Bond Fund vs. Indexed Annuities
Original post by Ciaran John of Demand Media
Bond funds and indexed annuities are both investment instruments that can provide you with supplemental income. However, the similarities between the two products end there, as these investment products differ in terms of cost, liquidity and risk. Bond funds contain hundreds or even thousands of bonds issued by different entities; fund investors own a stake in the fund portfolio rather than the individual bonds. When you buy an indexed annuity, you purchase an insurance contract and you receive a return based on a stock market index like the Dow Jones industrial average. Essentially, bond funds provide you with income while indexed annuities offer you the potential to grow your investment, but can also generate income.
Bond fund shareholders usually receive monthly dividend payments, so bond funds are ideal for people seeking immediate income. These dividends are funded with the interest that the fund company receives from the issuers of the underlying bonds. By comparison, indexed annuities are deferred annuity contracts, which means that you do not receive any income until the contract term ends. Indexed annuity terms often last for in excess of 10 years, after which you can cash-in your account or turn the lump sum into a lifetime income stream. Therefore, indexed annuities appeal to people who need future income rather than immediate income.
Many mutual fund companies sell a type of share known as A-class or front-end load shares. You pay an upfront commission when you buy these shares that often exceeds 3 to 4 percent of the purchase price. Some firms also sell B- or C-class shares, on which you pay a similar commission, known as a back-end load, when you sell your shares. You can also buy no-load shares on which you pay no commission, although the returns are sometimes lower than on load-shares. When you buy an indexed annuity, you pay nothing upfront but you have to pay annual contract fees that deplete the cash value of your account.
Bond funds are typically open-ended funds, which means that you can redeem your shares at any time by selling your shares back to the mutual fund company. You cannot redeem shares of a closed-end fund until the fund company winds down the fund, but you can sell your shares to other investors so you still have a high level of liquidity. During the term of an indexed annuity contract, the insurance company invests your money and you incur hefty penalties if you redeem your contract. These fees often top 10 percent of the contract value. You pay nothing once the annuity term ends, but some of these contracts last for 15 years or more. However, many states do have annuity free-look provisions, which means you can cancel your contract without penalty. Free-look periods usually last for between 10 and 30 days.
Bond fund share prices fluctuate because the values of the underlying bonds are subject to factors such as supply and demand. Additionally, when interest rates rise, the values of existing bonds fall and the opposite happens when interest rates drop. Therefore, you have no principal guarantees when you buy a bond fund, although bonds fluctuate less than stocks. On an indexed annuity, your returns depend on the performance of the chosen index -- although insurance companies usually cap your returns so your contract stops growing in value even if the index continues to rise. If the index falls, you can lose money, although most contracts assure you of a minimal return that amounts to at least about 90 percent of your original investment.
- FINRA: Bond Funds
- Securities and Exchange Commission; Bond Funds and Income Funds; March 2010
- FINRA: Equity-Indexed Annuities -- A Complex Choice
- "Forbes"; Are Equity-Indexed Annuities Right For You?; Brigitte Yuille; May 2010
About the Author
Ciaran John began writing in 1994 with contributions to "The Hourly Press" and "The Sawbridgeworth Observer." He holds a Florida Life, Health and Variable Annuity license as well as series 6 and 63 securities licenses. He has a Bachelor of Arts in theology from Kings College in London.