The United States has experienced historically low interest rates in recent years, resulting in lower returns for fixed-income assets. As a result, many individuals who are  close to retirement and  thinking about options for generating fixed income may avoid purchasing a deferred fixed annuity.

Is this a sound strategy?

As an alternative to a deferred fixed-income annuity, near-retirees could consider bonds. However, while long-term bonds may offer higher yields than deferred fixed annuities, they will experience capital losses when interest rates rise if they are not held to maturity. Similarly, while short-term bonds may not experience losses with rising interest rates, their lower yields may not be as competitive as today’s deferred fixed annuities.

Dr. Wade D. Pfau, Ph.D., CFA, wrote a white paper that explores the dilemma about the relationship between interest rates and bond prices versus fixed annuities for clients planning for retirement income. We also created a one-page summary of Dr. Pfau’s white paper that includes key takeaways.  

The benefits offered by deferred fixed annuities relative to bonds for retirement income include:

1. Protection of the annuity contract value from market volatility: Fixed annuities provide a predictable source of income and safety of principal. They also can offer growth without being invested in the market.
   
2. Higher yields: Deferred fixed annuities provide the ability to earn higher yields than Treasury bonds because the general account of an insurance company may invest in higher-yielding corporate issues.
3. Less credit risk: Deferred fixed annuities may offer lower credit risk because insurance companies can diversify their holdings across a large range of fixed-income securities.
4. Tax deferral: Because an annuity is tax-deferred for individuals, the contract value will earn interest without current income tax until the interest earned is withdrawn.

If interest rates rise, the new higher rate cannot be applied to the fixed annuity. Another consideration is that fixed annuities may be subject to penalties or withdrawal charges if distributions are taken prior to the end of the withdrawal charge period, while bond investors have the flexibility to sell the bond before the maturity date.

Still, Dr. Pfau’s conclusion—contrary to what one might expect—is that a deferred fixed annuity may offer higher after-tax returns than bonds, even if purchased in a low interest-rate environment. This can set the stage better for retirement and creating lifetime income.

We encourage you to read the white paper and share your thoughts with us. If you have any questions, speak to your Pacific Life consultative wholesaler or contact Pacific Life’s Retirement Strategies Group at (800) 722-2333 or send an email to RSG@PacificLife.com.