Let’s start by lumping individual stocks and mutual funds under an exchange-traded fund umbrella. Once we’ve done that, we can explore the question of which to invest in.
Annuities and ETFs are completely different instruments, though they share some common features. If you were comparing oranges and apples, you would find both are fruits, but oranges supply 140% of daily vitamin C compared with apples at 7%. Yet apples are rich in soluble fiber and polyphenols, which guard against high blood pressure and cholesterol. Likewise, annuities and stocks embody similarities and differences.
Comparing head-to-head
Annuities are insurance contracts created by financial organizations to guarantee a steady income stream either for life or for a certain term, much like a private pension. In exchange for your premium, the insurer assumes the market risk, protecting you (the annuitant) from the unknown. There are several types of annuities, including immediate, deferred, fixed and variable.
Most people buy annuities primarily as a safeguard; they protect against the longevity risk of running out of money. But they also offer other benefits. They can be purchased before or after retirement. They can be structured to pay death benefits. Moreover, a fixed annuity is like a self-cleaning oven: It relieves the work of ongoing investment management. Note, though, that annuities may not keep up with inflation.
Annuities have some additional drawbacks. The insurance company could go out of business, so before you buy, check to be sure it gets high ratings for financial strength. Further, your funds will largely be locked in, with stringent surrender fees, as annuities are not intended to be a source of instant cash.
Let’s turn now to ETFs. A quick review of ETFs reminds that they track the value of a collection of securities, or of a sector, such as stocks, bonds, commodities or currencies. ETFs’ salient advantage is easy diversification. Equity ETFs may grow in line with the overall market at about 10% annually.
ETFs are more tax efficient than annuities and also allow a step-up basis to reduce your heirs’ taxes. Annuitants pay taxes at ordinary income rates but may be able to defer until they start receiving the income flow, at which point they might be in a lower tax bracket.
Annuity fees are the elephants in the room
Some annuities come with a slew of fees and charges. Commissions also are almost invariably higher than those charged on ETFs. Nevertheless, simple immediate annuities carry few costs. The insurer is effectively taking a chance, basing their calculations on the annuitant’s age and gender.
Commissions are separate from fees and go to compensate the salesperson. Single premium immediate annuity commissions may range from 1% to 3%, while commissions for a deferred income annuity tend to run about 2% to 4%. While fees can be as high as 10%, you might see a 6% to 8% commission on a fixed-index annuity.
More complex annuities, like those with riders and customizations, generate more costs. For example, variable and indexed annuities might also deduct a percentage on interest-earning products.
Some other common expenses include:
- Upfront commissions
- Charges to extricate (surrender charges); these start around 10% and decrease over the surrender period
- Fund-expense charges
- Administrative fees
- Investment management fees
- Contract add-on costs
Best of both worlds
You need not choose between annuities and stocks. Retirees often pair the two, using an annuity for stability and guaranteed income and ETFs, or equivalents, for growth and liquidity.
Annuities can help supplement Social Security, which normally does not pay enough by itself to cover living costs. Dividend funds and dividend ETFs provide an alternative path, delivering both income and capital gains. True, they may be subject to volatility, but investors who principally live off the dividends should not be overly affected.
Don’t annuitize all your savings in one swoop. Keep some back for major or unexpected expenses. Talk to your financial adviser about how you can diversify your income streams for retirement.
