When you are preparing for retirement, bonds and annuities can both offer a comparable income stream and tax advantages. Whereas bonds are a standard financial vehicle available from a variety of businesses and governments, annuities are a specialized financial instrument only offered by insurance companies and regulated by state government.
Bonds can be issued by governments (e.g. foreign, federal, state, municipal) and a variety of corporations. However, they all have a similar structure: the bond pays interest at regular intervals and then the face value at maturity.
For retirement purposes, most investors favor some type of tax-free bond, which means bonds issued by a government. TIPS (Treasury Inflation-Protected Securities) are an interesting subset of these bonds, because their yield goes up and down with the rate of inflation, and as they are issued by the federal government, they are tax-exempt. Almost all other bonds pay a set interest rate.
People also like to buy municipal bonds for retirement because they are tax-exempt as well.
Buying and Selling Bonds
Bonds can be bought and sold using a brokerage account, or bought directly from the government issuing them. For example, people like to buy U.S. Treasury bonds directly from the federal government because there is no transaction fee (see Resources).
Bonds can also be sold on the open market, and their price goes up and down in an inverse relationship with the prevailing interest rates.
Annuities are issued by an insurance company and sold to you by a broker. The interest rate is only guaranteed for a certain amount of time, and thereafter can be reset by the insurance company. They pay a slightly higher interest rate than government bonds, but they are also riskier because the insurance company can default.
There is a penalty (a "surrender charge") for selling the annuity before it matures. This is a big disadvantage when compared with bonds, which can be sold on the open market at no penalty. The surrender charge is forgiven after a certain amount of time, but resets if you add any money to the annuity.
Bonds Are Simpler and Offer More Control
The most compelling advantage a bond has over an annuity is that it is less complicated. Unfortunately, unscrupulous brokers have taken advantage of the complex annuity rules to lock their clients into inappropriate annuities while earning big commissions.
You can purchase bonds yourself, easily compute the payout, and sell them at any time. That kind of control and clarity is extremely desirable.
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