Variable Annuities vs. Mutual Funds

Key Facts About Variable Annuities vs. Mutual Funds

• Variable annuities accumulate growth based on the performance of underlying investments but are shielded from full market exposure.
• Mutual funds pool money for investing in securities such as bonds and stocks.
• Annuities have more tax advantages than mutual funds but are less liquid and may have slightly higher ownership costs.
• Annuities and mutual funds have different features. Which product is best for you depends on your goals and time horizon.

What Is a Variable Annuity?

A variable annuity is a type of annuity that accumulates value based on a portfolio of various securities. The performance of the investment portfolio determines the variable annuity’s value and how much income you receive from it.

Investors can customize their variable annuities to better align with their financial goals. You can choose which subaccounts your annuity’s value is allocated to. Subaccounts represent the securities such as mutual funds, stocks and bonds that form a variable annuity’s investment portfolio.

You can also add living benefits, which promise certain guaranteed returns. Living benefits help balance the investment risk that comes with a variable annuity. According to the Institute of Business & Finance, over 85% of variable annuities are sold with a living benefit.

Pros of Variable Annuities

• Tax-deferred growth
• Variety of investment options
• Lifetime income option
• Guaranteed rate of return option
• Death benefit option

Cons of Variable Annuities

• Complicated contracts
• Fees can be expensive
• Surrender charge
• Withdrawals/payments are taxed as ordinary income

Including both annuities and mutual funds in your retirement income strategy can help you address longevity risk, sequence of returns risk, market risk and liquidity in retirement.

Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®CEO of Blue Ocean Global Wealth

Marguerita M. Cheng, CFP®, CRPC®, CSRIC®, RICP®, is the chief executive officer at Blue Ocean Global Wealth. As a CFP Board of Standards Ambassador, Marguerita educates the public, policymakers and media about the benefits of competent and ethical financial planning. She is a past spokesperson for the AARP Financial Freedom campaign.

What Is a Mutual Fund?

A mutual fund is a company that pools money from many investors to invest in a diversified portfolio of stocks, bonds or other securities. When you buy shares of a mutual fund, you buy a portion of the mutual fund’s holdings.

Mutual funds offer instant diversification, professional management and liquidity. They also have the potential for higher returns compared to fixed annuities based on the mix of underlying investments in the portfolio.

The performance of a mutual fund is measured by the increase or decrease in the total market value of the fund’s shares. Profits from mutual funds are realized as dividends and interest (income distributions) or as sales of appreciated fund shares (capital gains distributions).

Investing in mutual funds can be a reliable way to diversify your portfolio, as mutual fund shares are invested in the portfolio of different securities the fund holds. However, investing in mutual funds involves market risk, along with other drawbacks.

Pros of Mutual Funds

• Portfolio diversity
• More liquidity than annuities
• Variety of investment options
• Professional investment management

Cons of Mutual Funds

• Low yields
• Can’t control how the fund invests your money
• Risk of losing principal investment
• Can carry a range of fees

Comparing Variable Annuities and Mutual Funds

Variable annuities and mutual funds can both be used as diversified investment vehicles to help you save for retirement. Though they share a similar function, these products have several important differences. 

However, they are not mutually exclusive investment options. To make the most of each type of investment, create a focused plan for what each asset will accomplish. Variable annuities have a more beneficial long-term tax profile but lack the liquidity that mutual funds provide.

Your risk tolerance and your retirement timeline should determine whether an annuity or a mutual fund best fits into your financial plan. The following chart from the Institute of Business & Finance highlights the key features of variable annuities and mutual funds.

Variable Annuities vs. Mutual Funds

Feature	Variable Annuities	Mutual Funds
Several investment options	✓	✓
Tax-deferred growth	✓
Tax-advantaged income	✓	✓*
Possible long-term capital gains treatment		✓*
Withdrawals of growth taxed as ordinary income	✓
Losses can be harvested for beneficial tax treatment		✓
Ability to make changes without taxation	✓
Guaranteed 2% to 6% min. annual appreciation	✓
Guaranteed 2% to 6% min. annual withdrawal	✓
Lifetime income option	✓
Systematic withdrawal program available	✓	✓
Investor controls all annual taxable events	✓
Creditors claim protection in some states	✓

Variable annuities are highly customizable products that can create a reliable income stream. “The main attraction and advantage of an annuity is that it serves as a source of tax-deferred and predictable income for individuals in their retirement,” Mark Stewart, a CPA for Step by Step Business, told Annuity.org. 

While variable annuities are somewhat less predictable than other types of annuities, the living benefits most contracts come with offer some assurance of principal protection and guaranteed minimum returns.

