Indexed investment have experienced a tremendous rise in popularity over the last few years as investors search for alternatives to direct stock market investing. Two types of investments in particular have emerged as investor favorites: Indexed annuities and exchange-traded funds (ETF). While they share some of the same characteristics, the two are designed very differently and they are intended to meet different investment objectives. A closer look at each of them will help you determine which one is most suitable for your needs.
ETFs are very similar to a mutual fund in that they are comprised of a basket of securities that mirror the securities that make up a widely followed index, such as the S & P 500. Unlike a mutual fund, the portfolio is not managed; rather it is kept static so that its performance will mimic the actual performance of the underlying index. ETFs are available for commodities indexes and specific stock sectors as well.
They trade as a marketable security which means that they can bought and sold on the exchange at any time. The price fluctuates in response to movement of the underlying index, so an ETF can be purchased in the morning and then sold that afternoon for a profit if the index moves up. For that reason, ETFs appeal to investors with shorter term goals and who like the liquidity of shares.
Because it is a static portfolio, the fees for buying ETFs are fairly low, and because their returns are equivalent to the performance of the various indexes, they are ideally suited for investors whose objective is to match the performance of the indexes.
When ETF shares are sold for a profit, they trigger a capital gains tax which can be more favorable than the ordinary income tax rate. Losses can be deducted from gains to reduce the tax consequences.
Indexed annuities are a little more complex than ETFs, but they offer a whole different set of benefits. They are an annuity contract, which means they are issued by life insurers with certain guarantees and tax benefits. As with any annuity the account values grow tax deferred and access to the values is restricted based on withdrawal fees that insurer may charge as well as possible IRS penalties that apply on withdrawals made prior to age 59 ½. And like most annuity contracts, they offer death benefit guarantees as well as a minimum interest rate guarantee.
That’s where the similarities end. The distinguishing feature of indexed annuities is the accumulation account and the way the annuity rate is credited to the account values. As with ETFs, indexed annuities tie the performance of the account value to a major stock index. However, instead of allowing the values to simply move in tandem with the price movement of the index, the insurer applies a participation rate which will determine how much of the index gain is actually credited to the account. So, if it applied a 70% participation rate on an index gain of 20%, only 14% of the gain is credited. The rate is only applied once per year, and remains fixed for the next year.
Indexed annuities also include a limit or cap on the amount credited. The cap may be something like 10%, which means, instead of 14% credited, as in the example above, only 10% is credited. While this may not seem like such a great deal for investors, they need to consider the minimum guarantee feature which ensures that, even if the index should decline in value, the account will still be credited with a rate of return. In essence, the account will never incur a loss.
Indexed annuities include a reset feature which adjusts the principal balance each year to include the gains achieved over the previous year, and because the account can never experience a loss, the principal balance, or basis in the contract, will continue to grow.
The income and withdrawals from indexed annuities are taxed like all annuities, as ordinary income when they are received.
Analyzing the Suitability of Both
Both investments are ideal for investors who want to add a more conservative element to their portfolio. Both investments seek to track the performance of the underlying index. ETFs present more risk because the share prices can fluctuate, while indexed annuities are virtually risk-free. The more risk adverse an investor is, the more appealing an indexed annuity might be.
ETFs are suitable for investors who want the flexibility and liquidity that share trading offers, while indexed annuities are better suited for people who are able to invest for a long term horizon. Even with indexed annuities, there is access to account funds for meeting short term needs.
Investors looking for a tax edge could do well with either investment. If ETF gains qualify for the favorable capital gains rate, that could prove better than the ordinary income tax rate paid on annuity income. The key difference is in the investment objectives. A person who is able to invest and hold for the long term may fare better with an index annuity with its continuous tax deferral.
Ideally, a mix of both investments would serve any investor with a conservative tilt and a long term horizon well. ETFs are ideal for younger investors who are seeking short term gains while indexed annuities are better suited for slightly older, retirement-minded investors.