Saving for retirement can be a tough choice. With so many different ways to invest your money and make your nest egg grow, it’s only natural that many to-be retirees tend to feel overwhelmed.
That said, preparing for retirement is one of the key decisions to make early in life to ensure healthy personal finance, and it goes hand in hand with budgeting your expenses, building and diversifying passive income streams and choosing and using the right credit card to build your credit.
Two common options are annuities and exchange-traded funds or ETFs. Each one of these options offers its particular sets of pros and cons for investors and people saving for retirement. In this post, we’ll compare annuities and ETFs head to head, so you can make a more informed decision about which of the two is better for you.
What are annuities?
Annuities are insurance contracts created and issued by a financial institution or insurance company to provide a guaranteed and steady income stream in the future in exchange for a premium. The guaranteed income stream can be set for a preset amount of time or throughout a person’s retirement years, therefore alleviating a retiree’s concerns of outliving their savings.
One of the best things about annuities is the possibility of purchasing one even after you have already retired. This can help you postpone the decision of purchasing one while, in the meantime, you get to make your nest egg grow faster with other investment vehicles.
How do annuities work?
Annuities are insurance products issued by insurance companies. As with all insurance products, you have to pay a premium which, in this case, covers the income you’re likely to receive during retirement as well as the fees associated with the service. The premium is calculated based on your age, gender, state of health and other criteria to ensure that it will be enough to cover all payments without the insurance company losing money.
The insurance company covers market risk
To make the account grow over time, the insurance company will invest the funds from all the premiums you and the other annuitants pay. This eliminates the need to decide what to invest in or which bank to choose for your savings and financial goals.
However, whenever you invest in the stock market or any other type of asset, there is always a risk of losing money. If you were the one investing and markets went south, you would lose money, but in the case of an annuity, the insurance company assumes this risk and is obliged by contract to keep paying you the agreed income no matter what happens to the account’s value.
Phases of a typical annuity
An annuity will typically go through two phases:
An accumulation phase
One type of annuities called deferred annuities will have an accumulation phase before payments begin, during which you fund the account. The money you invest in the annuity in this stage grows tax-deferred, much like in a 401(k). Immediate annuities don’t have an accumulation phase.
An annuitization phase
After the accumulation phase, you start receiving payments in the annuitization phase. Its duration depends on the type of contract, with some stretching for a predefined period while others last for the rest of your life.
Some types of contracts never enter an annuitization phase but begin payouts through another mechanism set up in the contract as a provision called a contract rider.
Types of annuities
There are four basic types of annuities:
Immediate and Deferred Annuities
Annuities that are set up to begin paying out immediately after a lump sum is deposited are called immediate annuities, while the ones that start paying at a later date are called deferred annuities. The former type lacks an accumulation phase and can be purchased at any time, even after retirement, making them a great way to use your savings. The latter allows you to start saving early on in preparation for retirement.
Fixed and Variable Annuities
Some of the simplest or more basic annuity contracts guarantee fixed payments during the annuitization phase. These are called fixed annuities. Other annuity contracts called variable annuities, on the other hand, may expose part of your funds to the market during the accumulation phase, the annuitization phase or both, potentially earning you a greater return than fixed annuities.
Annuities offer the flexibility of customizing your contract through provisions known as contract riders. These can usually bypass or compensate some of the pitfalls that basic annuity contracts have.
What are ETFs?
ETFs or exchange-traded funds are a type of financial instrument traded like any other asset in a stock exchange. These instruments are designed to track the value of a collection of securities like an entire industry sector (technology, for example), a commodity such as oil, or any other type of asset. They are versatile instruments that can even be designed to track specific investment strategies.
The SPDR S&P 500 (SPY) is a common example of an ETF, in this case, one that tracks the S&P 500 Index. Being marketable securities, ETFs have an associated price that allows them to be bought and sold in exchanges, allowing investors to profit from the price difference.
How do ETFs work?
