When choosing investment vehicles, it is important to know the differences between them and how each suits your needs. Some people want to leave their money in an investment to let it grow, where others use investment earnings as a source of income. Comparing indexed annuities and mutual funds will make it clear which categories they fall into.
The word annuity originated around 1500 C.E., and it refers to an agreement to a specified income paid out at regular intervals for a fixed period of time, or possibly for the recipient`s lifetime. Prior to these payments coming out, a premium was paid in either in one lump payment or over time. All that is a fancy way to say that annuities are like a source of income that pays you. It is common for retirement investments to be set up so when you retire they start to pay out as an annuity, almost like a paycheck. If you saved enough for your retirement they will continue for the rest of your lifetime. If you did not save enough, the payments will stop when there is no money left.
Indexed annuities are annuities that are linked to a particular stock index. When the index increases in value, say five percent per year, the annuity pays that five percent out as income. Typically there is also a management fee which is subtracted from the percentage before it is paid out. For example if the management fee was one percent and the return was five percent, it would pay out four percent.
Mutual funds were really popular in the 1980s and 1990s. A mutual fund is a managed investment portfolio that allows you to invest incrementally over time. These funds include a number of stocks, and sometimes commodities like gold and silver. When the average value of the portfolio goes up, the value of your investment goes increases. If some stock values increase a lot, while others decrease less, you will still make money. Mutual funds are managed and have management fees that come out of any increases in the portfolio value. Managers make decisions about which stocks to buy and sell to help the portfolio be profitable and meet its goals. When you retire, you can arrange to have your mutual funds converted to annuities to pay you an income, but mutual funds themselves do not
Differences in returns
The returns of indexed annuities, or how much they pay you, are set by the returns of the stock index it is tied to – if that index goes up you get income, or if it stays the same you get zero income. An index is a group of stocks that have something in common – the S&P 400 is an index of mid-cap companies with market capitalization of $2 billion to $10 billion, or the NASDAQ Composite Index which is a market-capitalization weighted index of the more than 3,000 common equities listed on the NASDAQ stock exchange. Indexes have large numbers of stocks which is hard to duplicate with mutual funds or individual investing. A large number of stocks in your investment portfolio means that when a single stock drops to almost nothing, your investment is still secure because the other stocks will help balance it out. If you personally invest in 10 stocks and one plunges to almost nothing, that is 10 percent of your investment gone. Indexed annuity payouts are still based on the stock market, so they are not guaranteed even though they are fairly stable.
Mutual funds are better than personal investing, but not as good as indexes. The mutual fund manager puts together a portfolio of usually 100 or so stocks. This averages the ups and downs of any one stock, but it does not match the wide spread of a typical index. For this reason mutual funds can have higher and lower swings in value. Mutual funds can pay dividends which are different from annuities. Dividends are profits that companies distribute to their shareholders. Mutual funds often give you the option of reinvesting these dividends to help your investments grow faster, but you can choose to have the dividends paid out as they happen which will be a form of income. However, dividends go up and down as companies do better or worse in business – they are not a stable form of income.
Differences in management fees
Management fees come from your profits of your investments so they are very important. If you save one percent on management fees, over 30 years you will have made 35 percent more on your investments due to compounding returns.
Any managed investments based on indexes are typically cheaper than non-indexed investments. This is because there is little decision making skill required – you simply buy and sell stocks to match the index. Non-index based investments require a manager who understands the stocks they are working with, and is lucky. For this reason indexed annuities should have lower management fees than non-indexed mutual funds, and keep more of your earnings in your pocket.
Differences in stage of investing
Mutual funds are great investment vehicles because they allow you to put a little bit of money away frequently over time. This allows you to quickly build up a good investment without having a lot of money to start with. This type of investing suits young people who usually invest their available lump of savings in their house, and only have small payments free to invest each month.
Annuities are better suited for retirees who have little other income after saving for the rest of their life. Retirees want a steady source of income they can depend on which is provided by indexing their investment over many stocks. They cannot afford to lose their investment money because they depend on it to live. This contrasts with younger investors who have time to make up for any losses which allows them to take more risks for a chance at better profits.
To sum up indexed annuities and mutual funds have many differences because they meet different investing needs for investors at different stages in their life. However both can be very good investment vehicles to meet or surpass your investment goals.