Comparing Annuity vs. Mutual Funds for Retirement
The annuity vs. mutual fund comparison for retirement accounts should include several key points, such as expenses, the need for income, and the investor's tolerance for risk. Annuities and mutual funds can be good investments for retirement but there are differences that investors need to understand before choosing which is best for their needs.
Before comparing annuities with mutual funds, let's cover the basics of how each works.
The first distinction to make is that there are two primary types of annuities -- fixed annuities and variable annuities. A fixed annuity works similar to a bond, which means that there is a fixed interest rate paid to the investor for a specified period. Variable annuities have sub-accounts that are typically mutual funds. Therefore, when there is a comparison between annuities and mutual funds, the annuities are typically variable annuities, not fixed.
It's also important to note that annuities are not investment securities; they are insurance products. This is a key point because it means that annuities are not regulated by the Securities and Exchange Commission (SEC). Therefore, insurance companies are not required to be as transparent about expenses as are mutual funds. However, an advantage of annuities as insurance products is that they can be guaranteed by the insurance company.
Annuities also grow tax-deferred, which means investors are not taxed on dividends, interest, or capital gains while their money is in the annuity. Also, the amount you contribute to the annuity (the cost basis) will not be taxed on withdrawal. Only the capital gain can be taxed.
Finally, annuities can be "annuitized," which means they can be turned into an income stream that is typically guaranteed for a certain period of time. For example, if you chose to receive a certain amount over a 15-year period, this periodic payment would be guaranteed during the term. You can also request payments over other terms, such as your life or your life plus the life of a beneficiary.
Annuities are most commonly used as a means of deferring taxes on investments or as a means of producing income in retirement.
Mutual Fund Basics
Mutual funds are pooled securities that invest in a particular set of underlying securities, such as stocks or bonds. Before buying mutual funds, the investor will open a brokerage account, an individual retirement account (IRA), or a 401(k) plan with their employer. The underlying security types, called holdings, combine to form one mutual fund, also called a portfolio.
There are thousands of mutual funds in the investment universe but they can be broken into a handful of types or categories of funds, such as large-cap stock, small-cap stock, international stock, and bonds. Mutual funds can be used for a variety of objectives but are most appropriate for long-term growth or for income while in retirement.
Which Is Right for Retirement?
Now that you know the basics of annuities and mutual funds, let's break down the key differences for investors, specifically those who are near or in retirement.
- Safety: If you want guaranteed income, annuities are your best bet. Since they are insurance products, the insurance company can offer a guarantee that you'll never receive less than a stated periodic payment. Some annuities also provide guaranteed growth, which can prevent severe losses in market downturns.
- Expenses: Keep in mind that guarantees are not free. Annuities tend to have much higher expenses than mutual funds. This is how insurance companies make money on annuities: in exchange for the guaranteed income or growth, they earn more in the market on your money and pay you less. Expenses on annuities can often be higher than 2 percent, whereas mutual funds can be much lower than 1 percent, especially if you use index funds, which can be as low as 0.10 percent.
- Returns: Due to lower relative expenses, Mutual funds can earn higher returns than annuities.
- Tax-deferral: Annuities grow tax-deferred but mutual funds can only receive this tax advantage if they are investing in a traditional IRA or Roth IRA.
The bottom line for retirees and other investors is that if you need a guarantee, annuities are best. If you want the potential for higher returns, and you don't mind taking on the added market risk, mutual funds are for you. If you do decide to invest in annuities, use a low-cost fund company like Fidelity or Vanguard, both of which offer low-cost annuities in addition to their mutual fund offerings.