People plan for their eventual retirement to ensure they can enjoy their golden years in comfort and security. Annuities are a popular component of many retirement strategies, particularly with the increasing life expectancy in the U.S. in recent decades. However, you might still have lingering questions about how safe annuities really are.
In this article, we’ll explore the risks associated with different types of annuities and discuss strategies for minimizing them.
Annuities are insurance contracts between an individual and an insurance company. The individual (owner) purchases an annuity through either periodic or lump-sum payments. With fixed annuities, the owner receives either: (a) a guaranteed monthly income stream starting immediately or at a future date, or (b) a guaranteed return on their money at a predetermined interest rate.
Given this structure, it’s easy to see why annuities are considered effective retirement planning tools. For example, you could purchase an annuity in your 40s and receive a steady stream of guaranteed lifetime income when you stop working in your 60s or beyond.
Fixed annuities are generally considered safe – much safer than individual stocks or startups. However, they are not without risks, which we’ll address below.
One of the most common questions about annuities is whether it’s possible to lose money. The answer depends largely on the type of annuity.
Variable Annuities
With variable annuities, the premium you use to fund the account is invested in various “subaccounts” that can be affected by market fluctuations. If the market rises, your annuity value increases. However, if the market drops, you could lose a significant amount of your investment.
It’s important to note that some optional riders on variable annuities may be marketed as providing protection against market downturns. However, the fact is that you are typically not fully protected from downside risk.
Fixed Annuities
Fixed annuities, on the other hand, do protect against market risk. In this case, the insurance company assumes the risk. Your principal and future payments are guaranteed (provided the issuing company remains solvent).
Another question that arises is whether annuity companies can go out of business and default on their commitments. The short answer is “yes,” annuity companies can become insolvent. However, it is quite rare for highly rated medium- to large-sized insurance companies to fail.
Fixed annuities are also backed by State Guaranty Associations, which typically provide coverage of up to $250,000 in benefits per owner, depending on the state. While this isn’t the same as Federal Deposit Insurance Corporation (FDIC) protection, it does offer a level of assurance if the issuer faces financial difficulties.
Inflation is another risk to consider when planning for retirement. With rising inflation, the purchasing power of money gradually decreases. This concern also applies to annuities that provide a fixed, contractually guaranteed interest rate or income stream, such as fixed annuities.
For instance, if you receive $3,000 per month from your annuity while inflation is high, your money will lose its value over time. This is something to keep in mind when planning for long-term retirement income.
Multi-Year Guarantee Annuities (MYGAs)
At AnnuityAdvantage, we specialize in selling MYGAs, also known as fixed-rate or CD-type annuities. These annuities provide a guaranteed interest rate for a specified time period (typically 2 to 10 years). However, like all annuities, MYGAs are still subject to the risk of inflation. If your guaranteed annual interest rate is 5% and inflation rises to 8%, the real value of your annuity will decline.
“Liquidity risk” refers to the possibility that you may not be able to access your annuity funds when you need them. Annuities are generally illiquid assets, meaning they may not be easily converted into cash in the short term. As a result, you should consider allocating only long-term funds to an annuity.
Almost all deferred annuities, whether variable or fixed, include “surrender periods” during which withdrawals may result in penalties. However, many offer penalty-free withdrawal provisions, usually allowing up to 10% of the contract value to be withdrawn annually.
People sometimes wonder about the difference between annuities and life insurance because both involve considerations of death and beneficiaries. However, while life insurance pays out to your beneficiaries upon your death, annuities are usually meant to provide income for retirement during your lifetime.
With life-only income annuities, if you pass away before the full value of your annuity has been paid out, the insurance company may retain the remaining balance. However, many annuities can be tailored with various payment options, such as a joint-and-survivor arrangement, enabling payments to continue to a designated beneficiary, such as a spouse.
While fixed annuities are generally considered safe, there are several strategies to manage their risks and further secure your financial future. Here are a few approaches:
Annuities are not insured by the Federal Deposit Insurance Corporation (FDIC), which protects bank accounts up to $250,000. However, annuities are subject to state-level protections. Each U.S. state has a Guaranty Association that provides a safety net for annuity owners, typically covering up to $250,000 per individual policyholder.
One of the most effective ways to reduce risk is through diversification. While fixed annuities are considered safe, it is still risky to place all your retirement funds in a single asset or with a single annuity issuer.
You can diversify in several ways:
When selecting an annuity, it’s important to evaluate both the insurance company’s financial strength and the type of annuity that aligns with your risk tolerance.
Annuities are a popular and reliable option for many individuals saving for retirement. However, it’s essential to understand the risks and make informed decisions to ensure they align with your long-term financial goals.
If you still have questions or want to discuss annuity options further, consider speaking with one of the specialists at AnnuityAdvantage (set up a time to talk with us). We have extensive experience in navigating annuity risks and can help you create a secure retirement strategy.
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