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When discussing annuities, there are several different types. The term annuity generally refers to an insurance product that offers guarantees. Fixed annuities guarantee a specific interest rate as well as the original principal. They offer a fixed rate, similar to a certificate of deposit, to its holders. On the other hand, variable annuities often come with guarantees of specified income or withdrawal benefits.
They are more similar to mutual funds in that both invest in a pool of money that is diversified among stock, bonds and cash. For purposes of comparisons, variable annuities will be the main focus of this article.
Both mutual funds and annuities can be purchased through a broker-dealer and through a corresponding financial advisor, or, sometimes, they can be purchased directly through the issuing company. Vanguard and Fidelity are two of the most popular investment companies, and the public can buy both mutual funds and annuities directly.
Let us look into the similarities and differences between these two investment vehicles.
Find out about the most important criteria for selecting a mutual fund here.
The biggest similarity between mutual funds and variable annuities is that both use pools of money from investors to purchase a variety of stocks, bonds or cash. Mutual funds can invests in almost any strategy available to the market, ranging from as specific as a small niche section of the market or as broad as an entire index or asset class. For example, the Dreyfus Brazil Equity A (DBZAX) specifically invests in companies that are based in Brazil. On the other hand, the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) is designed to give investors broad exposure to the entire stock market.
Variable annuities are very similar to mutual funds because of the underlying sub-account investments that work very similar to a mutual fund. Sub-accounts pool money together to buy stocks, bonds and cash under the guidance of a portfolio manager. For instance, Prudential Annuities has the AST Clearbridge Dividend Growth Portfolio, which primarily looks to give investors income, capital preservation and capital appreciation through dividend stocks and bonds.
2. Fee Structure
Another similarity between mutual funds and annuities is the expenses and sales charges. Mutual fund sales charges work through either an upfront “A share” sales charge or through a level “C share” sales charge. The Dreyfus Brazil Equity Class A has an upfront fee load of 5.75%, while the Dreyfus Brazil Equity Fund Class C (DBZCX) has a 1% upfront sales charge with a 1% annual sales charge. In the cases of both the upfront or level load, the investor immediately pays the fee which is deducted from the total investment value. Mutual funds also have an expense ratio, which is the cost for the underlying money manager and trading costs. The Dreyfus Brazil Equity Class A has an expense ratio of 2.34% and the Dreyfus Brazil Equity Class C has an expense ratio of 3.16% (which includes the 1% annual sales charge). To analyze mutual funds beyond their expense ratio, click here.
Variable annuities also work in a similar fashion when it comes to sales charges. There is both an upfront sales charge and a level load associated with variable annuities. However, a major difference is that unlike a mutual fund where the sales charge is taken out of the investment value, it is charged in the form of a Contingent Deferred Sales Charge (CDSC) only if the annuity investor was to cash out early. For example, the Prudential Premier Investment B Series has a seven-year CDSC. If the investor was to cash out in year three, the CDSC would be a 6% penalty. In year six, it would be reduced to a 3% penalty. After the seventh year, there would no longer be any penalty and the investor can cash in if they desire.
In the Prudential Premier Investment C Series, there is no surrender penalty and the investor can cash in at any point. However, like mutual funds, annuities also have internal expenses. There are fees for the base insurance, which is 0.55% in the B Series and 0.67% in the C Series. Along with the insurance charge is the fee for the sub-accounts, which average around 1.0%. Finally, if the variable annuity has a living or death benefit, there are additional annual fees as well. For example, the Return of Purchase Payments Death Benefit for the B and C Series is 0.17%.
A major difference between mutual funds and annuities is the taxation when held outside a retirement account. Mutual fund holders are taxed for dividends and are subject to capital gains whenever a position is sold. Mutual fund holders are also subject to capital gain distributions that are embedded within the fund. This is when the portfolio manager makes several taxable changes within the fund using the underlying investments. These capital gains are then passed directly to each individual mutual fund shareholder, regardless of when they first purchased the fund.
Annuities are different when compared to mutual funds because they offer a form of tax-deferral. Annuity holders can exchange sub-accounts without incurring any capital gains. Any dividends issued within the sub-account are not taxed and the sub-account money managers do not pass on capital gain distributions when they sell underlying positions. However, even though this may be a benefit for some investors, when it comes to withdrawing or cashing out the annuity, any gains above the original cost basis are taxed as ordinary income as opposed to capital gains rates. So, if an annuity owner purchased a $50,000 annuity and then sold it a few years later for $100,000, the $50,000 gain would be taxed at their tax bracket. If this was a mutual fund, that same $50,000 gain would be taxed at either the 15% or 20% capital gains rate.
Click here to find how mutual fund distributions are taxed.
2. Regulatory Framework
Another difference between mutual funds and annuities is how each is regulated. Mutual funds are regulated through the Securities and Exchange Commission. The SEC created the Investment Company Act of 1940 to ensure that all fund companies abide by the same rules to provide transparency, liquidity, safety and an audited track record. Individuals who sell mutual funds must be fully licensed with either a Series 6 or Series 7 General Securities Representative Exam, which is administered by Financial Industry Regulatory Authority (FINRA).
Annuities are not regulated by SEC, but instead by state insurance commissioners. In order for an individual to sell annuities, they must pass their state’s corresponding insurance license. For example, the state of Florida requires agents to pass the 2-15 Health & Life (Including Annuities & Variable Contracts) Agent License test as well as a 60-hour approved insurance course.
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