By contrast, mutual funds aren’t designed to set up an income stream, and they don’t come with the same protections as an insurance product like a variable annuity. When you invest in mutual funds, you risk losing some or all your principal if the fund’s share prices drop dramatically.

Rates of Return Differences

Because mutual funds and variable annuities both derive their rates of return from the performance of an investment portfolio, it’s difficult to predict or compare their returns.

Annuity holders receive their returns as a series of regular payments or, in many cases, as a lump sum when they become eligible to cash in their annuity.

In contrast, according to FINRA, mutual funds give you the option of receiving “distributions in cash or having them automatically reinvested in the fund to increase the number of shares you own.”

According to the Institute of Business and Finance, one of the most important factors to consider when comparing returns of mutual funds and variable annuities is the way investors behave in the real world.

Mutual fund investors might consider themselves “long-term investors,” but research from the polling group Dalbar shows that many fund owners sell before they get the most out of their investments.

Dalbar’s research found that fund investors experience just 50% to 75% of S&P 500 gains. This is not because the index performs better than the fund they chose, but rather because investors panic when share prices drop or sell off to try and chase a “hot” new fund. As a result, these investors lose out on the long-term gains that mutual funds are designed for.

Variable annuity owners, however, are more likely to stay the course. Living benefits may play a role in this phenomenon; the guaranteed protection allows investors to make more aggressive choices with their portfolio, knowing they will still receive some growth no matter how the market does.

Cost Differences

Investors must pay ownership costs for both mutual funds and variable annuities. According to the mutual fund advisory service Morningstar, owning mutual funds costs an average of 1.5% per year, while the average annual cost of owning variable annuities is 2.2%.

Common fees for variable annuities include administrative fees, mortality and expense risk fees, investment management fees and surrender charges. Typical mutual funds charge annual fees called expense ratios. 

The 0.7% gap between the ownership costs of these two products narrows if you account for additional costs associated with mutual funds. For example, selling or exchanging mutual funds can result in paying income tax. Receiving interest or dividend distributions from fund shares can also trigger a tax event. To avoid excess taxable income from ownership of mutual funds, investors should consider holding actively managed mutual funds in tax-deferred accounts.

Additionally, many mutual funds incur sales charges or commissions each time you purchase shares. These commissions typically cost between 4% and 5.5% but can be as high as 8.5%. Investors should be mindful of the share class of a mutual fund which may impact the total fees they pay and when. For instance, the same mutual fund may have Class A, Class B, and Class C shares where the nature of the fees differs.

Class A mutual fund shares typically have an upfront sales charge which will decrease with the size of your initial investment. Class B shares have no upfront fees, but instead contain a deferred sales charge which decreases the longer you hold the shares. Class C shares have neither upfront nor deferred sales charges but typically have higher yearly fees.

Liquidity Differences

Mutual funds are generally much more liquid than annuities. You can sell your mutual fund shares at any time. Unless your mutual fund is held within a qualified retirement plan, early withdrawals from the account won’t be subject to IRS penalties.

Annuities, on the other hand, are designed to be long-term investments. As a result, it’s difficult to withdraw funds from a variable annuity before the contract annuitizes and payments begin without facing hefty surrender charges. The IRS also levies a 10% penalty on any withdrawals made before you turn 59 1/2.

Taxation Differences

Variable annuities and mutual funds have very different tax implications. As mentioned, the tax-deferred growth of a variable annuity sets it apart from mutual funds and other comparable investments. Variable annuity owners don’t pay taxes until they start receiving money from their annuity, which can be especially beneficial for individuals in higher tax brackets. 

If the annuity is part of a qualified retirement plan like a 401(k) or IRA, all the money withdrawn or distributed is taxable. But most annuities are nonqualified, meaning they were funded with after-tax money and the payments from these kinds of annuities are only partially taxed as income.

Unlike annuities, mutual funds do not grow tax-deferred unless held within a qualified retirement plan. Any distributions are subject to taxes when they are received, and you’ll pay capital gains taxes if you sell at a profit.

Mutual funds are also subject to a tax liability known as “embedded gains.” Embedded gains occur when fund owners force shareholders to receive distributions from a fund’s profits even if the shares they own have dropped in price. The shareholder then owes capital gains tax on “earnings” from the mutual fund even though their potential net worth has decreased due to the fund prices dropping.

Embedded gains can happen at any time for mutual fund owners – though capital gains are usually paid out in mid-December – and there is really no way to anticipate or prevent this liability. However, embedded gains do not affect variable annuities since the principal is not directly invested in the market.

When comparing annuities and mutual funds, several factors come into play. Always consult with a financial advisor before making a decision.

Frequently Asked Questions About Annuities & Mutual Funds

Editor Hannah Alberstadt contributed to this article.