Are Annuities Safe?

Annuities are generally considered safe investments. They offer a guaranteed income, often for life, providing a sense of security for your retirement years. As with most financial instruments, they come with their own set of risks. But, with prudent management, annuities can serve as a secure element in your portfolio.

What Are the Inherent Risks of Annuities?

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 of 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The risk that surrender penalties will create losses if funds are withdrawn early.

One other risk that is inherent to certain types of annuities, particularly immediate annuities with a straight life payout, is the risk of death. It’s a risk because these kinds of annuities are almost 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 in a straight life payout immediate annuity 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 ways to prevent one’s heirs from losing that income are to purchase an additional rider, which could be expensive, or to choose a different payout option, such as a period certain payout.

Because of their inherent guarantees, annuities are often seen as a safe way to protect your income from the risk of living too long. However, they still pose some risks that you need to be aware of.

Because of their inherent guarantees, annuities are often seen as a safe way to protect your income from the risk of living too long. However, they still pose some risks that you need to be aware of.

Brandon Renfro, Ph.D., CFP®, RICP®, EACo-Owner of Belonging Wealth Management

As a Certified Financial Planner™ professional and Retired Income Certified Professional®, Brandon Renfro is well-versed in the financial information and strategies needed to meet retirement goals. In addition to co-owning Belonging Wealth Management and assisting clients, Brandon writes regularly for financial publications.

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. 

All risks 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 offer something that most investment vehicles don’t. Annuities are insurance products intended to create a guaranteed stream of income over a set period, 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.

Does a Recession Make Annuities Riskier?

Recession doesn’t necessarily introduce any more risk to investors than is already inherent in an annuity. 

According to Certified Financial Planner™ professional and Annuity.org contributor Stephen Kates, annuities are generally able to withstand an economic downturn as long as the annuity provider that issued the contract stays solvent. 

“Ninety-nine percent of insurance companies are probably in a good position to do that,” Kates said.

However, Kates noted that deferred variable annuities could be impacted by a recession because of their direct market participation. 

“A lot of deferred variable annuities are participating in the market, so the investments you own within that are subject to the risk of the market,” he noted. 

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.

What Are the Advantages of an Annuity?

The main advantage of annuities is their ability to provide contract owners with a lifetime of guaranteed income. Immediate annuities can allow someone entering retirement to augment their 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 the time of purchase as a long-term savings strategy.

The illiquid nature of annuities also means that they shouldn’t be 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.

Be aware that 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.

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 state guaranty associations, which pay 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.

Variable annuities are tied to the performance of an investment portfolio, which can fluctuate in value over time. As the stock market changes, the value of a variable annuity can increase or decrease, exposing investors to the same type of loss they would suffer if they owned the investments outright.

Investors can preserve the value of their variable annuities by purchasing a guaranteed minimum income benefit (GMIB) rider. With a GMIB rider, the insurance company guarantees that the annuitant will receive a minimum monthly payment, regardless of how market volatility affects their annuity’s value.

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.

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Are Some Types of Annuities Safer or Riskier Than Others?

Different types of annuities carry different levels of risk, along with varying degrees of potential returns. In general, the more risk an annuity places on the contract owner, the greater the growth potential. Conversely, annuities — where the insurer bears more risk — tend to have a lower potential for returns.

Immediate annuities are the simplest and least risky type of annuity. These are contracts that convert a premium payment into a guaranteed income stream. As long as your insurance company remains solvent, you’ll get exactly what you are promised from an immediate annuity.

Fixed deferred annuities are another type of extremely low-risk annuity. These annuities guarantee a fixed rate of growth for a certain period of time. Fixed annuities are more risky for insurers than for the annuity owners, because the insurance company bears the loss if their investments’ performance isn’t enough to pay the guaranteed interest rate at a given time.

The interest rate of a fixed annuity is determined by the insurance company and can change monthly, quarterly or annually. This means that purchasing a fixed annuity comes with the risk that the contract’s rate may decrease later if the insurer decides to cut rates.

Fixed index annuities — which accumulate value based on the performance of a market index — carry a moderate level of risk for contract owners. These products are protected against losing any value, though poor market performance may result in little to no growth. The downside protection of fixed index annuities comes at the expense of limiting how much the annuity can grow if the index performs well.

Variable annuities carry the most risk of any annuity product because they, typically, directly participate in the market. Because the value of variable annuities is invested directly into the market, these products have both the highest growth potential and the highest risk of losing value.

A lot of deferred variable annuities are participating in the market, so the investments you own within that are subject to the risk of the market.

Stephen Kates, CFP®, Licensed Life Insurance ProducerPrincipal Financial Analyst for Annuity.org

Stephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.

What Should I Consider Before Buying an Annuity?

Before buying an annuity, understand what your retirement income must be to finance your consumption goals and determine if your current investments and expected savings plan will be sufficient to meet your expectations.

Then consider how annuities might help fill any income gaps during retirement or make up savings shortfalls while you are still working.

Once that crucial planning is complete, you should weigh:

The Types of Annuities Available

Fixed, Variable, Indexed, Immediate and Deferred

How Each Type Fits Your Plan

Is there a growth deficit that requires more income?

How Much Risk You Are Willing To Accept

Are the potential returns worth the risk?

Which Insurer To Use

Is a B-rated firm acceptable, or is greater security necessary?

What Should I Do Next?

The next step to take before buying an annuity is to talk with an experienced 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.

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Frequently Asked Questions About Annuity Safety