- Annuities tend to carry less risk than individual stocks and bonds, but — like all financial instruments — they come with a degree of risk.
- Annuity risks include the risk the insurer will become insolvent or that your annuity’s purchasing power will decline before your payout.
- You can manage annuity risks by diversifying your portfolio with other investment options.
A key advantage to buying an annuity is the opportunity to realize tax-deferred compounding growth over a long period of time without the risk that comes with investments that are vulnerable to market fluctuations.
What Are The Inherent Risks In Annuities?
Annuities, like most financial instruments, are not without risk. Annuity payouts are based on the annuitant’s life expectancy. Because we have no way of knowing how long any individual will live, buying an annuity means accepting the risk that you won’t necessarily reap all the potential benefits from your purchase.
The inherent risks in annuities include:
- Credit Risk – the risk the insurer will become insolvent
- Purchasing Power Risk – the risk that inflation will be higher than the annuity’s guaranteed rate
- Liquidity Risk – the risk that funds will be tied up for years with little ability to access them
- Surrender Risk – the risk that surrender penalties will create losses if funds are withdrawn early
There is one other risk to annuities that is inherent in to them. That’s the risk of death. It’s a risk because annuities really are the opposite of life insurance.
With life insurance, people bet they’ll die before the insurance company expects. If they do, the insurance pays off. Annuitants make the opposite bet. They wager they’ll live longer than the insurance company expects.
If an annuitant dies early, the insurance company keeps the premiums and the lifetime stream of income it purchased. The only way to prevent one’s heirs from losing that income is to purchase an additional rider, which could be expensive.
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Does Recession Make Annuities Riskier?
Recession doesn’t necessarily introduce any more risk to investors than is already inherent in an annuity. There are specific risks to variable annuities that could be exacerbated by recession, but they are most likely to be triggered by the actions of the annuitant rather than the economy.
Early surrender is the biggest of these risks. It could trigger early withdrawal or surrender penalties and subject the annuitant to market exposure and potential loss of principal.
While a severe recession could increase the risk of the underlying insurance company’s insolvency, that risk can be mitigated. In general, investors would be well advised to consider only annuities issued by insurers rated BBB (Good) or better by AM Best.
For those seeking greater comfort, limiting their criteria to insurers with an AM Best rating of A (Excellent), AA (Superior) or AAA (Exceptional) could help them avoid insurance companies that might default on their obligations.
However, investors need to be aware that neither a recession nor a high AM Best rating will do anything to lessen the severity of the other risks inherent in annuities. Those risks need to be managed.
How Do I Manage Annuity Risks?
Purchasing an annuity should be considered as thoughtfully as investing in securities. While annuities are less risky than individual stocks and bonds, they are not riskless assets. And all risk can be managed.
The easiest way to manage risk is to diversify it. That means including annuities in an otherwise well-balanced portfolio of other assets, such as stocks, bonds, and cash. Where appropriate, owning more than one type of annuity may make sense. A mix of fixed and variable annuities could provide additional growth and income to and through retirement.
Understand how the current interest rate environment might impact your retirement income to determine whether to include or exclude a given annuity from your portfolio.
Most importantly, don’t panic. Don’t let external influences — short-term market volatility, negative news headlines, opinions of financial commentators — derail your long-term financial plan and the strategy designed to help you achieve it.
How Do Annuities Stack Up Against Other Investments?
Annuities are an insurance product intended to create a guaranteed stream of income over a set period of time, often for the life of the annuitant. There are no investments that can do this.
Bonds can provide a dependable stream of interest income until maturity. Stocks can grow wealth over very long holding periods. But neither of these investments can, at a set point in time, convert to a lifetime of guaranteed income.
Annuities can be structured to mimic the behavior of stocks. This is possible with variable annuities. Fixed annuities can simulate the return on bonds. If used properly, and not sold prematurely, annuities can provide the investment returns of other assets with much less volatility.
What Are the Advantages of an Annuity?
The main advantage of annuities is their ability to provide contract owners a lifetime of guaranteed income. Immediate annuities allow someone entering retirement to augment other sources of income. They can also be used later in retirement to replace income lost after an employer retirement plan or IRA rollover is exhausted.
An effective financial strategy is to purchase an annuity with payments scheduled to begin at a certain age — for example after age 70½ — to optimize Social Security benefits by minimizing taxable income.
Another important advantage annuities have over other types of investments is that, depending on whether the annuity is qualified or nonqualified, the income they generate may not be fully taxable. Only the interest earned is taxable when it is distributed from a nonqualified annuity.
