As the economic environment becomes tougher, the debate about having an annuity vs. mutual fund for retirement continues. Many Americans, including Veterans, have long turned toward annuities to convert their retirement nest eggs into guaranteed lifetime income streams when they stop working. However, the low capital gain tax and simplicity of mutual funds continue to fuel their popularity in retirement plans.
Is an annuity still a suitable investment for your golden years? Discover the difference between annuities vs. mutual funds so you can make the right decision for your financial plan.
What Is an Annuity?
An annuity is a bond between an insurance firm and an individual, in which an investor places money into an account and gets guaranteed payments within a specific timeframe.
“Annuitization” of the funds allows you to receive an agreed sum of money during your retirement, securing your income in your later years. You can also pick an annuity plan with lifetime payments or your life, plus that of your beneficiary’s life. There are two primary types of annuities: fixed and variable.
Fixed annuities pay an established rate of return. An insurance company guarantees the return, and you get your money back plus interest if you hold the fixed annuity for a specific period (usually ten years).
Fixed-rate annuities are good options for people who want to make sure they have their principal protected. They may not be ideal for investors who are looking for high returns.
Variable annuities pay market rates. The sub-accounts typically represent a mutual fund wrapped in a deferred-tax insurance product. Much of the comparison of annuities vs. mutual funds typically involves variable annuities, as they have much more in common.
Payouts for a variable annuity can be guaranteed for life, regardless of the investment earnings. You can also include a death benefit payout clause. However, the amounts fluctuate over time, depending on the performance of the underlying assets in the market.
Advantages of Annuities
- Guaranteed returns for the agreed period.
- Principal protection with minimized risk of losing your money.
- Deferred distributions that allow delayed payments until you attain retirement.
- Better protection from market losses, with most insurers being more conservative about investments.
- Legacy inheritance for your dependents.
- Access to your funds, up to a specified amount, without any penalties.
Downsides of Annuities
Traditional annuities have a higher minimum investment requirement with similarly high upfront charges. The commissions and management fees charged beforehand can reduce the amount invested in your annuity.
However, there are alternatives to traditional annuities that allow you to keep your money. For example, AAFMAA’s ANNUITYLife®, doesn’t charge any upfront fees, commissions, or other surprise fees. This means your entire savings is put toward your retirement income, you only pay low fees out of the proceeds your money makes for you.
What Is a Mutual Fund?
A mutual fund is an investment solution that pools money from many investors to buy stocks, bonds, or other assets. Mutual funds are managed by professionally trained money managers who invest in various securities on behalf of the fund’s shareholders.
The investors buy shares in the “company,” with the pooled funds invested across multiple industries, stocks, and bond options. There are thousands of mutual fund products available. Some of the common categories are:
- Index funds
- International funds
- Small-cap stock
- Large-cap stock
- Balanced funds
- Fixed-income funds
The investment is based on a particular objective. You may need to consult your investment manager to understand your financial plan before settling for a specific mutual fund.
Advantages of Mutual Funds
The leading benefit of investing in mutual funds is diversification. You’re able to spread your risk across multiple investments at once. This minimizes the threat posed by one particular stock or bond failing, which could tank your portfolio if you depended on just one or two investments for your retirement savings.
Mutual funds are liquid and easy to sell because investors can buy or sell their shares anytime before closing out their accounts. Again, it is advised to consult your investment manager before closing a mutual fund as there could be tax implications. Some additional benefits of mutual funds include:
- Professional asset management, minimizing the stress of picking the right stocks and index funds to invest in.
- Lower minimum balance; more accessible.
- Simple to understand and a great variety to choose from
Mutual funds allow the distribution of earnings as dividends, capital gains, sale of shares, or reinvestment into the fund. Reinvestment will enable investors to hold more shares as a long-term investment strategy.
Downsides of Mutual Funds
With mutual funds, there are a few disadvantages to keep in mind. Mutual fund managers often charge high fees to run these funds, which can significantly eat into your earnings.
Investing in mutual funds can also mean that you have little to no control over which stocks or bonds are included in your basket of investments. Aside from a basic investment thesis of industry, time horizon, size, etc., you simply buy shares and rely on the managers to pick the best assets. As with any investment, returns aren’t guaranteed and loss is possible.
Annuity vs. Mutual Fund: Which Is Right for Your Retirement?
Now that you understand the basics of annuities vs. mutual funds, let’s explore the differences that can impact your investment choice.
Annuities are insurance-backed programs offering principal protection to the holders. There’s less risk of losing your money, depending on the type of annuity you pick. Mutual funds have no recourse, and volatile market conditions can lead to the loss of your investment.
Guaranteed payments during retirement can provide an income safety net when you opt for an annuity. It’s essential to note that the past performance of a mutual fund isn’t an indicator of future earnings.
Annuities grow tax-deferred. Mutual funds can enjoy the same privilege if invested through a traditional IRA or Roth IRA. It includes all of the income and capital gains reinvested in the fund.
Non-qualified mutual fund accounts may have to report income and capital gains on their tax forms. Luckily, long-term capital gain taxes for assets held longer than one year are typically lower than ordinary income. Ordinary tax income can range from 10% to 39.6%, while long-term capital gains range from 0% to 20% maximum. Short-term capital gains are taxed like ordinary income.
Mutual funds have the potential to earn significantly higher returns than annuities, but nothing is guaranteed and you are at risk for loss.
Annuities are more conservative, as insurance companies look to preserve your principal amount and provide guaranteed returns. Mutual funds may offer more flexibility in withdrawal and settlement options, while many traditional annuities charge penalties for early withdrawals above a specified amount.
The guarantees in traditional annuity plans can come at a cost. You may have to pay for high commission rates upfront, with some products charging nearly 10% of the original investment right off the top before you even start earning anything.
Additionally, you may have to incur mortality expenses and administrative costs. These kinds of administrative fees and commissions can make traditional annuities more expensive than mutual funds. Consult your financial planner to understand the costs of either investment vehicle.
When to Choose an Annuity
An annuity is a good option for those who want to protect their assets. So if you’re looking to park your money, leave it alone to grow, and want a guarantee it’ll be there with interest when you need it, an annuity might be the right choice for you.
Additionally, if you are concerned about market fluctuations and feel that investments are too risky for you at this stage of life, an annuity could also be worth considering. The guaranteed income through annuities makes them an attractive option in the annuity vs. mutual fund comparison.
When to Choose a Mutual Fund
If you want to invest in a diversified portfolio of stocks and bonds and don’t have the time or inclination to monitor the performance of your investments constantly, then mutual funds may be the way to go.
They’re also good if you want to invest in a specific sector or industry because they enable you to do so without conducting research on individual companies yourself.
Mutual funds also allow investors with different risk tolerances (or time horizons) an opportunity for investment diversification within their portfolios. Lower-risk investors can select low-risk mutual funds.
Those willing to take on more risk could choose higher volatility mutual funds that invest in equities and other assets with higher-risk profiles than fixed-income holdings such as bonds and cash equivalents.
We’re Here to Help
If you’ve wondered about the differences between annuities and mutual funds, we hope we have helped answer your questions. Each has its benefits, depending on what type of investor you are, your risk tolerance, investment timeline, and your retirement goals.
Talking to an expert about the specifics of your situation is always a great idea before you make decisions involving your finances. There’s no substitute for personalized advice from someone with direct knowledge and experience in helping military service officers prepare for retirement.
Contact AAFMAA’s Life Insurance team for more information.