PROS AND CONS OF ANNUITIES VS. MUTUAL FUNDS

What Is a Mutual Fund and How Is It Different from an Annuity?

Here’s the truth: Being in charge of your personal finances can be hard.

There’s a ton to know and it’s easy to get confused with all the different investment options out there.

No wonder financial advisors exist!

Annuities vs. mutual funds: If you're looking to save for retirement, you're likely interested in understanding the difference between annuities and mutual funds. These two popular investment options have many similarities.

They both can provide substantial investment growth over the long term. And both can be useful additions to your retirement plan. But while they are actually quite different from each other, they can be hard to differentiate. That's why we've dedicated this post to explaining the difference between annuities and mutual funds.

By the end of this article, you’ll be able to decide which product may help you best achieve your financial goals.

What Is a Mutual Fund?

A mutual fund is a product that pools together money from investors. It uses the funds to invest in a portfolio of securities.

You choose a mutual fund portfolio with an underlying investment objective based on your risk tolerance. You could choose a fund with a more aggressive approach that invests in riskier asset classes like stocks that gain and lose value quickly. This would be a higher risk, but with a potentially high reward.

Or, you could choose a mutual fund with a lower-risk investment objective. This might be a mutual fund that invests primarily in bonds or CDs.

If the securities that the mutual fund company invests in perform well, you can sell your shares and earn a profit.

But if they don’t, you could gain little or even lose your initial investment.

Additionally, depending on the securities in the portfolio, mutual fund investments can also earn dividends. The securities and exchange commission and FINRA oversee investment management and brokerage firms that sell mutual funds. This oversight helps reduce your risk of investment fraud.

What Are Annuities?

Annuities are insurance products that you buy from an insurance company. They can guarantee you lifetime income after you retire. They work like a pension that you fund yourself.

First, you pay the insurance company a premium. Then in retirement, the insurance company pays the money back to you with interest.

Annuities are popular saving options for retirement. The regular monthly income stream they can provide makes it easy to plan for your desired retirement lifestyle.

Different Types of Annuities

There are many different types of annuities, each with its own unique features. The options give you the flexibility to choose a product that best suits your needs and financial situation.

Immediate vs. deferred annuities

Immediate and deferred annuities differ in terms of when you begin to receive income.

With immediate annuities, the insurance company starts to pay you back soon after you buy the annuity. With deferred annuities, your payouts are deferred.

Your annuity grows tax-deferred over time, and you receive payouts years in the future.

Fixed, variable, and fixed index annuities 

Annuities also differ in how their interest is calculated.

Fixed annuities have a fixed minimum interest rate guaranteed for the term specified in the annuity contract.

The insurance company can increase the fixed rate. However, your interest rate will never fall below the minimum stated in your contract throughout the term of your annuity contract.

Fixed annuities are one of the safest kinds of investments because, as long as you keep the funds in the contract during the surrender charge period, you’re guaranteed to never lose money. And the crediting rates for fixed annuities are often better than those for other types of low-risk investments, like certificates of deposit.

Variable annuities are the type of annuity closest to mutual funds. That’s because when you buy a variable annuity, you choose sub-accounts to invest your money in. Throughout your variable annuity contract, your crediting rate will fluctuate.

The crediting rate that you receive depends on the performance of your chosen investments. If your investments perform well, your rate of return can be quite high. But if your investments tank, you could end up making no money—or even losing money. 

Like mutual funds, variable annuities are risky because you don’t know how the market will perform. Therefore, your money may grow, but it may not.

Fixed index annuities work like a hybrid of fixed and variable annuities. Like a fixed annuity, fixed index annuities have a fixed minimum interest rate—usually 0%. That means that you won’t lose money. However, like a variable annuity, your interest rate depends on stock market performance.

You choose a market index (like the S&P 500) for your annuity to follow. If your chosen index does well, the crediting rate you receive may be quite high. If it doesn’t, you may make very little or even no money. Different insurance companies allow you to choose from different indexes and crediting methods.

Single premium vs. flexible premium

There are also different ways to purchase an annuity. In a single premium annuity, you pay your premium upfront with a single lump sum. With a flexible premium annuity, you pay in installments over a period of time.

How Does an Annuity vs. a Mutual Fund Compare?

Mutual funds and annuities come with their own unique advantages and disadvantages. Explore how each investment compares on liquidity, taxes, contribution limits, risk level, and associated fees.

Access to funds

Mutual funds have more liquidity

You can expect mutual funds to be fairly liquid. You can usually sell your mutual fund shares any time you want (usually at the close of the stock market for the day) without any early withdrawal penalties. You’ll typically receive your proceeds within a few days. They are much more liquid than annuities.

Annuities have limited liquidity

Annuities are long-term investment products designed to provide you with income in retirement. They’re not for short-term savings or investing. With immediate annuities, once you hand the money to the life insurance company, it is no longer yours and you cannot get it back. You have to wait for your disbursements. With deferred annuities, you can withdraw from your annuity early, but you could face early withdrawal fees or tax penalties if you do.

Taxes

Mutual funds tax advantages depend on your distributions

Distributions from mutual fund fall into a few categories with unique tax situations:

• Dividend earnings from mutual funds are taxed as ordinary income.
• Profits from sold shares held for less than a year are also taxed at your regular income tax rate.
• Profits from sold shares held for a number of years face a capital gains tax as opposed to an ordinary income tax.

For many people, the capital gains rate is lower than their income tax rate. That means that if you hold your shares for longer, you could potentially pay less tax on a mutual fund than you would on an annuity. However, it ultimately depends on your income tax rate.