What Are the Disadvantages of an Annuity?
A significant disadvantage of annuities is that they are illiquid investments. They are intended to provide income either for a predetermined number of years or an entire lifetime. So, they should be viewed at time of purchase as long-term savings.
The illiquid nature of annuities also means that they shouldn’t been seen as a source of funds to finance an alternate investment or purchase a consumption-oriented goal, such as buying a vacation home or a boat.
Annuity contracts terminated during their surrender period can subject the holder to penalties and additional fees. In some cases, a premature sale can expose one to market risk and potential loss of capital. There is also a higher cost associated with annuities than with most investments.
Annuities can generate stock- or bond-like returns. But they are more expensive than stocks or bonds. Annuities are insurance products. That insurance comes at a cost, which can lower investment returns. An annuity’s underlying investments — also called subaccounts — often have higher fees than individual mutual funds.
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Can You Lose Money in an Annuity?
You can lose money in an annuity if the insurance company backing it goes bankrupt and defaults on the obligation. Annuity owners can take steps to avoid this, but if it happens, they could potentially lose some of their account value. A level of protection does exist, however. Insurance companies are legally required to belong to their state’s guaranty association, which pays claims up to statutory limits when a member company fails.
People who purchase an additional market value adjustment (MVA) rider can expose themselves to loss. An MVA rider is designed to reset a fixed interest rate guarantee to realign the percentage earned with the going market. An adjustment higher could create a gain for the annuitant. An adjustment lower could subject the annuitant to a loss of principal.
Indexed annuities that track an investment benchmark, such as the S&P 500, fluctuate in value over time. That fluctuation impacts the value of indexed annuities and can expose investors to the same type of loss they would suffer if they owned the investments outright.
This is the case with any variable annuity, unless you purchase a guaranteed minimum income benefit (gmib) as a rider on a variable contract. Fixed annuities have a set rate guarantee. As long as the contract is never sold, the owner cannot lose money. That is not the case with variable annuities. Over long periods of time, the risk of loss decreases but never disappears.
Read More: Calculate your projected annuity payout
What Is the Best Financial Planning Strategy for Retirement?
The best strategy for retirement is to carefully consider it as part of a comprehensive financial plan that takes many other factors into consideration.
In general, equities can help investors grow their wealth to and through retirement. Make sure your investment plan, asset allocation, and security selection methodology are aligned with your goals, risk tolerances, and personal preferences. Annuities can be a part of your mix and can produce tax-advantaged retirement income that securities can’t.
One of the most important parts of your retirement planning should be to seek the advice of a professional.
What Should I Consider Before Buying an Annuity?
Before buying an annuity investors should understand what their retirement income must be to finance their consumption goals. They should determine if their current investments and expected savings plan will be sufficient to meet their expectations.
Then they should consider how annuities might help them fill income gaps in retirement or make up savings shortfalls while they are still working. Once that crucial planning is complete, investors should carefully consider:
- The Types of Annuities Available
- Fixed, Variable, Indexed, Immediate, Deferred
- How Each Type Fits the Plan
- Is there a growth deficit that requires more income?
- How Much Risk Is Acceptable
- Are the potential returns worth the risk?
- Which Insurers to Use
- Is a B-rated firm acceptable, or is greater security necessary?
Working with an experienced advisor can help with all of this.
What Should I Do Next?
The next step to take before buying an annuity is to talk with an advisor who understands the differences between various types of investments and savings vehicles and can help you understand how each type might optimize your unique financial plan.
FAQs About Annuity Safety
Compared with other traditional investments such as stocks and bonds, annuities are low risk. Their fixed rates and guaranteed income make them safe in the right circumstances.
When it comes to safety, annuities are generally considered low-risk retirement investments. Income annuities and fixed annuities, in particular, are among the safest financial solutions available. They offer fixed rates and guaranteed income, making them a safe option in the right circumstances. However, it’s important to exercise due diligence and careful planning to ensure that you choose the right type of annuity for your needs.
Annuities make the most sense for people looking to create retirement income. They also make sense for people seeking tax-deferred growth and a conservative and steady strategy for building wealth. Conservative investors looking for a guaranteed rate of return on assets that aren’t volatile are also great candidates for annuities.
You face risk whether you invest in annuities or stocks. When creating a retirement portfolio, fixed-rate annuities tend to be a safer investment because they guarantee a specific rate of return, while stocks have the potential to provide a larger return. You can lose money in either.