Income for life: A better way

Our expert has long argued the virtues of annuities for securing a steady check. A reader want to know if a bond portfolio can work too.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: You are a big fan of annuities. I recently rejected that course for my mother in favor of a bond ladder. She receives a somewhat lower payout, but she does not give up her principal.

Every few years, her principal will be rolled over into new bonds (which can hedge inflation by paying higher rates if inflation goes up). Is there a reason the bond ladder isn't a better alternative? - Hal Shapiro, Arlington, Virginia

Answer: "Big fan" is going a bit far, but I do think an annuity can be a good choice in certain situations. Specifically, I think it can make a lot of sense for someone to put a portion of his or her retirement portfolio into an immediate annuity (also known as a payout or income annuity). These vehicles produce guaranteed lifetime payments if that person needs a guaranteed stream of income beyond what he or she is getting from Social Security and a company pension.

There are a lot of important qualifiers, however. I believe someone should put only a "portion" of one's nest egg into annuities because retirees also to hold on to stocks and bonds and cash - the stocks provide growth, while bonds and cash provide liquidity.

I limit myself to immediate annuities, which are the type that can turn a lump sum of cash into a guaranteed lifetime income.

There's another type of annuity that's sold more often that's known as a deferred annuity, which is better described as a tax-deferred saving or investing vehicle. I'm not a big fan of those because they usually carry hefty fees and have tax implications. All gains are taxed at relatively high ordinary income tax rates even if those gains stem from long-term capital gains, which would otherwise be taxed at lower rates. (More the differences between immediate and deferred annuities.)

And taking all that into account, I think an immediate or payout annuity still only makes sense if you need the guaranteed income.

What about bonds

Now, let's get back to your mom's situation. I have no problem with retirees investing in bonds. And it turns out I am a big fan of "laddering," or spreading your bond holdings among issues of different maturities - say bonds of two, four, six, eight and 10 years. This way, when a bond comes due, you get to reinvest at current interest rates. This strategy prevents your entire bond stash from getting hit too hard if rates start to climb.

But bonds also have some shortcomings, particularly for retirees looking to them for income. Bonds make fixed payments. So as prices for food, clothing, medical care and all sorts of other things rise over time, the real value of the fixed payments a retiree gets from bonds declines.

Yes, if inflation rises and pushes up interest rates, you will get a higher rate of interest on the next batch of bonds that comes up for reinvestment. But if inflation continues to rise, the real value of the payments on those bonds - as well as the ones that didn't come up for renewal - will still drop over time. Since a bond's payments are fixed, reinvesting at a higher rate doesn't immunize you from the effects of inflation over time.

This means that if you want to maintain mom's living standard, you can't rely just on the bond payments. So unless mom finds a way to scale back her spending, sooner or later you'll have to dip into principal to maintain her lifestyle. And once you do that, you raise the possibility that mom will run out of money. And if you have to sell when bond prices are down, that could happen a lot more quickly than you think.

Pros and cons of annuities

An immediate annuity, on the other hand, guarantees mom a lifetime income, regardless of how long she lives. If, like the Energizer Bunny, mom keeps going and going, so will the annuity. The payments won't stop.

And if mom lives beyond life expectancy, she'll benefit in another way from the annuity. You see, when you buy an annuity, you're pooling your money with thousands of other annuity buyers. The money that would have gone to those who die early ends up going to those who die later. So people who live longer than life expectancy get an extra return on their money. This is why an annuity can give a higher payout at a given rate of return than you could get creating an annuity on your own.

But annuities also have shortcomings. If you choose an annuity with a fixed payment, inflation will erode the value of that payment just as it does the purchasing power of a bond's interest payments. (You can get annuities with inflation protection, but you'll start with a much lower payment.)

And, as you point out, you also give up access to your principal once you buy the annuity. This is what allows annuities to provide that extra return by shifting money from those who die early to those who die late. (You can find some annuities that give your or your heirs access to your money, but again, you'll get a lower payment.)

So the real question is how much does your mom value having an income that's guaranteed to last as long as she does? How important is it to her to know she'll have money coming in no matter how long she lives?

I think that's pretty attractive for many retirees, although certainly not all. If Social Security and other pensions take care of most of your basic needs, then you probably don't need more security. And if you've got a huge nest egg, then maybe your chances of running through your stash are virtually nil, in which case why bother with an annuity?

But most retirees aren't in either of those positions. Which is why I think they ought to consider an immediate annuity as part of an overall portfolio.

Indeed, this is the strategy I outlined in Money Magazine in "An Income Plan That's Built To Last," which is part of a 43-page special report titled "Make Your Money Last a Lifetime."

If you're more comfortable with a laddering strategy and believe you can assure mom enough money for as long as she needs it, fine. But even if you do go that route, I hope you'll at least diversify mom's portfolio to include some stocks or stock funds that can provide growth that will help maintain mom's purchasing power longer term. Because if mom lives a long time (and we all hope she does), you want her to be happy and satisfied, not concerned about whether her bond payments will be able to support her comfortably in her later years.


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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.