Before we begin this week’s post I wanted to share this quote that arrived in my inbox this morning from my research partners at Bespoke Investment Group. It just seems fitting with everything going on out there in the world, and in our own households, these days.

“What we know is a drop, what we don't know is an ocean.” - Isaac Newton

We’ve been discussing alternatives to bonds in recent weeks for obvious reasons. Inflation is surging and some of it seems sticky, interest rates are rising, consumer confidence is flagging a bit, and sabers are rattling in the East, although there’s a glimmer of positive news this morning. During times like these it’s natural to wonder about other ways of doing things, if for no other reason than getting some validation that you were doing the right thing all along.

There are lots of potential stand-ins for bonds. I thought of including some, such as commodities or even crypto, but they all touch more on longer-term speculation than a reasonable medium-term store of value. TIPS have been in the news lately, but they’re also a longer-term bet. Solid fixed income investments play a large role in the capital structure of our lives and appreciating that structure is important. Mix too much risky or illiquid stuff with the wrong time horizon and you’re asking for trouble.

In that vein, let’s extend our list of bond alternatives by looking at annuities.

Annuities –

In general there are three types of annuities: variable, fixed, and immediate. I’ll go out on a limb and suggest that you throw out the first type, variable annuities. If you already have one with large, imbedded gains or perhaps fancy add-ons from a bygone era, great, you’ll probably want to keep it going. Otherwise, just toss them out as an investment option, and certainly as a replacement for bonds. The reasons why could easily end up in a rant that’s beyond the scope of this post, but the bottom line is variable annuities are convoluted and expensive, a hybrid claiming the best of everything while usually coming up short. (There’s another variation on this theme, an equity-indexed annuity. Throw those out too.)

The other two types of annuities are different and can be good alternatives for replacing some of your bonds under the right circumstances. Both are insurance contracts based on the interest rate environment but neither has a secondary market, so you won’t see their values fluctuating all over the place. The difference between them is fundamentally about time, how long you can park your money and when you want to spend it.

The mechanics of a fixed annuity are similar to a bank CD. You put cash down for a set period at a guaranteed interest rate. If you break it early there’s a penalty. The important difference is in who’s making the guarantee. With a CD it’s the bank backed by the federal government (up to at least $250,000). With a fixed annuity it’s just the insurance company. In practice, there’s a state fund that could help you recoup some losses if the insurance company goes bust, but that’s only vaguely similar to government insurance and shouldn’t be counted on in the same way. But assuming you’re sticking with a high-quality insurance company (as rated by AM Best, for example – Google makes this information easily available) it’s unlikely you’ll have to deal with bankruptcy in a shorter timeframe, say five years or less.

Looking at this shorter timeframe on, you could get 2.65% on over $100K if you were willing to let the money sit for five years. Rates drop to just over 2% for a couple years and periods in between have rates in the middle of that range.

By way of comparison, as of this morning the yield on the 10yr Treasury, a key bond benchmark, is hovering a hair over 2%. The 30-day SEC yield (a standardized way to assess bond fund cash flow) for the Vanguard Total Bond Market Fund is about 2%. Vanguard’s shorter-term bond option has a 30-day SEC Yield of 1.4%. And 1yr CDs on top out at 0.9%. There’s also a 5yr CD at 1.2%.

Say you’re thinking five years. You’d pick the annuity because the yield is higher, right? Maybe. The correct answer depends on your personal liquidity structure and willingness to take risk. The annuity return is fixed, and the bond fund’s isn’t, so that’s one up for the annuity. The annuity also offers tax deferral on the interest if you leave it in the contract, so that’s another bonus. The bond fund has the potential to outperform the annuity, and I would expect it to over five years. But the bond fund can be too volatile for some investors. So maybe bonds are tied with fixed annuities? Let’s add a layer of risk to the annuity and see how it stacks up.

At the end of five years the contract “matures”. You can either take the money and run or reinvest in another annuity. But let’s say you want some access to your cash in the meantime. Typically there’s a percentage maximum the company will let you withdraw early without paying a penalty. Beyond that the penalty could be hefty.

Annuity companies invest your cash, usually in high-quality bonds and work off the spread between what they make on their portfolio and what they’re forced to pay you in interest. Since, at least in our simple example, the company has to sell bonds to generate the cash you’re asking for, they’ll assess a Market Value Adjustment (a penalty) for taking out too much money too soon. The MVA is based on the bond market and bond prices tend to fall as interest rates rise. This potentially makes the MVA painful in a rising rate environment, such as we’re in now.

If you structure things right, however, you shouldn’t have to worry about an MVA. You’d still have ample cash in the bank (as we’ve discussed in prior posts), and you’ll still want to keep some bonds. My suggestion is that a fixed annuity shouldn’t account for more than half of your fixed income allocation and no more than a third of your liquid net worth. Beyond that, the MVA and any other penalties lurking in the contract’s fine print can become larger issues. But again, I would expect the bond fund to outperform the annuity over this five-year timeframe. This makes the annuity a good option for someone who’s super skittish about investing and is willing to risk underperforming for more certainty.

Now let’s look at immediate annuities.

These contracts bake in a small investment return and include a guarantee to pay recurring income for the rest of your life. Although people typically begin taking income immediately, hence the name, you could decide up front to defer income for several months, even years.

What’s interesting about these annuities is that the company is essentially sending you back your own money until you outlive their life expectancy for you. If you die earlier they keep what’s left but you can buy a time guarantee, such as for ten years, to protect your heirs. And the cost can really add up over time. For example, shows that a 65-yr-old woman in California could receive about $460 per month for life on a $100,000 purchase, but $420 per month with a “ten-year certain” guarantee.

Some fuzzy math shows us that $460 per month equals $5,520 of annual income, or a 5.52% annual return. Sounds great, right? But recall that this is overwhelmingly the buyer’s own money coming back to her until she lives another 18+ years and breaks even on her original purchase. Then she’s on the company’s dime but still lagging behind having invested in bonds and spending down the principal on her own.

In short, immediate annuities are an appropriate replacement for bonds if someone; 1) has no heirs; 2) needs to stretch their savings to meet their monthly needs; 3) has a recurring bill to pay that isn’t tied to inflation, such as the principal and interest on a fixed mortgage; 4) doesn’t want bond market risk; 5) could check all five of these off their list.

And the same rule applies that no more than half of your bond allocation should go into an immediate annuity because it’s fundamentally illiquid.

Have questions? Ask me. I can help.

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