Differences between Indexed Annuities and Mutual Funds

Indexed annuities and mutual funds are among the most common financial vehicles for building a retirement nest egg. Although they may both offer regular payouts, they work completely differently.

Indexed annuities are always an insurance product, and could be considered a type of life insurance. Mutual funds are offered by banks and financial brokers. Even though the payment in an indexed annuity is “indexed” to the stock market, it does not invest in it.

For this reason, these products are regulated differently, and even at different governmental levels. Mutual funds are regulated by the Securities and Exchange Commission (SEC) and by the Financial Industry Regulatory Authority (FINRA). Equity-indexed annuities are regulated by state insurance commissions.

Part of the capital appreciation of an indexed annuity is returned to investors in a stock index. This is what allows insurance companies to guarantee a minimum return if the contract is held to maturity. The State Guarantee Fund guarantees the principal. On the other hand, there are no guarantees with a mutual fund. If the investment sours, you can lose both your capital appreciation and your principal.

Payments from indexed annuities will range between the guaranteed minimum and a maximum cap. Within that range, they are guaranteed for life. Even if the insurance institution fails, your principal remains safe.

Payments from mutual funds are never certain. You can set your choice of cap on payments, but each individual payment is always dependent on their being enough money in the mutual fund. If you set fixed payments, they may pull from your principal. Thus, when you invest in a mutual fund, it is possible to outlive your total assets.

An indexed annuity is locked in until you reach the age of 59-1/2, and then it gives out fixed payments. There are heavy penalties for early withdrawal. These restrictions are similar to restrictions on an IRA. An indexed annuity is also tax deferred in the same way as an IRA. This may make an indexed annuity a useful complementary financial vehicle for funds above the IRA contribution cap and held outside the IRA, especially because there is no limit on the principal. Insurance products, including indexed annuities, are not among the allowable investments for IRAs.

Mutual funds are never locked in, but they are not tax deferred either. If you want your mutual fund to be tax deferred, you should place it in your 401(k), IRA, or Roth IRA, up to the contribution limit.

Finally, you will receive all your capital appreciation from a mutual fund, less any commissions, transaction fees, and fund management fees. If you do not readjust the principal after setting it up, the total fees won’t usually exceed 10 percent, and will usually be much lower. In contrast, an estimated 15-20 percent of investor premiums stays with the insurance company and its sales representatives.