Indexed Annuities Vs Mutual Funds

Indexed annuities are always compared to mutual funds as people approach retirement. This isn’t because the two concepts are so similar. In fact, the two products are very different. The comparisons are mainly done during sales presentations and depend upon who is doing the selling. Many people invest their retirement assets in mutual funds during their working careers. Then as they approach retirement, they begin to think about annuities to guarantee them lifetime monthly payments.

It is the insurance salesman tries to convince these investors that a guaranteed index annuity is the way to go. The account representative at your brokerage firm tries to stress that annuities are too inflexible and, therefore, mutual funds should be used throughout retirement. Why? The insurance salesman will get a commission if the money is moved. The account representative will lose an account if the money is moved. Both have monetary motivation to state their case.

The Case for Mutual Funds

Mutual Funds come in many flavors and sizes. Presumably, the retiree would invest in a mixture of stock funds. These equity funds would include large growth stocks, large value stocks, small company growth and value stocks. The retiree would also include a number of bond funds which would be a mixture of short term, medium term and long term bonds.

The stock and bond funds together would create an optimum blend of investments that would provide long term growth and a reasonable level of risk.

Over the long term, no-load mutual funds might be the best vehicles to hold one’s assets. These are relatively very cheap methods of getting market growth. Mutual funds have historically returned double digit growth during times of stock market increases. Double digit decreases have also been experienced, but this is usually downplayed as compared to the growth potential over the long term.

Any other method of investing one’s assets during retirement, the account representative would say, would tie up the retiree’s assets, or expose the retiree to an unacceptable level of risk.

The Case for Indexed Annuities

Indexed annuity combines some aspects of fixed annuities and stock market performance. Prior to retirement, you receive interest based on the performance of a stock market index, such as the S&P 500 index. If the index rises, your account is paid a portion of the gains via a higher interest rate. Your portion of the upside is determined by the interest rate cap in effect under your contract. Some contracts have high caps, where you might get 70% of the stock market participation. Others may have lower caps to limit the upside potential.

If the index drops, you are protected from losses since your principle is guaranteed. The insurance company guarantees to credit your contract with a minimum guaranteed rate of interest. Then when you retire, you will begin to receive guaranteed monthly payments for life.

The indexed annuity gives some upside potential with a guarantee against loss of principal. A mutual fund cannot even come close to this combination of factors.  An insurance company is the only entity that can make such guarantees.

To pay for these types of guarantees, the insurance contract will have higher expenses than mutual funds. They also have surrender charges which are imposed if the contract is terminated in the early years, usually the first 7 years.  The insurance salesman will tell you that this is a small price to pay for such lifetime guarantees.

Annuities are also tax deferred. You only get taxed on the earnings portion when payments are received. Earnings that stay in the contract are not taxed until withdrawn. This is in contrast to mutual funds where a movement of assets from one mutual fund to another would be a taxable event. Taxes would need to be paid on earnings anytime you rebalance your mutual fund lineup.

Which Investment is Best

There is no best investment in a general sense. Investments are either more or less appropriate given a particular financial situation.

The common middle class couple approaching retirement does not have a large nest egg and needs to live on a monthly income, including social security. If they do not have company pension or 401k plans, their smaller nest egg is going to have to be stretched to last for many retirement years. An indexed annuity in this situation would be ideal. The couple can have the comfort of knowing they will have the annuity check coming in for life with some upside potential. This couple does not need the insecurity of mutual funds possibly not producing enough earning for the couple to live out their lives. If more money is needed after buying the indexed annuity, one or both retirees can get part time jobs as a supplement.

For highly paid workers or those fortunate enough to have a defined benefit pension plan and a 401k plan, less certainty of monthly payments is needed in retirement. The company pension will provide a monthly payment, which is essentially an annuity. The other assets can be invested in securities which will provide more long term growth potential. For these people, mutual funds make more sense in retirement for a major portion of their assets.

Analyze Your own Situation

No article can give you a sufficient analysis of your financial situation to lead you to the right answer. You need to make this judgment call. However, if it appears that you will be better off with an annuity, your greatest challenge is going to be committing your assets and giving up control of your investments. This is quite difficult to do mentally. However, the peace of mind you will experience knowing exactly how much will be coming in every month is an advantage you should not ignore. You will be able to sleep at night.