When a fund provider wants to create an ETF, they’ll choose a basket of assets and buy them (i.e., the underlying assets). Then, they create a fund (the ETF) to track the underlying assets’ performance and sell shares, which are called units, in that fund to investors. Unitholders own a part of an ETF but not the underlying assets in the portfolio.
The money that an ETF generates is paid out to investors as cash distributions or is reinvested. The type of distribution depends on the type of asset or assets the EFT tracks:
- If the ETF tracks bonds, you may receive interest distributions.
- If the ETF invests in dividend stocks, it can pay dividends.
- Investors may receive capital gains if the ETF sells an investment for more than it paid.
If you decide to reinvest the cash distributions yourself through the fund, you’ll likely have to pay a sales commission. But most funds offer the chance to automatically reinvest your distributions by buying more units of the fund, in which case you most likely won’t have to pay them.
Types of ETFs
There is a wide array of ETFs for different goals:
Bond ETFs are a way to provide regular income and distribute funds depending on the performance of bonds.
A stock ETF is a basket of stocks that may or may not track a specific industry, with the aim to provide diversified exposure for investors.
Industry ETFs target specific sectors/industries to gain exposure to the said industry without owning the underlying assets.
Commodity ETFs invest in commodities like gold or oil and provide a cheaper form of investment than physical possession. They’re a good way to diversify a portfolio.
Currency ETFs track the performance of currency pairs and are used for speculation, hedging against volatility, diversifying portfolios or as a hedge against inflation.
Inverse ETFs trade on the expectation of a decline in the stock market, and they work by shorting stocks. These ETFs increase in value when the market declines.
Annuities vs. ETFs – Which is better for retirement?
Now that we’ve covered what annuities and ETFs are and how they work, let’s discuss which one is a better option for retirement.
When it comes to investing your savings, an ETF is a way to diversify your portfolio. For example, buying shares of a technology sector ETF is usually less risky than buying stocks of a single tech company. However, ETFs do not guarantee income or the performance of your savings, which means you could end up losing money if the market crashes. Additionally, there is also a risk of the ETF closing for various reasons, in which case you’d be forced to sell your shares, probably at a loss.
If you’re looking for guarantees regarding income or growth, annuities are your safest bet.
The cost is one of the aspects where annuities usually fall short in front of many other types of investments, and ETFs aren’t the exception. ETFs are a much cheaper way to invest than annuities, and when you let the differences in fees and commissions compound throughout the years, you’ll see that the cost of an annuity can become astronomical, especially for longer-term deferred annuities.
Performance and returns
Since some ETFs track indexes or even stocks in specific industry sectors, investing in ETFs generates returns comparable to investing in the stock market, which has a historic tendency to grow at about 10% each year. On the other hand, annuities either don’t grow with the market, or they cap your profits when markets perform well (in the case of variable annuities).
Consequently, ETFs usually perform much better than annuities, and when you add in lower fees, the difference becomes even more noticeable.
Income options and flexibility
ETFs are more flexible investments than annuities. Deferred annuities, for example, impose strong constraints on withdrawals in the form of heavy penalty fees, which is not the case with ETFs. The latter also offers more options in payments and distributions than annuities.
However, people who choose annuities are usually not looking for payment flexibility but rather for payment stability and guarantee, which is something annuities offer but ETFs do not.
ETFs may be more tax-efficient than annuities. While annuities grow tax-deferred, payments received during the annuitization phase are taxed as ordinary income, which is the opposite of tax-efficient. On the other hand, ETFs distributions could be taxed as capital gains in certain cases. This makes ETFs more tax-efficient than annuities.
The bottom line
When it comes to retirement planning, it’s important to consider all of your options to make an informed decision. An important part of this is understanding the pros and cons of investing in ETFs vs. annuities. If you’re looking for guarantees regarding income or growth, annuities are your safest option. However, suppose you’re looking for a more flexible and cost-effective investment that provides better tax efficiency and are willing to take on market risk. In that case, ETFs are a much better way to invest your savings for retirement.