harder to get out of. The penalty for withdrawing money early from an annuity (also called the surrender charge) can be as high as 7%, plus a 10% tax penalty.

Bonds can be understood as a loan between you and the bond issuer. You loan a sum of money, and the issuer agrees to pay you a set interest rate while you own the bond.