Are Variable Annuities Good or Bad

Variable annuities have had a lot of articles written about them. They are advertised as insurance contracts with guarantees and the potential of stock market gains over time. They are also criticized as being overly expensive, hard to understand and inflexible. So are variable annuities good or bad?

Good or bad is not the right terminology when considering a major product offered by most insurance companies. The better terms would be appropriate or inappropriate when looking at your individual financial situation. Any insurance contract can be a benefitin a particular financial situation. You need to understand the variable annuity to determine if it might be appropriate for your long term goals.

How a Variable Annuity Works

A variable annuity contract was designed by the insurance industry to compete with the mutual fund industry. It has provisions for guarantees, deferral of taxes on earnings and death benefits, similar to fixed annuity contracts.

Where the variable annuity is unique is that prior to the time when you start receiving annuity payments, you can select how your account value will be invested. You can choose to have your money invested in a number of mutual funds. The insurance company decides which mutual funds will be offered under the contract as investments. These do not necessarily have to be in mutual funds managed by the insurance company. Many companies allow you to select funds from major mutual fund families such as T. Rowe Price, Fidelity, Scudder, etc.

It is important to understand that during this accumulation phase of the contract, you are picking your investments. It is the same as taking your assets and placing them in a combination of stocks and bonds or mutual funds. So, all investment gains or losses are applied to your particular contract.

Once you retire, you will start to receive guaranteed benefit payments for the rest of your life. However the amount of benefit payments will be dependent upon the performance of the mutual funds you selected as your investments.

The Advantage of the Variable Annuity

The primary advantage of the variable annuity should be obvious. During the accumulation phase you are permitted to determine how your money will be invested. Many contracts also come with riders that you can select to increase the level of guarantees you have under the contract. For example, one such writer will guarantee that you are fund balance will never fall below a particular amount. In essence you may gain the upside investment potential, without risking the downside loss. Such guaranteed riders are not available if you invest all of your assets in plain mutual funds with the brokerage company.

Income taxes on your earnings are deferred until you take money out of the contract. You can adjust your portfolio investments as you wish. Moving money from one mutual fund to the other as the economic climate changes gives you flexibility. This can be done without triggering a taxable event as long as the money stays within the contract.

If you put your money directly into plain mutual funds, you will be taxed on the earnings each year, unless your investments are covered under an IRA or 401k. Any portfolio adjustments will trigger a taxable event and determine if you pay ordinary tax or capital gains tax on those assets.

You have complete control over your investments during the accumulation phase. This combats one of the major objections to buying deferred fixed annuities where you are credited with a fixed rate of interest each year.

Of course, with all the advantages of a variable annuity, there must be disadvantages.

The Disadvantage of a Variable Annuity

When investing in equities, you need to understand how the stock markets works and build a diversified portfolio of quality mutual funds. Many people simply do not have the experience and knowledge necessary to do this properly. They risk putting their money in the wrong funds at exactly the wrong time in the economic cycle. Such investing will have a large impact on the level of eventual annuity payments at retirement.

Guarantees come at a cost. Annuity contracts carry much higher expenses than if you had invested in plain mutual funds. Mutual funds can be relatively cheap, especially if you use no-load funds for your investments. However, with mutual funds you do not get any guarantees attached to you portfolio.

Along with higher annual expenses, the variable annuity contract also imposes a surrender charge if you terminate the contract during the early years, usually 7 years. You need to view a variable contract as a long term contract as opposed to mutual funds where you can move in and out of them each day if you wish.

Annuities at retirement require a commitment. Once you go into pay status, you cannot merely change your mind and try to withdraw your money. So, be sure that long term annuity payments are what you want before you start to receive payouts.

Diversify Your Retirement Nest Egg

Even if you decide that a variable annuity is a good choice for your financial situation, do not put all your assets in one contract. The first rule of financial planning is to diversify your investments. No investment will perform the best all the time. Diversification allows you to smooth out the ups and downs of markets. It provides protection over the long term.

