Comparing Variable Annuities with Mutual Funds

Variable annuities are not the only retirement planning investment option. Actually, there are many alternatives, such as mutual funds, the stock market, a 401(k), a money market, or CD. It is recommended that investors keep a level of diversification in their investment portfolio so that downturns in one instrument can be mitigated by another.

One investment alternative that is often compared to a variable annuity is a mutual fund because of its similarity.

Both products allow the holder to manage their risk tolerance. Variable annuities provide payments over the lifespan of the investor that are tied to the performance of the underlying investments in the annuity (which often include mutual funds themselves). Diversification is achieved by investing in multiple sub-accounts.

Mutual funds achieve risk mitigation in a different way. With this product, several investors pool their resources to buy many different underlying securities. Funds are administered by a fund manager who actually does the investing. Individuals are given access to a broader range of diversification than they would be able to achieve on their own. They are, therefore, able to maximize the performance and minimize the risk of their investments.

Mutual funds offer a variable rate of return and are suitable for investment planning, like variable annuities. They are considered moderate growth, moderate risk investments. Mutual funds have management fees that are similar to variable annuities. The fee is typically in the 1 to 3% range.

Tax treatment is a key difference between variable annuities and mutual funds. With non-qualified mutual funds, income is taxed annually as ordinary income. Variable annuities, on the other hand, are tax-deferred until withdrawal. Mutual funds do, however, offer a benefit to young investors in terms of tax treatment. Income is only taxed when it is withdrawn. Mutual funds, unlike variable annuities, do not have a 10% tax penalty if income is withdrawn by the investor prior to the age of 59.5. Exchanges between mutual funds are taxed as capital gains if completed outside of an IRA or 401(k). However, transfers between sub-accounts inside of a variable annuity wrapper are tax-free.

Because of the tax penalty for withdrawal before the age of 59.5, variable annuities are more suitable for long-term investment goals, particularly retirement. Mutual funds are slightly more flexible in that depending on the fund selected they can be used to meet short and intermediate goals as well as long-term ones.

The proceeds from variable annuities also tend to be less volatile then the earnings from mutual funds. However, this stability does come at a price. Variable annuities continue to make payments for as long as the annuitant is alive. After the death of the policy holder, the contract is fulfilled and is terminated unless a death benefit option has been included in the contract. Mutual funds, on the other hand, still have a value that can be passed on to beneficiaries after the investor's death.

In summary, a mutual fund is probably the closest alternative to a variable annuity. However, there are differences between the products that should be closely considered before signing the contract. Both meet different needs for different investors.