What is Annuity?
Annuity is a financial instrument that pays a fixed amount to the investors at regular intervals. It is majorly used by individuals post retirement to serve as a source of regular income. For instance, pension plans are a type of annuity.
Broadly speaking, there are two types of annuities, fixed annuity and variable annuity. In a fixed annuity, the investor earns a fixed interest on the principal. On the other hand, variable annuities have sub-accounts which may include investment in stocks, bonds and mutual funds as well. The National Pension Scheme (NPS) is a classic example of variable annuity.
What are Mutual Funds?
Mutual funds collect resources from a pool of investors and invest them in equities, debt securities and other financial instruments. The returns from these asset classes are distributed proportionately amongst the investors of the fund.
Mutual Fund schemes are professionally managed by qualified fund managers, which allows even the naive individual with little knowledge about the financial markets, to invest in equities and make substantial capital gains.
Here we’ve compared the two financial products based on few parameters:
- Mode of investment
One can either make a lump sum investment in a mutual fund scheme or opt for Systematic Investment Plan (SIP) mode of investment. SIP allows investors to make periodic investments in a mutual fund scheme. One can invest weekly, monthly, quarterly, semi-annually and annually.
In an annuity, an investor makes a lump sum investment, which is later periodically withdrawn, as per the investor’s interest.
Mutual funds are a popular investment option because of the diversification they offer. The investment portfolio of MF consists of diverse financial instruments such as equity stocks, debt securities, cash and cash equivalents, etc. This effectively protects the investor’s capital from market risk, and allows him/her to capitalize from the benefit each asset class offers.
Annuities majorly invest in fixed income instruments with the exemption of variable annuities that may invest in equity securities, debt instruments, etc.
- Risk appetite of the investor
Before investing in any of the financial instruments, it is imperative for an investor to analyse the extent of risk exposure s/he is willing to take in regard to his/her investments.
If your risk appetite varies from low to moderate, it is better to opt for annuity plans, as the returns from these are guaranteed. Mutual Fund schemes are recommended to individuals with high risk appetite, as the returns are market linked. Although, it should be noted that the investment in mutual funds has the potential to deliver higher returns than those from annuities.
Investment in annuity schemes is deductible from the taxable income of the investor upto certain extent. However, the capital gains from these plans are treated as regular income for the tax purpose, and are taxed as per the income tax slab of the investor.
Incase of mutual funds, taxation depends on the type of mutual fund scheme. Equity mutual funds are taxed at 15% if the investment is withdrawn within one year. Long Term Capital Gains Tax of 10%, with indexation benefit, is levied over and above ₹1 lakh, if you redeem the fund units post 1 year of investment.
Investment in Equity Linked Savings Scheme (ELSS) also provides tax-savings benefit on investment. Investment upto ₹1.5 lakh in ELSS is exempted from taxation in one financial year, under Section 80(C) of the Income Tax Act.
Both the products come with a specific fee for the services they offer. Mutual funds charge a small fee to manage your assets, known as expense ratio. Annuities charge a higher asset management fee, owing to the guarantee that they give on your investment.
Which is better: Mutual Funds or Pension Plans?
The answer to this question varies for different individuals, depending on their investment objectives, financial goals and risk appetite. If you want to create a substantial corpus of wealth for your retirement, you can invest in mutual funds early in life, provided you have a moderate to high-risk appetite. When you retire, you can transfer the accumulated corpus to an accrual debt fund, and opt for Systematic Withdrawal Plan (SWP). Regular cash-flows from this well serve as a regular income for the investor post retirement as well.
Incase of annuities, you can either opt for NPS, which works on the similar lines as that of any mutual fund scheme, or go for a fixed-income guaranteed pension plan. The former is highly prone to market risk, whereas the latter ensures fixed income for the investors during their retirement days.