Investors who consider annuities for their investment portfolio need to do so in the context of an overall strategy that is based on their long term objectives, time horizon, and their financial concerns. They should also be viewed as but one component of an asset allocation plan that achieves optimum diversification and balance for their investment profile. Some investors may find that annuities may not work in their strategy even though they like the basic features they offer. Others may find that annuities are a good fit for their portfolio, but want to diversify by adding similar investment products. In either case, it would be important to know the alternative to annuity investments in order to make the best decisions for your investment strategy.
Bank CDs are often compared with annuities when the issues of safety and competitive fixed yields are considered. CDs have always been considered to be safe investments due largely to the fact that they are issued by banks and backed by the Federal Deposit Insurance Corporation. The rates offered by banks on their CDs are comparable to those offered on annuities. Because the methods for determining yields on CDs and on annuities differ, CDs yields tend to be slightly lower than annuity yields. However, CDs with long maturity terms can offer rates significantly higher than those with shorter terms. A five year CD will yield as much as a point more than a one or two year CD. Larger deposits (i.e. $100,000 or more) can also earn a much higher rate in a jumbo CD. If you try to cash out a CD before its maturity, the yield will be adjusted downward as a penalty. Interest earned from CDs is always taxed as ordinary income except if it is earned inside of a qualified retirement plan.
Tax Free Bonds
The interest generated from bonds issued by state and municipal governments are exempt from federal taxes. Tax free bonds purchased from within your resident state are also exempt from state income taxes. While the yields on tax free bonds are lower than those on taxable bonds issued by the federal government or corporations, their tax treatment can make them more attractive for investors in higher income tax brackets. For instance, a tax free bond yielding 3% would be equivalent to earning 4.5% on a taxable bond for someone in the 28% tax bracket. If you are in the highest tax bracket – 38%, you would a taxable bond would need to yield 5.3% to match the tax free yield of 3%.
Until recently, bonds issued by state and local governments have been considered to among the safer investments. State general obligation bonds were considered to be the safest. In view of the recent fiscal difficulties many states and municipalities are facing, this may no longer be true. Still, you can probably count on the ratings assigned by the ratings agencies, such as Standard & Poor’s’ or Moody’s to guide you to the highest quality issues. Additionally, tax free bonds are interest rate sensitive, meaning that, if interest rates increase, the value of the bonds will decrease. So, even though the income from the bonds can be considered safe, the actual bond values will fluctuate. Tax free income is hard to beat for investors in the top brackets. The important consideration for retirees is the fact that tax exempt income is included in the calculation to determine how much of their Social Security income is taxable. Alternatively, annuity income, which is partially tax exempt is not includable in the Social Security calculation.
Mutual funds are often compared with variable annuities for investors seeking investment diversification and professional management. With literally thousands of funds from which to choose, there is no shortage of options for investors who seek the broadest diversification. Some mutual fund families consist of dozens of different funds from a range of asset categories, such as growth stocks, aggressive growth stocks, international equities, individual industry sectors, corporate bonds, government bonds, real estate, and many more. The number of “no-load” funds offerings continues to grow, so the only cost consideration are the management fees which can vary widely depending on the type of fund and how actively it is managed. The earnings from mutual funds are taxable in the year they occur either in the form of capital gains taxes or ordinary income taxes on interest and dividends. Most mutual funds require a small initial investment ($500 or $1,000) and allow for even smaller monthly investments.
Is there such thing as an Alternative Annuity Investment?
Certainly any one of these investment provide a viable alternative for an investor looking for diversification and stability in an overall investment strategy. And, through a combination of these products, it is possible to achieve some tax advantages along with long term growth potential. All of them should be a part of any investor’s consideration for inclusion in a properly allocated portfolio. The question remains whether any one of them, or some combination, contain the unique characteristics of an annuity that can provide the same level of safety, stability, savings guarantees, income guarantees, tax advantages, and flexibility. Those familiar with annuity investments would probably conclude that they don’t, however, investors must determine for themselves just how important these benefits are in the grand scheme of their investment strategy.