Annuities Vs. Mutual Funds for Retirement Investments

Annuities and mutual funds are both long-term investments that can make sense for some investors when it comes to making choices for retirement. Both annuities and mutual funds share some common investment characteristics. However, they differ in many respects as well, in terms of investment options, taxation, fees and payout structure. While there may be an advantage of buying a variable annuity rather than a similar mutual fund, investors should know the differences before putting away long-term retirement money.

Difference Between Annuity and Mutual Fund

An annuity is a contract between an investor and an insurance company. In exchange for one or more payments, known as premiums, the insurance company guarantees periodic payments back to the investor. Typically, these payments are made for the remainder of the investor's life, or possibly that of his or her spouse as well. Some annuities also come with additional features, such as a minimum increasing death benefit or an accidental death insurance benefit.

A mutual fund is a collective pool of money invested on behalf of individuals by professional money managers. Funds are invested according to written investment policies. Usually, mutual funds come with no guarantees, with the performance of the underlying investments determining the future payout for investors.

Types of Annuities

Fixed annuities pay out a guaranteed interest rate for the duration of the annuity's term. For example, an annuity might pay out 3 percent interest for 10 years, after which the annuity matures. While the interest is guaranteed, that guarantee is only as solid as the financial strength of the company issuing the annuity. Fixed annuities can be immediate, meaning they begin making payments shortly after purchase, or deferred, in which case they pay out at a specified date in the future. The period before an annuity pays out is known as the accumulation period. Once payouts begin, the annuity is in the annuitization period.

Variable annuities, as the name implies, don't have fixed returns. Rather they offer unpredictable, unspecified returns, although some do have a guaranteed minimum return. In some ways, variable annuities act more like mutual funds. Investors choose from a number of different investment options, such as large-cap growth stocks, small-cap value stocks, international stocks, commodities or government bonds. Money managers invest the variable annuity funds according to the investment objective of each option. The ultimate payout value for a variable annuity is based on the performance of those individual investments, which can rise or fall in value and are not guaranteed.

Types of Mutual Funds

Fundamentally, mutual funds are all similar. The purchases of individual investors are all combined into a single pool of money that a professional manager uses to buy securities on behalf of all shareholders. Gains or losses are measured on a per-share basis.

Structurally, mutual funds come in three types: open-end, closed-end and exchange-traded. Open-end funds are the traditional fund structure, in which investors buy or sell shares directly with the fund company, and transactions are only conducted once per day, after markets have closed. Closed-end funds act more like stocks, trading on exchanges and available for purchase any time that the stock market is open. Exchange-traded funds are something of a hybrid. They trade on the stock exchanges but with shares regularly issued by the managing company.

Open-end funds always trade at their net asset value, or the total value of the invested funds divided by the number of outstanding shares. Closed-end funds trade up or down based on supply and demand and general market conditions, and may be valued above or below their net asset value at any time. Exchange-traded funds are usually priced at about their net asset value, since the fund company continually issues additional shares.

Mutual funds offer an almost limitless range of investment options. You can invest in funds tracking an individual stock index, like the Standard & Poor's 500 index. You can also buy funds focusing on any particular market segment, such as mid-cap stocks or foreign stocks and bonds. No matter what part of the market you want to invest in, you can likely find a number of funds representing those sectors.

Annuity Benefits

One of the main benefits of an annuity is the guarantee that backs it up. Although it's only as solid as the underlying company, a guarantee is a good thing to have when it comes to retirement savings and income. Annuities also benefit from the promise of lifelong income. With people living longer in retirement, knowing that you will never outlive your income can help lead to a stress-free retirement.

For those that find the returns of fixed annuities too low, the potential of increased gains via a variable annuity might hold appeal. The main advantage of buying a variable annuity rather than a similar mutual fund is that variable annuities offer tax-deferred growth.

Mutual Fund Benefits

On the other hand, mutual funds have a long list of benefits that annuities can't match. For starters, mutual fund fees are generally much lower than those attached to annuities. Both fixed and variable annuities typically have large surrender charges, which start high and decrease by 1 percent per year. In many cases, you'll pay 6 or 7 percent if you want to get out of an annuity within the first year, and you'll be tied up with some sort of charge for six or more years. Variable annuities also have insurance charges, management fees, contract fees and other costs. Annuities also have an IRS restriction on withdrawals before age 59.5, with premature withdrawals triggering a 10 percent penalty.

The tax structure of annuities can also be unfavorable, as all profits taken out of an annuity are taxed at ordinary income rates, even if they were generated by long-term capital gains. Mutual funds are also typically more liquid than annuities, which often have surrender charges as long as 10 years; the most liquid mutual funds either cost nothing to sell or can be sold on the stock exchange at any time, in the case of closed-end or exchange-traded funds. You may have to pay a commission, but that will usually be much less than an annuity surrender charge, which can range from 1 percent to over 7 percent.

Annuity Vs. Mutual Fund

Overall, annuities can often be more complex for investors than mutual funds. Annuities often have complicated structures, offering various bonus payments and rider clauses to go with withdrawal restrictions and hidden fees. Mutual funds may not come with many bells and whistles, but they are easily accessible, both on the buy and sell sides, and they usually have clearly stated investment objectives and management methods.

When choosing which type of investment makes sense for your retirement, take an assessment of what is most important to you. If you need the comfort of a guaranteed income stream that will last your entire life, a fixed annuity issued from a reputable company may appeal to you. If you want to generate the highest possible account balance by the time you retire, that might tilt the scales toward a variable annuity or a mutual fund. If liquidity and low fees are a concern, annuities might not be your best option.

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About the Author

John Csiszar has written thousands of articles on financial services based on his extensive experience in the industry. Csiszar earned a Certified Financial Planner designation and served for 18 years as an investment counselor before becoming a writing and editing contractor for various private clients. In addition to his online work, he has published five educational books for young adults.


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