Boomer Retirement Income Smackdown: Bond Ladders vs. Annuities

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.