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.
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