Consider putting part of your retirement nest egg in a variable contract and keep the remainder in other types of investments. On the whole, your total portfolio should be balanced throughout the accumulation years. You can then decide at retirement how much should be in a life annuity and how much should continue to be in growth investments.


What Are Annuities Used For

For many years, annuities were simply a method of receiving a stream of payments in exchange for a large chuck of money up front. During the latter part of the 20th century, annuities were modernized by the insurance industry so that they fit just about all financial situations.

Annuities offer flexibility in many of their provisions. You have flexibility of how and when money goes in to an annuity, how and when it comes out, and the investments that will be used by your money is in the contract.

If you are lucky enough to have a defined benefit pension plan, you actually already have an annuity. Once you retire you will begin to receive payments for the rest of your life under some type of payout option. In this situation, you may wish to buy an annuity to supplement that pension income. However you will probably want to put any additional assets into investments which allow for greater capital gain during your retirement years. This might include various types of mutual funds, or a combination of stocks and bonds.

As you can imagine, each person’s financial situation is different and, therefore, the reasons for buying an annuity differ also. Let’s look at some of the more common reasons.

Guaranteed Lifetime Income

Having a guarantee that you will receive payments for the remainder of your life is probably the primary reason people buy annuities. An annuity can be bought at any time. You can start an annuity program in your 20s and contribute a small amount each month into the contract. In this case you would have a deferred annuity since payouts will not start for a number of years in the future.

You can put your money into a contract all at once, such as just before you retire. In this case you would have an immediate annuity since you begin to receive payments shortly after you pay the entire premium. This latter method also gives you complete flexibility during your working career to invest your money in any type of investment program you desire. However, when you retire, you may desire more security in receiving monthly payments, and that is the point at which you would buy the annuity.

There are a couple of considerations you will have when deciding to buy an annuity. Your first concern should be the safety of the insurance company. Since you are making a very long term commitment with your assets, you want to be sure that the insurance company is going to be in existence for a very long period of time. However, insurance companies do become insolvent periodically. For this reason it is imperative that you select an insurance company that is well-known, healthy, and is highly rated by the rating agencies. The primary rating agency that you should review is A. M. Best.

Another consideration is being locked in long term to a single interest rate. The advantage of having a fixed payment each month for your entire life, also becomes a disadvantage. Inflation is the number one problem that a retiree faces over a long period of time. Living on a fixed income each month may be nice at first. However inflation will erode your purchasing power steadily during your retirement years. A new car which costs $20,000 today may cost $40,000 a number of years into retirement. A can of soda which today costs one dollar, may cost you $2 dollars in the not too distant future. Your fixed annuity will not keep pace with inflation.

It is the inflation problem that prompts many financial planners to suggest that you do not place or your assets in a fixed annuity. You need some of your assets placed in investments which will outpace inflation. So if you are considering a fixed annuity at retirement, you may place half your assets in an annuity contract, and invest the other half in a portfolio of high-quality stocks and bonds or mutual funds.

Periodic Payments

Annuities are used in various situations in which periodic payments are required. An annuity does not always have to be paid for life. Also an annuity does not have to be bought from an insurance company. Any form of periodic payments is technically deemed an annuity. Insurance companies are needed if you wish to receive additional guarantees of payments for life.

One such situation involving periodic payments might be a corporate buyout situation, in which a company pays a business partner for a specific period of time. Or, the company could be a partnership in which one of the partners wants to leave. Here, the partnership would pay the departing partner over a number of years.

Even your state lottery uses annuities for periodic payments. Most people think when they win the lottery that they will get a lump sum. However many of the states have lottery rules where the amount of winnings will be paid over a certain period of time, such as 20 years. You may still be able to select a lump sum, however you will receive much less than you think. For instance, as a general rule from, if you win $1 million, you can expect 50% of that to pay for federal and state taxes. If your state has a rule that the winning amount will be paid over 20 years, and you want a lump sum, you can expect another 25% reduction in the overall amount. So the amount you actually receive in this example will be roughly 25% of the overall lottery winnings. This is not widely known and is a shock to state lottery winners.

Asset Accumulation

Annuities can be used during the asset accumulation phase of your career. The annuity product was originally constructed so that you put in monthly amounts and when you finally retire you would begin to receive payments. The interest credited to your account is guaranteed at all times and you are guaranteed against loss of principle.

