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Indexed annuities and mutual funds: What鈥檚 the difference?

Retirement requires a whole new perspective on your portfolio. Instead of focusing solely on growth, you鈥檙e now tasked with creating a plan to spend down your assets while also helping ensure those assets will comfortably last through your retirement. Your approach to risk may change as a result. 

As you consider your financial goals and obligations, it鈥檚 natural to reconsider how you view various accumulation and income-generating options. A common comparison is that of mutual funds vs. indexed annuities 鈥� so we鈥檝e outlined some things you need to know about how they work and their similarities and differences.

What鈥檚 the difference between a mutual fund and a fixed indexed annuity? 

While both track the performance of securities, they work differently and involve different levels of risk. Each was designed for different purposes 鈥� as we explain below 鈥� and both can be a good fit, dependent on your retirement goals.

A mutual fund is an investment vehicle whose value fluctuates depending on the performance of its underlying securities. An investor who buys shares of a mutual fund is investing, albeit indirectly, in those securities. Because mutual funds are invested in a range of companies, based on what the fund owns, investors often use mutual fund investment to diversify their portfolios. But this means that the investment is tied to market performance: If the fund performs well, the investor gains, but if the fund doesn鈥檛 do well, the investor stands to lose money, including their principal. 

A fixed indexed annuity (FIA) gives you the opportunity to earn interest credits based in part on the upward movement of a stock market index 鈥� but FIAs are not stock market investments and do not directly participate in any stock or equity. You鈥檙e not exposing your money to the risk that investing entails, and your principal and any accumulated interest are protected from loss due to market downturns. FIAs may also offer riders that allow you to customize your annuity to, for example, provide guaranteed lifetime income in retirement or create a legacy for your heirs. Keep in mind that riders typically come with a charge that could exceed any interest credited, resulting in a loss of principal. 

How do mutual funds work?

In mutual funds, investors pool their funds to purchase shares in a basket of equities, typically stocks and bonds. When the fund performs well, all investors benefit from the fund鈥檚 growth. When the fund performs poorly, all investors are exposed to loss. The appeal of investing in mutual funds is their growth potential. Additionally, mutual funds are more liquid than some other products.

While there are different types of mutual funds, investors most often receive regular distributions based on the fund鈥檚 performance. 

How do fixed indexed annuities work? 

FIAs are insurance products that offer growth potential tied to the performance of an underlying market index. With a FIA, your money isn鈥檛 directly invested in stocks, bonds, or other investments. Instead, interest is credited based on the percentage gain in the index, limited by a cap or other mechanism that allows the insurance company to provide protection from loss if the index declines.

How growth works in mutual funds and fixed indexed annuities 

When you invest in an individual stock through a mutual fund, the returns generated by that stock directly impact the value of your mutual fund shares. In essence, the value of your share is tied directly to the combined returns of all of the fund鈥檚 underlying securities, minus any fund expenses.

With a fixed indexed annuity, growth is tied to the performance of an index. This index could be a benchmark index, such as the S&P 500, or another index. The annuity holder then has the opportunity to allocate their annuity鈥檚 Accumulated Value to one or more indexed interest crediting strategies. Interest credits are determined by the performance of an underlying market index, modified by a mechanism that limits the interest credits, like a cap, spread, or participation rate. 

For example, let鈥檚 say the participation rate was 60% and the stock index gained 8%. The credited yield (the interest you would make from the annuity) would be 60% x 8%, which equals 4.8%. Because these formulas can vary, we recommend you consult with a financial professional about how to compare your options. 

Avoiding losses in mutual funds and fixed indexed annuities 

Mutual funds and FIAs balance risk and reward in very different ways.

A mutual fund participates fully in the gains and losses of its underlying investments. Generally, if those securities collectively gain or lose 20 percent of their value over the year, the value of your mutual fund shares will also gain or lose 20 percent. 

On the other hand, a FIA provides protection from loss due to stock market downturns. While it is possible to earn zero percent interest in any given crediting period, you cannot earn less than zero due to a market decrease. 

Accessing funds

The two products also differ in terms of liquidity, or how easily you can access your money. Shares of mutual funds can be bought and sold daily, with some limitations on selling shares soon after they are first purchased as a way to deter short-term trading.

FIAs are designed to help you achieve long-term savings and income goals. If you withdraw more than the free withdrawal amount specified in your annuity contract, the excess withdrawal will be subject to a withdrawal charge and Market Value Adjustment, if applicable. In addition, any withdrawals before age 59陆 may result in an IRS鈥搈andated early withdrawal penalty.

Other differences between mutual funds and fixed indexed annuities

Tax considerations also differ between mutual funds and FIAs. FIAs, for example, offer tax-deferred growth. You pay no taxes on growth within the annuity until you receive a payment or make a withdrawal. With some mutual funds, if the fund manager sells an asset and realizes a gain, you could be subject to taxes on that gain even if you haven鈥檛 sold any of your shares.

There are also different fee structures and different approaches to management. FIAs tend to see fewer fee changes because they鈥檙e designed to be long-term holdings. Fee amounts are set from the outset. With mutual funds, on the other hand, fees can go up as the size of the fund鈥檚 portfolio grows. 

Both mutual funds and annuities can be valuable components of your portfolio, but it鈥檚 important to have a full understanding of how both work as tools and how they can help you reach your goals. 

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Although fixed indexed annuities offer principal protection from market downturns, the deduction of applicable charges could exceed any interest credited, resulting in the loss of principal.

Withdrawals and surrender of taxable amounts are subject to ordinary income tax, and except under certain circumstances, will be subject to an IRS penalty if taken prior to age 59陆.

Under current tax law, the Internal Revenue Code already provides tax deferral to qualified money, so there is no additional tax benefit obtained by funding a qualified contract, such as an IRA, with an annuity; consider the other benefits provided by an annuity, such as lifetime income and a Death Benefit.

Any information regarding taxation contained herein is based on our understanding of current tax law, which is subject to change and differing interpretations. This information should not be relied on as tax, legal or financial advice and cannot be used by any taxpayer for the purposes of avoiding penalties under the Internal Revenue Code. We recommend that taxpayers consult with their professional tax and legal advisors for applicability to their personal circumstances.

Guarantees provided by annuities are subject to the financial strength and claims paying ability of the issuing insurance company.

Indexed annuities are not stock market investments and do not directly participate in any stock or equity investments. Market indices may not include dividends paid on the underlying stocks, and therefore may not reflect the total return of the underlying stocks; neither an index nor any market-indexed annuity is comparable to a direct investment in the equity markets.