Annuities and mutual funds can both be helpful tools for managing your finances. But choosing the right investment vehicle can seem complicated, and each tool has advantages and disadvantages.
This comparison of annuities vs mutual funds can help you understand how these investments work and where each might fit into your financial plan.
What Is an Annuity?
An annuity is an insurance contract that often has guarantees for predictability. For example, you can use an annuity as a long-term investment account, or you can convert retirement savings to a stream of income that's guaranteed to last for your entire life.
A few highlights of annuities include tax features, income for life and principal guarantees.
Any earnings inside of an annuity are often tax-deferred. However, you may owe taxes when you withdraw earnings (or when an annuity is funded with pre-tax money).
Some annuities provide a stream of income that's guaranteed to last for a specific timeframe. That might include an income that lasts for the rest of your life, or you can choose other timelines such as a 20-year payout. Regardless of how long you live or how investments perform, those income payments typically continue.
Annuities might allow you to pursue growth without risking your original investment. For example, you might get limited exposure to market gains without participating in losses. However, some annuities, like variable annuities, can lose money when markets fall. Alternatively, an insurer might add credits to a pot of money from which you can eventually take income.
What Are Mutual Funds?
Mutual funds are pooled investments that combine funds from numerous investors. A fund typically has an objective, so investor assets go into stocks, bonds or other investments that align with the fund's goals. For example, a fund might aim to pursue growth by investing in large companies based in the U.S.
Mutual funds provide an easy way to spread your money among numerous investments. A single mutual fund might provide exposure to hundreds (or more) of investments. When you build a portfolio of mutual funds with different objectives by adding a variety of asset classes to your holdings, you could have exposure to thousands of securities across the globe with a handful of funds.
Pros and Cons
There are, of course, upsides and downsides to both annuities and mutual funds. Understanding the pros and cons of each can help you make informed decisions for managing your finances.
Annuities have unique guarantees that are difficult or impossible to find elsewhere. For example, you can set up a stream of income that lasts for as long as you live — regardless of market crashes or longevity. Other guarantees can keep your principal safe (with some annuities) or provide a growing pool of value to draw income from. Plus, annuities offer tax-deferred growth.
However, annuities can be complicated. With a variety of options available, you might misunderstand products or skip over important features. Annuities can also require a commitment. With some programs, you may need to pay surrender charges if you withdraw too much money from an annuity within a few years after buying.
Mutual funds are easy to trade, and they're available on most major brokerage platforms. It's relatively easy to build a diversified portfolio and let the fund company handle the logistics of managing your money.
However, mutual funds fully participate in market movements. If markets crash, a mutual fund can lose a significant amount, impacting your ability to take income or fund other critical goals. You might also owe taxes on earnings each year.
The Bottom Line
How do you choose between annuities vs mutual funds?
Annuities might make the most sense when you want guarantees from an insurance company such as principal protection or lifetime income. They can also help you shield earnings from year-by-year taxation. Mutual funds may be appropriate when you want more flexibility to withdraw funds at any age, potentially with long-term capital gains tax treatment (as opposed to ordinary income tax that might accompany some annuity withdrawals).
Fortunately, you don't need to choose one or the other. Instead, you can design a plan that draws on the strengths of each strategy. For example, you might put guarantees on some of your money using annuities, and you might invest other savings in mutual funds.