In order to stay competitive with the mutual fund industry, insurance companies developed the variable annuity. This type of annuity contract allows you to invest your account value in various mutual fund investments. The purpose is to allow greater growth potential by having your assets invested in stocks and bonds type funds. Of course, such investments carry additional risk. So the insurance company is not providing guarantees of interest and principal during the accumulation phase of the contract.

The variable annuity contract is also fairly expensive when compared to ordinary mutual fund investments. For this reason, many financial planners suggest that you place your assets in various high-quality usual funds during your working career and then by a single premium immediate annuity at retirement.

Tax Shelter

Contributions to annuity contracts are made with after-tax dollars. You get no tax deduction on your contributions. However, while your money is in an annuity contract, you are not taxed on any earnings are capital gains. You are only taxed when you make withdrawals.

High earning workers will usually make the maximum contributions to their 401(k) plan and, if eligible, to some type of IRA plan. If they are still looking for additional tax deferred investments after that, they might consider an annuity. Tax deferrals under annuities can be delayed all the way up to age 70 1/2. At this age, the tax law forces you to start taking withdrawals.

For those who buy the annuity to receive lifetime income, the tax on any earnings is spread out over the life of the recipient. Your beneficiaries also have tax advantaged options in when and how they wish to receive payments after your death.

Sound Sleep

Relative to the guaranteed income stream that you receive during retirement, the greatest advantage of an annuity is the feeling of security you receive when you retire. You can go to bed at night with the assurance that you will receive payments each and every month while you live.

Financial planners do not emphasize this point enough. Even if you have a large portfolio of stocks and bonds, you may still have the nagging feeling in retirement that you could outlive your assets. With an annuity, this feeling goes away. You might wish that your payments for higher each month, however, the feeling of certainty is a very real advantage of an annuity. You may not know this feeling until you retire. So, ask a retiree who does not have an annuity, and he will tell you that his number one fear is outliving his assets. With an annuity, you will not have this fear.


How Can Annuities Help You

The subject of annuities brings many different reactions from people. Those who are nearing retirement, and will have their pension plan benefits coming in the form of lifetime annuity are naturally quite pleased with their financial situation. Then there are those who voice the fact that you lose control of your assets when you buy an annuity.

The main agreement appears to be lifetime guarantee in exchange for long term commitment of your assets. There are many different types of annuities, so we will focus on the type of annuity where you pay the entire purchase price at one time near retirement, and receive lifetime guaranteed payments. This is known as a single premium immediate annuity. You put your money in and start receiving payments within a month or so.

Annuities Compared to Stocks

In trying to decide if you should buy an annuity, you need to look at what the alternative would be if you kept your money invested yourself and tried to receive monthly income. Financial Planners will recommend a portfolio of stocks and bonds. Stocks will provide long term appreciation which is not available to an annuity owner.

Any comparisons of annuities to a stock portfolio will be done using stock market performance for the last 20 -40 years. This performance will probably be in the area of 10% return. So the financial planner will tell you that a portfolio of stocks should return approximately 10% over the long term in the future.

The problem is stocks carry much additional risk of losing your principal, and will not produce a fixed income. While you could just decide upon a fixed amount to withdraw each month from a stock portfolio, you are totally at the mercy of the companies in which you invest foregoing dividend payments. There is a total lack of security and risk of loss when looking at stocks for long term pension payments.

If you need to withdraw principal at some point, you risk doing so at exactly the wrong time, which would be during a recession. You still have the control that you wanted over your portfolio, but during these market downturns you will probably wish that you had locked up your money in an annuity.

Annuities Compared to Bonds

Annuities are usually compared with a portfolio of bonds in deciding if the annuity is a good deal. This is a good comparison since a bond portfolio will produce a steady flow of interest payments which can be withdrawn each month as your pension payments. This is also a good investment to compare since it is closer to what an insurance company would invest in when quoting your annuity.

Insurance companies take your annuity premium and invest it in their general account. The general account of any insurance company is the giant fund or holding bin for all income producing assets. It this fund which, by law, backs all the future payments that will be made under all of the company’s guaranteed products, such as life insurance policies and annuities.

