Friday, October 23, 2015

Variable Annuities vs. Mutual Funds

Breaking down the similarities and differences between two common investments

Source: TaxCredits.net
Variable annuities and mutual funds are some of the most common investment vehicles for retirement savings. While both products contain a number of identical features that often make it challenging for inexperienced investors to distinguish between the two, they are actually quite different.

Understanding these differences is essential to ensuring that your future financial situation is given the best possible opportunity to thrive.

Both types of investments involve participation in existing portfolios of stocks, bonds, or other securities.

For the uninitiated, choosing the best possible securities from the seemingly endless plethora of options is more than just overwhelming — it’s impossible. This led to the creation of the pooled account concept (mutual funds), as individuals have an easier time selecting from a list of pre-existing portfolios, rather than attempting to create such a portfolio on their own.

As investors buy mutual funds and variable annuities, they add money to the overall pool, and those accounts will mirror the performance of the chosen portfolios. Variable annuity investment options are called sub-accounts, many of which are simply clones of successful mutual funds, and in some cases are even managed by the same mutual fund money managers.

So, both mutual funds and variable annuities respond to changes in the market, the extent of which is determined by the portfolios, or fund choices. As Zacks explains, “sub-accounts and their mutual fund doppelgangers typically report almost the same earnings or losses and any discrepancy is minuscule.”

However, that’s where the similarities between mutual funds and annuities end.

Differences Between Mutual Funds and Variable Annuities


One significant difference between mutual funds and variable annuities is the account custodian. Mutual funds may be purchased from the fund company directly, or through a third-party broker. Variable annuities, on the other hand, are purchased from life insurance companies.

Variable annuities are technically insurance products, and they offer a range of features not available with mutual funds. The most significant feature of an annuity is the ability to avoid participating in, or being negatively affected by, stock market declines. Through the use of specialized riders and account enhancements, insurance companies have the ability to shield investors from losses that would otherwise threaten the stability of their retirement savings.

Another feature unique to annuities is the existence of bonuses. In an effort to attract customers, many insurance companies offer an up-front one-time bonus on deposits into new annuity accounts. While the size and scope of bonuses differs, that fact stands that after a pre-determined period of time any bonus money becomes fully-owned by the annuity owner.

Mutual funds, on the other hand, are unable to provide bonuses to new customer accounts. The only money deposited into a mutual fund account will come from that account’s owner.

Aside from the investment portion of the account, variable annuities frequently contain additional desirable characteristics: living benefits and death benefits.

Living benefits, such as the ability to make penalty-free withdrawals for nursing home expenses, permanent disability, and terminal illness, are attractive to many annuity investors. Mutual funds, on the other hand, are unable to offer such features.

Most variable annuity contracts contain death benefit provisions as well, some offering an opportunity for the account owner’s heirs to inherit even more money than what was in the account at the time of the annuitant’s death. Mutual funds, however, can only provide a deceased account owner’s family with the exact value of the account.

What’s the Catch?


While variable annuities seem to have better features, that comes at the cost of more expensive fees.

Mutual funds are most commonly purchased as A-shares, which results in an up-front fee assessed by the fund company. That fee, called a sales charge, can be as high as 5.75%, and directly reduces the size of the account owner’s deposit. Larger deposits command lower sales charges.

Conversely, variable annuity contracts do not reduce contributions by deducting up-front sales charges. Instead, the insurance companies charge monthly or annual fees that are often higher than those charged by mutual funds.

The most significant fee, however, is the surrender charge. In exchange for all of the features and benefits provided by the insurance company, a variable annuity contract stipulates that the money must remain within the account for a specified duration. Any withdrawals or transfers in excess of an allotted amount will result in a surrender charge, which could be as high as 10%. Only after the expiry of the surrender period can penalty-free withdrawals be made.

Bottom Line on Mutual Funds and Variable Annuities


No one retirement arrangement is suitable for every investor. Many people prefer the comprehensive, all-inclusive nature of annuities, and are willing to pay slightly higher fees to ensure both their financial future and peace of mind. Other people, however, are comfortable and capable of securing their own death benefits, and would rather pay minimal fees to maximize potential investment returns.

There is no right or wrong, as the choice is clearly one of personal preference and suitability.

Article originally appeared on InvestorPlace (10/23/2015)