Are Bonds Passé?

Stocks provide growth, while bonds and other fixed-income instruments provide income and reduce volatility. That’s the traditional view of asset allocation. But today, most bonds pay low rates and produce much less income than they once did. The traditional wisdom should be revisited.

Fixed annuities of various types can replace bonds, because they can offer higher yields and tax deferral and, optionally, guaranteed lifetime income. All annuities are tax-advantaged; earnings are not taxed until you start taking money out.

Are you looking for a better-paying alternative to bonds and certificates of deposit?

Then consider a fixed-rate annuity, also known as a multi-year guaranteed annuity. Like a bank CD, it offers a set interest rate for a set period, usually three to 10 years. Rates today are usually significantly higher than those of a bank CD with a comparable term. For example, a five-year fixed-rate annuity from one company was offering a guaranteed annual yield of 3.45% for five years as of mid-August 2020 — compared to about 1.5% for the best five-year CDs, according to Bankrate. Fixed-rate annuities work well to fund an IRA, too.

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Pros: Besides offering competitive rates, fixed-rate annuities are a simple, straightforward product that makes comparison shopping easy. All of your deposit goes to work for you immediately. There’s some liquidity because many annuities let you withdraw up to 10% of your accumulation value annually without penalty.

Cons: There’s no growth potential beyond the guaranteed interest rate. If you cancel the annuity before the term is up, the insurer will charge a penalty. Withdrawals before you reach age 59½ may be subject to an IRS penalty of 10% of the earnings that are withdrawn as well as ordinary income tax.

Are you looking to secure guaranteed lifetime income so you won’t ever run out of money in retirement?

Lifetime income annuities are longevity insurance. They let you convert some of your savings into a personalized lifetime pension. You can buy guaranteed lifetime (or joint lifetime) income, beginning immediately or at a future date. The former is called an immediate annuity; the latter is called a deferred income annuity.

Income annuities make the most sense for people who believe that they will enjoy longer-than-average life expectancy. Of course, it’s hard to predict. You may feel that your life expectancy is subpar but end up blowing out the candles on your 100th birthday cake!

Pros: You receive guaranteed lifetime income with tax advantages, as only a portion of the income is taxable; the bulk is nontaxable return of principal. Here’s where the big advantage comes in: Once you’ve exceeded your life expectancy and gotten your entire principal back, your monthly income will still keep coming, even if you live past 100. At that point, your payments will become fully taxable.

Cons: No cash value. You’ve traded your savings for future income.

While lifetime income annuities are most popular, you can also buy an income annuity for a set period, such as 10 years. This can work well for someone who needs to fill an income gap until Social Security or an employee pension kicks in.

Are you looking for long-term growth potential without any downside?

There’s one financial product that offers this: the fixed indexed annuity. It offers market-linked growth potential while guaranteeing principal. Indexed annuities credit interest annually based on the growth of a market index, such as the Dow Jones Industrial Average or S&P 500, usually with upside limits. But you lose nothing in down years.

Pros: Indexed annuities offer a “have-your-cake-and-eat-it-too” benefit, uniquely combining growth potential with guaranteed principal. Over the long term, this approach is likely to outperform other guaranteed-principal products, such as fixed-rate annuities and CDs.

Cons: They’re not a good product for short-term holding periods because the interest rate fluctuates considerably. In years when the index is down, you won’t earn anything. Furthermore, these products are complex. Features, upside limits and crediting methods vary greatly, making apples-to-apples comparisons tricky. Withdrawals before 59½ may be subject to an IRS penalty of 10% of the earnings that are withdrawn plus ordinary income tax.

Annuities are not insured by the FDIC. However, there is a form of insurance provided by state guaranty associations in case the insurer becomes insolvent. Coverage varies by state.

Annuities are guaranteed by the issuing insurance company. Therefore, it is important to check the insurer's ratings provided by agencies such as A.M. Best, Standard & Poor's or Moody's. These agencies grade insurers for their overall financial strength and their claims-paying ability. Be sure that the insurance company you go with is financially stable, as you will want it to be there in the future when you need it.