Due to the nature of the products and long term guarantees, the general account contains conservative fixed investments. These investments will vary, but will include large blocks of treasury bonds, corporate bonds, private placement bonds, loans and some real estate. Stocks will not be included in the general account or will be a very minor portion of the account.

Theoretically, the insurance company will take your annuity premium and buy a portfolio of bonds. In reality, your premiums merely get added to the general account. But the general account is buying and rolling over maturing investments every day. The insurance company will base its pricing model on the investments that can be purchased that week or month. So the insurance company will actually base their pricing on the movements of the bond markets at any particular point in time.

The comparison of your buying a portfolio of bonds, vs. the interest rates the insurance company quotes to you, is actually a very real comparison.  If you can buy a diversified portfolio of short and long term bonds earning a certain level of interest, the insurance company can do the same. Actually, the insurance company’s general account is invested in longer maturity bonds than you would buy. The general account has enough cash and maturing investments to cover short term liabilities so new money coming into the account is usually invested for longer periods.

Your Bond Portfolio vs. the Insurance Company Pricing

If you buy a bond portfolio to create payments over your entire retirement period, you will diversify this into short, medium and long term bonds. You need short term to ensure there is always enough cash to pay your benefits in case interest payments should drop at some point.

Since the insurance company is investing longer term with any new premiums, the company should be able to provide a higher monthly payment than you could achieve with your bond portfolio. Long term bonds normally produce more interest than shorter term bonds. This is normally true and you also get the insurance company guarantee for life.

However, the insurance company needs to reduce their quoted interest rate a bit for safety and to pay for the guarantees they are quoting under the contracts. They also have expenses, which will be higher than those in running your own bond portfolio.

So, what can you expect when getting an annuity quote? The quote you receive as your monthly guaranteed payment will actually be fairly close to the payment you can achieve when investing in your own portfolio of bonds. That’s right, the two numbers will not be that far apart. If they are, you need to look at the types of bonds you are considering buying. Are they lessor quality corporate bonds? Are they smaller company bonds? If so, you may be taking more risk in your portfolio than you should. With the insurance company general account, the assets are invested in fairly high quality, diversified, fixed income investments.

Commitment vs. Guarantee

The question really comes down to your making a long term commitment compared to keeping control over your portfolio. If you are getting a good interest rate quote from the insurance company, and you cannot get much more on your own, why not go for guaranteed lifetime payments? Many financial planners would say that if you can earn almost the same amount as the insurance company, why not keep control over your assets in case your financial situation changes.

This is a great question and the primary decision point that you have. However, remember that you are now entering retirement, and you want security. Even if you have a large portfolio of bonds giving you a satisfactory level of monthly payments, you will always have the nagging feeling that something can go wrong. Some event will cause your bond portfolio to go off track and not produce the desired level of payments 20 years from now.

If you ask any retiree about their greatest worry in retirement, they will say that it is outliving their retirement assets. So there is a psychological advantage to having the insurance company guarantees attached to your monthly payments.

Diversify the Assets

If you can’t choose whether to buy a long term annuity for the guarantee, or build a bond portfolio for the flexibility, then do both. Take a good portion of your assets and buy the annuity. Take the remainder of your assets and build portfolio good quality investments that can give you more asset growth over the coming years. You do not, and should not, have to put all your retirement assets in one investment. Diversifying the assets will give you both the guarantees and flexibility you desire for the long run.

Risks of Owning Annuities

All investments contain risk. When people think of investment risk, they focus on the possibility of losing of money. People don’t like losing money, so conservative savers and investors will shy away from any type investment that may fluctuate in value. The most common example is the stock market. These people will put all their money in an annuity or bank CD, and tell themselves they are taking no risk. Let’s look at risk of these fixed investments, with particular emphasis on annuities.

Annuities and CD’s Avoid Loss of Principal

People keep massive amounts of money in bank CD’s. These assets have the full backing of the bank. If the bank should become insolvent, the FDIC will guarantee your assets up to $250,000. Essentially, there is no risk of losing money. People focus on FDIC insurance guarantees as the primary reason for keeping all their money in a bank.

