As the first wave of Baby Boomers turns 65 this year, retirement income is a growing issue for advisors and their clients. The question often comes down to this: What’s the better income producer, a bond ladder or an annuity, and how much will it cost?
The answer, according to industry experts, should depend on a person’s retirement goals and how much money they have to invest. But the reality, they say, is that misunderstandings about the two products often muddy an investor’s decision about which one to buy. This, of course, puts advisors in the position of informing their clients about two very different but equally complicated retirement-income alternatives.
But interviews with several experts show that when discussing bond ladders versus immediate annuities with retiring Boomers, advisors can feel confident in laying out these fundamentals:
- Clients who can afford both an immediate annuity and a bond ladder should get both. The choice is not determined by income level, but rather varies by an investor’s goals and comfort level.
- If a client can afford to pay for just one guaranteed income product, an immediate annuity is the best way to go because it lasts for a lifetime, and a bond ladder doesn’t.
- Even so, clients should avoid putting all of their retirement money into an immediate annuity because they should ideally retain some liquidity in their portfolios.
- Investors should avoid bond funds and buy individual bonds instead.
- Annuities are generally cheaper to buy because one size fits all, but bond ladders are a good value because they can be custom-tailored for an individual’s spending needs.
And yet, advisors see “a very, very low utilization of immediate annuities” because clients often assume—wrongly—that if they buy one there will be nothing left for their children to inherit, says Michael Kitces, publisher of The Kitces Report and director of research for Pinnacle Advisory Group of Columbia, Md.
“Immediate annuities are nice as a retirement income vehicle, but most people have more goals than just retirement income. Once you start layering other goals in, you begin to have problems,” says Kitces, who is also co-author of “The Annuity Advisor,” a book that discusses what annuities can and can’t do.
Retirement Goals More Important Than Income Level
“We sometimes see even very affluent folks pick up annuities because they want a guaranteed income stream and there’s enough wealth there that they can deal with what’s left over. The challenge for middle-income folks who are struggling with this is that they want some of each an immediate annuity and a bond ladder and they can’t entirely afford some of each. If your income goal is $3,000 a month for life, it may turn out that the only way you can get that is to spend
every penny you own on an immediate annuity because that’s how much it costs. If I’m worth $10 million, it won’t take all $10 million.”
Diversification is key to a retirement-income portfolio regardless of an investor’s income level, notes Chip Castille (left), head of BlackRock’s U.S. and Canada Defined Contribution Group.
“There’s probably room in a portfolio for both bond ladders and annuities,” Castille says. “Bond ladders give you flexibility—you can always sell a bond ladder back—whereas with an annuity you can’t. The annuity is kind of like the Hotel California of investments. You can check in, but you can’t check out. But if you need a place to stay, California is a pretty nice place to visit, right? There’s no better deal. I don’t know when I’m going to die, so with an annuity, I’ll take some of my money—and I wouldn’t recommend that you take all of it—and put it into a pool where everybody diversifies away the uncertainty of when they’re going to die. If I happen to live long, I will continue to receive cash flow.”
Bond Ladders Are Flexible; Annuities Are Forever
Kitces views annuities and bond ladders as an apples-to-oranges comparison, however, because they do different things. Immediate annuities guarantee a lifetime income stream, while a bond ladder will make a finite series of fixed-maturity payments until all the bond payments have been made.
“You can live longer than the time horizon of the ladder. You cannot outlive your immediate annuity income,” Kitces says, adding that when the investor dies, most or all of whatever value was remaining is lost and accrues to the insurance company that sold the annuity. Bond ladders, on the other hand, protect investors against the impact of interest rate changes and provide them with the exact cash flows they need.
Even professionals who structure laddered bonds see the value of annuities.
“I understand why people invest in annuities. I get it. It’s one of the few income products that’s actually out there, and a bond ladder isn’t really an income product. It’s an individual bond strategy but it’s not specifically designed around generating income,” says Brent Burns (left), president and co-founder of Asset Dedication in Marin County, California.
