Annuities vs. Mutual Funds

Annuities and mutual funds each have a place in saving and investing. In most cases, however, one may be a better fit than the other. Your risk tolerance and your retirement timeline will determine whether an annuity or a mutual fund fits into your financial plan.

You’ll gain a better idea of which of these financial vehicles suits your goals if you understand the differences between them.

Annuities are contracts issued by insurance companies. They are designed to provide guaranteed income during a person’s retirement years and have the added benefit of nominal growth as compared with equity investments.

The customizable nature of annuities makes them ideal for people who have specific retirement and estate planning goals.

In addition, the tax treatment of annuities appeals to people who want to defer taxes until they reach the age at which they will begin taking distributions.

Whether deferred or immediate, annuities offer people the flexibility to reap the benefits of fixed rates or — if they’re comfortable with a less stable return — to develop a strategy for taking advantage of market gains.

These reasons for buying an annuity differ from the benefits of mutual funds.

The United States Securities and Exchange Commission (SEC) defines a mutual fund as “a company that brings together money from many people and invests it in stocks, bonds or other assets. The combined holdings of stocks, bonds or other assets the fund owns are known as its portfolio. Each investor in the fund owns shares, which represent a part of these holdings.”

Note that this definition refers to a mutual fund as a “company” and the fund’s holdings as a “portfolio.” This differentiation is significant because it can be a source of confusion for people who have limited experienced in investing.

To gain a clear understanding of a mutual fund, you can equate it to a product- or service-related business entity, such as Google. When you buy shares of Google, you’re purchasing a piece of the company and its assets. Similarly, when you buy shares of a mutual fund, you are buying a portion of the mutual fund’s holdings.

Unlike deferred annuities, mutual funds do not grow tax-deferred unless they are part of a qualified plan, such as an individual retirement account. However, taxable mutual funds do enjoy a “stepped-up” basis at death for tax purposes. This means that when a mutual fund holder passes away, the person who inherits the mutual fund holdings will not owe tax on the inheritance.

Most employer-sponsored retirement plans invest employees’ money in mutual funds.

As the Financial Industry Regulatory Authority (FINRA) notes, “Mutual funds are a popular way to invest in securities. Because mutual funds can offer built-in diversification and professional management, they offer certain advantages over purchasing individual stocks and bonds. But, like investing in any security, investing in a mutual fund involves certain risks, including the possibility that you may lose money.”

Returns from mutual funds are distributed differently from any returns one would receive from an annuity. Annuity holders receive payouts as a series of regular payments or, in many cases, as a lump sum at the time 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.”

Profits from the fund’s dividends and interest are called “income distributions,” and those from the fund’s sales of shares are called “capital gains distributions.”

The performance of a mutual fund is measured by the increase or decrease in the total market value of the fund’s shares.

Like annuities, mutual funds exist in a variety of categories, with each category offering unique benefits. Mutual funds also carry fees, similar to certain types of annuities, which vary depending on the type of fund, and some even charge penalties for early withdrawals.

Guaranteed lifetime income is the primary goal for people who buy annuities, whereas the objectives for people who invest in mutual funds range from aggressive growth to guaranteed income.

The overlap in these goals naturally leads to overlap in the ability of annuities and mutual funds to achieve these goals.

For example, index funds — one category of mutual funds — are similar to index annuities in that they align with a stock index, such as the S&P 500. Expenses are lower, so these funds appeal to investors who want growth opportunity without excessive management and administrative fees, also known as “expense ratios.”

This is similar a client choosing an indexed annuity for the opportunity to benefit from market gains without the risk of losing money.

Likewise, income funds are similar to income annuities, which are intended to provide a steady cash flow to the contract holder in retirement. The value of income funds can increase, but growth for this type of mutual fund is conservative and most suitable for retirees and people with low risk tolerance.

Once you understand the basic differences between annuities and mutual funds, you are better prepared to plan for your retirement years. If you are already in your retirement years, providing yourself with an immediate income may be a priority for you. No matter your timeline, your financial goals will determine which financial vehicle is suitable for you.