Fixed annuities are not covered by the FDIC, or any other federal agency. This is the primary argument of bank officers when you are trying to compare buying a CD or a fixed annuity. So, on the surface, it appears that the owner of an annuity can only rely on the strength of the insurance company to guarantee his annuity payments many years into the future.

The above point is usually noted when financial planners tell you to look only at the strongest insurance companies. Technically this is true. However, an important consideration is how the insurance companies are regulated, which never seems to be advertised.

Insurance Companies are regulated by the state or states in which they are located, and in which they do business. Therefore, the largest insurance companies are regulated by all 50 states since they do business in those states.  The important point is that each state has a mandated insurance fund into which all insurance companies in the state contribute. This fund is used to protect policyholders in case one of the insurance companies should become insolvent. The amount of insurance varies by state. The largest amount of protection is in the states of Washington and New York. These two funds protect up to $500,000 per policyholder.

Also, in most cases of insolvency, the state insurance commissioners request one or more of the other, stronger companies to step in and buy the assets of the insolvent company. This is routinely done, though it is not written into law that it must be done.

Given the above, the owner of an annuity offered by a top rated insurance company can feel safe that money will be there to pay his monthly payments when he retires. This is not a legal guarantee as with a bank CD, but in reality it is an extremely safe investment.

Of course, the situation is different with variable annuities. These annuities are designed to allow the contract owner to invest his money in various mutual funds, thereby having more potential for investment gain. While there are guarantees under these contracts, the contract owner does risk losing money and needs to aware of this risk.

Inflation Risk of Annuities

Bank CDs and fixed annuities all provide for a set interest rate to be credited to your account. This gives people comfort since they know that they are getting a set amount of interest that is guaranteed to be there when they retire. However, this fact comes with a cost. The cost is the loss of purchasing power over time. Inflation is always with us. Sometimes it is very high as it was in the 1970’s. Sometimes it is low, as it was from 2007 to 2011. We know inflation is occurring and usually voice the examples of the cost of gasoline and food to prove it. But overall inflation occurs slowly over time, so that we don’t even realize it is happening at a particular point in time.

No matter how old you are, think back to your teenage years and how much a car or house cost at the time. Even if you are relatively young, think about how much a can of soda or candy bar cost when you were growing up. The point is that prices have gone up and will continue to go up. Inflation is not an item that goes up and down like the stock market. It will always go up, unless the economy is in a particular deflationary period. This is not a normal event.

So, what is the effect of inflation on your fixed income investments? The value of your investment will not drop. However, inflation will cause you to lose purchasing power with those assets. If your annuity or CD is earning 4% and inflation is increasing at 3%, you essentially have real growth of only 1%. So, 20 years from now, your assets will not have grown much on a net basis. This is the reason professional managers and financial planners suggest putting your money in stocks. Stocks have more potential to outpace inflation.

On the other hand, the fixed rate of return from an annuity or CD is what you wanted when you made the investment. You like the certainty and guarantees. Annuities have the additional guarantee that you will receive your retirement payments for as long as you live. This guarantee under an annuity contract is extremely valuable and comforting.

The way you offset the inflation problem, yet still get guarantees, is to not put all your investments in one basket. The concept of diversifying your assets is a must. You should never have all your assets in one type of investment. This also goes for annuities. Put a good portion of your retirement money in a fixed annuity so you get payments for life. If you are covered under a pension plan, put less of your other assets into an annuity contract. You can then put your non-annuity assets into investments which will better outpace inflation. These investments should include a mixture of stocks, bonds, real estate and commodities.

Risk of Not Understanding the Investment

The risk of investing without understanding how the investment works is always a danger. If you invest in the stock market, you risk a severe loss if you do not understand the particular stocks or funds in which you are putting your money. With annuities, you must understand each of the contract provisions and how they work. Annuities are long term commitment. If you don’t understand exactly how the contract works, you risk getting unintended results many years down the road. Take the time to read all material, positive and negative, that you can find. Then ask every question you can think of when talking to the insurance agent. In doing this, you will quickly narrow your focus to the most important points of concern to you.

Once you make a decision, you will be secure in the fact that you know what you will be getting in the future.