Burns’ company creates what he calls “Reese’s peanut butter cup” income portfolios that stagger the principal on bonds coming due plus the interest on bonds that haven’t yet matured. The combination, he says, is custom-tailored to match a client’s exact cash flow needs from one year to the next—an advantage that annuities don’t offer, he says.
Both Burns and Kitces agree that bond funds should be avoided. Bond ladders, created with individual bonds, are safer, they say.
“The problem with bond funds in a rising interest rate environment is that they lose money,” Burns says, “and the advantage of an individual bond in a
rising interest rate environment is that you can hold it to maturity and collect a coupon, so you get the yield to maturity as your worst-case scenario, which is a positive.”
“The question is,” Kitces says, “how do you generate cash flow as a series of income and principal liquidations? If you do it with bond funds, you run the risk that when it’s actually time to liquidate a portion of the bonds, you’re selling bonds that have declined in price, and because you’re selling them, they’ll never recover. If I buy a bond fund and rates go up, I may find that my value is not what I thought it was, and when I need to start selling assets to generate cash flows, I don’t have as much cash as I was expecting, whereas if I’m doing this with a bond ladder, I can have an absolutely known series of payments ahead of time without any risk that they’ve been distorted by changes in interest rates.”
How Much Will It Cost? No Easy Answer
Opinions vary on whether a bond ladder or an immediate annuity is cheaper to buy.
Castille of BlackRock, which has introduced a target date fund that turns into an immediate annuity when a worker retires, asserts that dollar for dollar, the cash flows from an annuity generally cost an investor about one-third less than a bond ladder. Why? Because insurance companies build a “mortality credit” into annuities. In other words, insurers price annuities based on their expectation that not all investors will be alive to receive the money, and that diversification of the risk pool makes the product cheaper.
Bond ladders, on the other hand, are individually created, which adds to their cost, according to Castille. “Though I understand there are some synthetic bond ladders coming out, for the most part bond ladders are usually created ad hoc for individuals, so fees are going to vary a lot more than they would if you brought institutional pricing to the annuity market. A big advantage of the products you see coming to the market that offer lifetime income is more institutional pricing,” he says.
Burns of Asset Dedication, however, says that annuities are costly because “there are a lot of fees baked into annuities,” including insurance components and commissions. “We’re starting to see some no load or very low load annuities, but even there we’re cheaper, partially because our fees are very low, and partially because the efficiencies of our algorithms make it so we can minimize the cost to buy our cash-flow stream.”
Either way, concludes “The Annuity Advisor” co-author Kitces, it’s difficult to compare costs directly.
“It’s not like you write a check for $1,722 to pay for this strategy and $1,217 to pay for that strategy,” Kitces says. “When you buy bonds, your cost depends on whoever you pay to set up the ladder, how much you pay them and the cost-effectiveness of how they actually do the bond transactions, which varies entirely by who your advisor or custodian is and who is executing the bond transactions, which is where a lot of bond market makers make their money, and you don’t ever see those costs directly.”
On the immediate annuity side, Kitces adds, the cost structure is built into the annuity. “You don’t really see the cost structure per se,” he says. “The annuity company has some costs embedded into what offering they’re ultimately going to give you because they have to run an annuity company and provide a profit margin to their shareholders. But I don’t really have a way to compare the cost of an immediate annuity with income for life versus the cost of a bond ladder with income for life because you can’t even get guaranteed income for life with a bond ladder.”
Save the Date: Investment Advisor’s 4th Annual Retirement Income Symposium, Now or Never—2011: The Year Baby Boomers Turn 65, Oct. 17-18, Hilton Boston Back Bay, Mass. Day two will include a retirement income strategy debate featuring Brent Burns of Asset Dedication and Charles Farrell of Northstar Investment Advisors.