Annuities and bonds are popular ways for investors to generate an income stream. Both are considered part of the "fixed-income" asset class; however, annuities can generate income for life without requiring reinvestment.

Annuities

Annuities are long-term contracts with an insurance company. You invest money, either as a lump sum or over time. In exchange, you receive income through regular payments. There are several types of annuities, categorized by when payments begin:

Immediate Annuity

You make a single lump-sum payment to the insurer, which agrees to pay you for the rest of your life or another specified period. As the name suggests, an immediate annuity begins paying as soon as you fund it. You generally purchase this type of annuity if you are approaching retirement and want steady income.

Deferred Lifetime Annuity

These are similar to immediate annuities, except the income stream does not begin until a later date chosen by the "annuitant"—that is, the investor. Generally, investors purchase this type of annuity if they want to save money on a tax-deferred basis.

Annuities Also Vary in How Payments Are Calculated:

• Fixed annuity: Provides regular periodic payments.
• Variable annuity: Payments vary with the performance of investments in the fund.
• Fixed indexed annuity: Payments vary based on changes in a specific index, such as the S&P 500.

With any annuity type, you decide when to withdraw income. Usually, that is during retirement. The monthly annuity payment is based on several factors, including:

• Interest rates when you purchase the annuity
• The amount of money you deposit
• Your age
• Your gender
• The length of the payment guarantee

While traditional life insurance provides protection if you die sooner than expected, an annuity protects you if you live longer than expected. A retiree with an annuity can choose a joint-life option that continues payments to a surviving spouse. The retiree's monthly benefit amount will be lower to compensate.

Annuities: Pros and Cons

As with any investment, annuities have advantages and disadvantages that should be considered before making a decision.

Pros

• Lifetime income, no matter how long you live.
• Tax deferral. You do not pay taxes until you withdraw funds.
• Guaranteed rates with fixed annuities. Variable annuity payouts depend on investment performance.

Cons

• High fees. Up-front sales charges and annual expenses can add up.
• Lack of liquidity. An early withdrawal may trigger a substantial surrender charge.
• Withdrawals are taxed as ordinary income.

Advantages of Annuities

Annuities offer many advantages, but the main one is guaranteed lifetime income, even if you live past 100. During the accumulation phase—the period from purchase until you receive payments—you can make periodic contributions. Taxes during this phase are deferred until the money is withdrawn as income.

Disadvantages of Annuities

Annuities often come with high sales charges and high annual expenses. Fees may be even higher if you have an actively managed fund or purchase special riders to increase your coverage. Adding to these costs is the surrender charge if you withdraw funds during the first years after purchasing the annuity. Taxes on annuities can also be considered a disadvantage. Rather than being taxed as long-term capital gains, as most investment income earned over a long period is, annuity payments are taxed as ordinary income. For investors in lower tax brackets, the difference may not be very significant. For wealthy investors, it is a major consideration. The top ordinary income tax bracket is 37% as of 2022; long-term capital gains are taxed at 20%.

Bonds

Think of a bond as an IOU between you and a company, municipality, or government. You act as the lender, and the borrower—for example, the company—pays you interest over the bond's life. When the bond matures, you get your initial investment back. High-quality bonds have long been a mainstay for conservative investors. They offer a steady, though relatively low, return along with very little risk to the principal investment. In retirement, those interest payments are often used to supplement income. That is the biggest difference between annuities and bonds. When you buy a bond, you receive interest payments for a set period and then get your money back. Annuities often pay for the rest of your life, no matter how many years that may be.

Bonds: Pros and Cons

Like annuities and other investments, bonds have advantages and disadvantages. Pros

• Generally earn higher returns than annuities.
• Easy to buy. You can purchase bonds through your broker or on the TreasuryDirect website.
• Predictable income for a specified period.

Cons

• Unlike annuities, income lasts for a finite period.
• Default risk. The company or municipality could stop making payments.
• Fewer options than annuities for how and when to receive interest earnings.

Advantages of Bonds

• For the investor, buying a bond is not a permanent decision, or even necessarily a long-term one. Bonds are issued for terms as short as three months or as long as 30 years, sometimes longer. An investor who thinks bond rates may rise soon can buy a short-term bond and reinvest the principal later, when rates may be better.

• Bonds generally earn higher returns than annuities. The exception is the fortunate person who lives to 100 or beyond. An annuity's lifetime guarantee means an excellent return on investment for those who live a long time.

• Bonds are easy to buy and cost less in fees and commissions than annuities.

Disadvantages of Bonds

• Bonds provide income for a finite period, not for life like an annuity. You must reinvest your money if you want to keep earning interest.

• And although the risk of losing principal in bonds is small, it exists. If a company goes bankrupt or a government defaults, the investor's principal may be lost.

In Summary.

Annuities and bonds offer a steady income source. With annuities, that income may last the rest of your life. Bonds, however, provide income for a specific period, from three months to 30 years or more. Of course, once a bond matures, you can reinvest the money in another bond to continue receiving that income. The interest rate in effect when you purchase an annuity has a major impact on future payments. In a low-interest-rate environment, some investors may wonder whether it is better to wait for higher rates before buying an annuity. Maybe, maybe not. Before deciding, consider how long you plan to defer annuity income. If it is a long time, the insurer would have time to grow your premium at a higher interest rate and would probably pay more. If payments will begin soon, there is no real advantage to waiting. There are many different types of bonds and annuities. Finding the right one for your retirement portfolio can be challenging. When in doubt, consult a qualified financial advisor who can make recommendations based on current interest rates, your age, risk tolerance, and time horizon.