Should you choose an annuity or a mutual fund for your retirement income? Many Americans, including Veterans, have long turned toward annuities to convert their retirement nest eggs into guaranteed lifetime income streams when they stop working. However, mutual funds are also popular because of their low capital gain tax and simplicity.

Explore the differences between annuities and mutual funds so you can make the right decision for your financial plan.

What Is an Annuity?

Offered exclusively by insurance companies, an annuity is a financial product that provides a predictable cash flow to its holder,  often used to supplement retirement income. In exchange for a lump sum payment or series of payments, the insurer agrees to make periodic payments to the annuity holder, either for a fixed period or for the holder’s lifetime. 

Annuities come in different forms, such as fixed, variable, and indexed, each with unique investment strategies and risks.

Fixed Annuities

Fixed annuities pay an established rate of return. An insurance company guarantees the return, and you get your money back plus interest if you hold the fixed annuity for a specific period (usually ten years).

Fixed-rate annuities are good options for people who want to make sure their principal is protected. They may not be ideal for investors who are looking for high returns.

Variable Annuities

Variable annuities pay market rates. The sub-accounts typically represent a mutual fund wrapped in a deferred-tax insurance product. Payouts for a variable annuity can be guaranteed for life, regardless of the investment earnings. You can also include a death benefit payout clause. However, the amounts fluctuate over time, depending on the performance of the underlying assets in the market.

Variable annuities have more in common with mutual funds, which is why they are typically compared to each other.

Indexed Annuities

Indexed annuities, also known as equity-indexed annuities, provide returns based on the performance of a specified market index, such as the S&P 500. They combine features of both fixed and variable annuities by offering a guaranteed minimum return with the potential for higher returns tied to the index. 

While gains can grow when the index performs well, there is typically a cap on maximum returns, and losses are limited as the principal is generally protected from negative index performance. Indexed annuities are often chosen for their balance of growth potential and downside protection, making them a popular choice for those seeking income with moderate risk.

Advantages of Annuities

Annuities offer several advantages:

• Guaranteed income stream: Annuities can provide a reliable income stream, often for life, helping retirees cover living expenses without worrying about outliving their savings.
• Tax-deferred growth: Earnings within annuities grow tax-deferred until withdrawn, allowing investments to grow over time without immediate tax implications.
• Principal protection: Certain types of annuities, such as fixed and indexed annuities, protect the principal from market losses, making them attractive for those with a low-risk tolerance.
• Death benefit options: Many annuities offer death benefits, allowing the remaining balance to be passed on to beneficiaries, making it a potential part of an estate plan.

Disadvantages of Annuities

Annuities have several potential disadvantages, which could impact their suitability for some individuals:

• High fees and costs: Annuities can have high fees, including administrative fees, mortality and expense fees, and potential investment management fees, which may reduce overall returns. There are alternatives to traditional annuities, however, that allow you to keep your money. For example, AAFMAA’s ANNUITYLife^® doesn’t charge any upfront fees, commissions, surrender charges, or other surprise fees. This means your entire savings is put toward your retirement income, and you only pay low fees out of the proceeds your money makes for you.
• Lack of liquidity: Annuities often come with surrender charges that apply if you withdraw funds within a specified period. This makes annuities relatively illiquid, and accessing funds early can be costly.
• Complexity: The variety of annuity types and terms can be complex, making it challenging to understand fees, guarantees, and payout options without thorough research or professional advice.
• Lower growth potential: Fixed and indexed annuities offer capped returns, which may limit growth potential compared to other investment options, especially in times of strong market performance.
• Tax treatment on withdrawals: While growth is tax-deferred, annuity withdrawals are typically taxed as ordinary income, which can lead to higher tax rates than the capital gains rate for other investments.

What Is a Mutual Fund?

A mutual fund is an investment solution that pools money from many investors to purchase a diversified portfolio of securities, such as stocks, bonds, or other assets. 

Managed by professional fund managers, mutual funds allow individual investors to access a broad range of investments without needing extensive market knowledge or large amounts of capital. The fund’s returns, minus management fees, are passed back to the investors based proportionally on the number of shares they own.

There are various types of mutual funds, each with distinct objectives and risk levels, including the following:

• Equity funds
• Bond funds
• Index funds
• Money market funds
• International funds
• Small-cap stock
• Large-cap stock
• Balanced funds
• Fixed-income funds

Advantages of Mutual Funds

Mutual funds offer several advantages that make them appealing to a wide range of investors:

• Diversification: Mutual funds invest in a mix of securities, spreading risk across various assets, which reduces the impact of a single investment’s poor performance.
• Professional management: Managed by experienced fund managers, mutual funds allow investors to benefit from professional expertise and informed investment decisions.
• Liquidity: Most mutual funds are easily bought and sold, making it simple for investors to enter or exit their positions without lengthy commitment periods.
• Accessibility: Mutual funds often have relatively low minimum investment requirements, making them accessible to a broad spectrum of investors.
• Variety: There are mutual funds for nearly every investment objective, from growth and income to sector-specific or socially responsible funds, allowing investors to align their investments with their goals and values.
• Reinvestment options: Many mutual funds allow investors to automatically reinvest dividends and capital gains, helping compound returns over time.

Disadvantages of Mutual Funds

Mutual funds come with certain disadvantages that investors should consider:

• Fees and expenses: Mutual funds charge management fees and may have additional expenses, including sales charges (loads) and 12b-1 fees, which can reduce overall returns.
• Lack of control: Investors in mutual funds have no direct control over the fund’s investment choices or timing, since decisions are made by the fund’s manager.
• Potential for lower returns: Actively managed mutual funds may underperform index funds or the overall market, especially after fees are deducted.
• Dilution and over-diversification: While diversification reduces risk, it can also limit gains. In striving for diversification, some mutual funds may invest in many securities, which can dilute potential returns if only a few investments perform well or the fund lacks a focused strategy.

When Would an Annuity Be a Better Option Than a Mutual Fund? 

An annuity is a good option for those who want to protect their assets or who are looking for guaranteed income. If you want to leave your money alone to grow, while guaranteeing it’ll be there with interest when you need it, then an annuity might be the right choice for you. Additionally, if you’re concerned about market fluctuations and feel that investments are too risky for you at this stage of life, an annuity could also be worth considering. 

The guaranteed income through annuities makes them an attractive option in the annuity vs. mutual fund comparison.

When Would a Mutual Fund Be a Better Option Than an Annuity? 

If you want to invest in a diversified portfolio of stocks and bonds and don’t have the time or inclination to closely monitor the performance of your investments, then mutual funds may be the way to go. They’re also a good option if you want to invest in a specific sector or industry because they enable you to do so without researching individual companies yourself.

Mutual funds also allow investors with different risk tolerances (or time horizons) an opportunity for investment diversification within their portfolios. Lower-risk investors can select low-risk mutual funds while those willing to take on more risk could choose higher-volatility mutual funds.

Annuity vs. Mutual Fund: How to Choose for Your Retirement

Choosing between an annuity and a mutual fund for your retirement goals is a big decision. Everyone’s financial situation is different, and there is no  right or wrong answer when you are thinking about your options. You should consider some  key factors, such as: 

• Security risk and tolerance 
• Current income and tax level 
• Life stage and retirement goals 

AAFMAA Is Here to Help 

Talking to a trusted financial expert about the specifics of your situation can help you make this decision. There’s no substitute for personalized advice from someone with direct knowledge and experience in helping military servicemembers and Veterans prepare for retirement.

If you’re thinking about a military life insurance policy or just have questions, contact AAFMAA today at 877-398-2263 or get a free quote for coverage right now.

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This article was originally published December 13, 2022.