Mutual funds are not tax-deferred

With mutual funds, you pay taxes on earnings every year, which is a disadvantage compared to annuities. The exception is when the mutual fund is held within a retirement account like a traditional or Roth IRA. In that case, they can also grow tax deferred.

Annuities have the advantage of being tax-deferred

You don't pay taxes on annuity funds until you withdraw your money. Annuities are taxed as ordinary income.

And because you usually receive your annuity payments in retirement when your income is quite low, your taxes are also usually quite low. Additionally, since annuities are tax-deferred, more of your money stays in the annuity to compound. This helps your annuity’s account value to grow larger at a quicker rate.

Contribution limits

Mutual funds have no contribution limits

Mutual funds typically don’t have any limits on how much you can invest. You can buy as many mutual fund shares as you like.

Annuities have no contribution limits

Most annuities don’t have any contribution limits. That makes them advantageous over some other types of retirement accounts like IRAs and 401(k)s.

Risk

Mutual funds can be higher risk for investments

Unlike a fixed annuity, mutual funds do not offer guaranteed growth. Instead, growth depends on the performance of the securities that make up the mutual fund. If those securities do poorly, you could lose your money.

Annuities are lower risk with guaranteed income for life

Fixed annuities offer guaranteed growth with guaranteed minimum interest rates. They’re very low risk. (Variable and fixed index annuities are riskier.)

As you do your research, remember to buy from insurance companies that are rated “Good” or better from rating agencies because it’s the insurer that backs your annuity.

Fees

Mutual funds can have additional fees

Mutual fund companies usually charge fees for managing the mutual funds. These fees are called "expense ratios," and they can be between 1% to 2% of your investment.

They also usually charge sales commissions, known as “loads,” when buying or selling shares. Loads are often around 5% of the sale price.

Annuities can come with management fees 

Some insurance companies charge annuity fees to manage your account. That’s why it’s so important to read your annuity contract carefully and choose an insurance company you can trust. At Canvas, our annuities have zero commissions, account charges, or fees.

Annuity vs Mutual Fund: Summarizing Similarities and Differences

Annuities and mutual funds are both effective ways to invest your money for retirement.

Here is a quick final summary what they have in common and their differences.

Similarities

BODY:

• Grow Money: Both annuities and mutual funds can grow your money over time.
• Retirement Income: Both can be held in individual retirement accounts and used for retirement purposes.
• Stock Market Dependent: Variable annuities, fixed index annuities, and mutual funds provide rates of return that depend on stock market performance. (Note that fixed annuities do not depend on the stock market.)

Differences

BODY:

• Tax Deferral vs. Annual Taxes: Annuities grow tax-deferred. Mutual funds only receive this advantage if they are held within a traditional or a Roth IRA.
• Ordinary Income Tax vs. Capital Gains Tax: The IRS taxes most mutual fund earnings as capital gains. Annuity income is taxed as ordinary income.
• Guaranteed Retirement Income vs. Income Not Guaranteed: Annuities guarantee retirement income. Mutual funds can grow your money and provide an income, but it is not guaranteed.
• Guaranteed Interest Rate vs. Volatile Interest Rate: Fixed annuities provide a guaranteed interest rate, so your money is sure to grow. Mutual fund growth depends on market performance. (Note that both variable annuities and fixed index annuities depend on stock market performance as well.)

Which Is Right for You?

So now that you understand the differences between annuities and mutual funds, you’re likely wondering, “Which is right for me: an annuity or mutual fund?” Both can be valuable ways to grow your money for retirement. The right one for you depends on your financial goals, your retirement income needs, and your risk tolerance.

Choose an Annuity for Lower Risk

Most people planning for retirement want to make sure they’ll have enough to survive on.

Fixed annuities provide a fixed interest rate, so you can rest easy knowing how much your money will grow. If you want guaranteed investment growth (and the peace of mind that comes with it), annuities are the way to go.

Choose an Annuity for Guaranteed Income for Life

Annuities are the only product that can guarantee income until you die. If you want the financial security of a steady income for life, an annuity is a better bet.

Mutual Funds and Variable Annuities Can Provide Higher Returns

The higher risk of mutual funds may provide higher returns. That’s the same with variable annuities—there’s a chance that if you pick the right investments, you’ll get a higher return than you would with a fixed annuity.

If you want to try to maximize your earnings and are willing to put yourself at a higher risk to do it, a mutual fund or variable annuity may be a good choice for you.

How do you choose between a variable annuity vs. mutual fund?

Well, they are similar in that they both provide returns based on stock market performance. The difference is that with the annuity, your money is less accessible… but it also will provide you guaranteed income in retirement.

With a mutual fund, your money is more accessible, but there is no guaranteed income. Depending on which is more important to you—access to your funds or guaranteed income—a variable annuity or mutual fund may be a better choice for you.

Choose Mutual Funds for Short-term Investing

Annuities are retirement planning instruments.

They’re meant to be purchased for the long-term. If you want an investment vehicle for the short term, mutual funds are a better choice.

It’s Never Too Early To Plan for Your Retirement

The strength of both annuities and mutual funds is in their potential to grow your retirement savings.

Over the long term, these investment options can put your money to work and help increase your wealth. That’s why it’s never too early to start thinking about retirement. The sooner you get your money working for you, the more secure you’ll feel when you’re ready to stop working.

At Canvas, our annuities help thousands of people feel more secure about their financial future. If you want to learn how to obtain guaranteed income payments in retirement, talk to our licensed representatives. It could be the best retirement move you make.

The information in this article is accurate as of June 17, 2021. Please visit our site for the most up-to-date information.