Fixed-Index Annuities vs. Mutual Funds: Which Are Better for Building Ongoing Income?

Howard Kaye

We had an older couple in our office recently who wanted to talk about building ongoing income for their later years. It’s a question we’re getting more and more as people are outliving their retirement savings.  

Building a stream of income out of a lump sum payment can be a good way to stretch out funding to ensure it lasts a lifetime. Usually, people look at either using mutual funds or fixed-index annuities as a means of doing this. While both products seem similar, they’re inherently different and are generally designed for completely different purposes. Before you decide between the two, you need to understand the differences. You also need to know that because of the risk to principal, and the impact that mutual fund losses may have on retirement plans, we have opted not to get licensed or offer them to clients. As a wealth preservation firm, we are committed to keeping your retirement dreams safe.

Mutual Funds as Investment Vehicles

Mutual funds work by leveraging diversity. You pay in an amount and that amount is invested in a wide range of stocks, bonds, or a mixture of both. Due to that diversity, they’re mistakenly seen as a safe investment. Mutual funds are designed to be investment vehicles, but they can be used to create a stream of ongoing income. That income stream is always non-guaranteed.

Funds based on stocks may pay out dividends, which are simply small portions of earnings parsed out to investors. Bonds may be used the same way, in that a small amount of the interest returned will be sent to investors. These dividends may be taxable at the capital gains rate, rather than the ordinary income rate.

The issue you’re going to run into when trying to get an ongoing stream of income out of mutual funds is market risk. While mutual funds use diversity to limit market risk, that diversity doesn’t offer a guarantee. As a result, your earnings could fluctuate significantly, and there might even be instances in which no dividends or earnings are paid out, especially if the principal is reduced or vanishes.

Generally, mutual funds are best for earlier retirement planners because they allow a safe vehicle for growing funds. These funds aren’t protected from market risk, so investing in them earlier, before retirement is a better option. Mutual funds should be treated as potential savings vehicles rather than as sources of ongoing income. To create a dependable, guaranteed stream of ongoing income, a fixed-index annuity will be a better option.

Using Fixed-Index Annuities for Long-Term Income

The first thing to note about fixed-index annuities is that they are insurance products and not investments. While the annuities use the index as a benchmark for earnings, your money is not directly invested in the stock market. Instead, your earnings are based on the earnings within an index. Some of the more common indexes used include:

  • S&P 500
  • Dow Jones Industrial Average
  • BBC Global 30
  • The Global Dow
  • Wilshire 5000

This is by no means a comprehensive list. There are global indexes and each country will have a listing of its own domestic indexes. In addition, some indexes branch off into others that track individual industries. For example, while the Dow Jones Industrial average is the index most commonly used, Dow Jones & Company tracks 11 U.S. markets and multiple global ones.

Most often, the fixed-index annuity will use the S&P 500, which is an index that tracks the earnings and losses of the top 500 U.S. companies. The index your annuity is based on is one of the most important factors in choosing an annuity because it will determine your earnings.

In addition, when you get a fixed-index annuity, you will likely receive a roll-up interest rate or credit enhancement that drives up your future income by increasing the guaranteed benefit base on which your future income will be calculated. If your actual interest is greater, you will be credited the higher of the two values.

These earnings aren’t the only benefits of a fixed-index annuity. Some of today’s state-of-the-art annuities allow for income increases in the future as well as other valuable long-term care-type benefits, such as an income doubler that can double your guaranteed income for up to five full years for skilled nursing or home healthcare.

With a fixed-indexed annuity that has lifetime payments, it’s possible to receive payments that far exceed the initial premium paid in.

Taxes on the payments will be due at the ordinary income rate. If you bought the annuity with pre-tax dollars, then you will pay taxes on the entire amount. If you bought it with after-tax dollars, then you will only have to pay taxes on the portion of payment that represents interest earned.

Of course, fixed-index annuities do have their downsides. While they offer a market-risk free opportunity, they aren’t as liquid as cash. They are however, much more liquid than most CD’s or bonds. In fact, almost all of them offer “free withdrawals” each year. Once the surrender period is over, all of your funds are fully liquid. If you die during the annuity period, it’s possible that there won’t be much left behind to pay out to heirs. These types of product are best for someone looking to supplement income and who already has an estate plan in place for heirs.

If you think that a fixed-index annuity might be right for your situation, contact a Howard Kaye advisor. We work with a lot of different insurance companies to get the best possible insurance policies to help stretch out your income. Call us at 800-DIE-RICH or email for more information on these unique annuities.  

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