Are Annuities a Safe Investment? (What To Know About Annuity Risk)

Let’s face it: Over the years, annuities have gotten some pretty bad press.

Frustration over surrender charges and fees, confusion about industry jargon and rules, and fears of being sweet-talked into a bad deal by some insurance company’s agent have made annuity products—at least in some circles—sound pretty risky.

But annuities aren’t the pit of danger many make them out to be. On the contrary, annuities were designed to take the risk out of retirement, not put more risk into it. And, when used properly, that’s exactly what they can do! Annuities offer your retirement plan something no investment can: guaranteed lifetime income.

So, what are the risks of getting an annuity, and do those risks make annuities a poor investment? Let's take a closer look to find out.

Are Annuities a Safe Investment?

Yes. Unlike stocks and bonds, annuities are insurance products designed to give you guaranteed income in retirement. You fund your annuity with premiums (either a one-time lump sum or multiple premiums over time) and your premium grows over a number of years.

When you’re ready, you can convert your annuity into a stream of income, one that can last for the rest of your life.

What Risks Come With Annuities?

So, where does the risk come in? There are five risks that are common to all annuities. When people refer to annuity risk, they’re usually talking about one of the following five things.

1. You Die Earlier Than Expected

When you buy an income annuity, the kind that provides a guaranteed stream of monthly payments, you get to choose how long you want those payments to last.

If you choose a single-life or “life only” payout, you get monthly payments for as long as you live, and if you die prematurely, you forfeit the remaining payments. That’s why it is important to choose the type of payout carefully because there are other types of distributions that have death benefit features.

2. You Need Money Before Your Contract Is Up

Different contracts have different withdrawal options.

On the one hand, some contracts have a return of premium feature, allowing you to withdraw as much as you want at any time without a penalty, while some offer limited or no access to your funds during the surrender charge period.

The surrender charge period is the time during which a surrender charge will be assessed against withdrawals.

If you take money out of your annuity, the insurance company will multiply the surrender charge percentage (this usually varies by the contract year you’re in when you take the withdrawal) by the amount you’re withdrawing and deduct that from your withdrawal.

For example, if you withdraw $1,000 in the second year of your contract and the surrender charge for the second year is 5%, you will be charged a surrender charge of $50. That being said, many contracts will allow for some type of penalty-free withdrawal during the contract period, sometimes 5% or 10% of the account value.

Some contracts also allow for penalty-free withdrawals if you meet certain criteria (such as if you need the funds for medical expenses or nursing home care) or upon the death of the owner. Before purchasing an annuity, it’s important to ask questions about when and how you have access to your funds.

3. Your Annuity Grows Slower Than Inflation

Unlike Social Security, most annuities don't automatically adjust for inflation. So when inflation rates go up, your annuity payouts stay the same and are not adjusted for inflation. Inflation hurts both immediate annuities and deferred annuities.

Because deferred annuity rates are locked in for a period of time and do not adjust for inflation, the rate of interest credited to you may barely pace inflation rates. Inflation, however, isn't unique to annuities. It's a problem for all investments and savings accounts. Your best bet is to create a retirement plan with a financial advisor. They can help you use all of your retirement accounts—401(k), IRA, annuity, investments—to keep your rate of return above inflation rates.

4. You Lock Into a Lower Interest Rate

The last risk is missed opportunity. Once you sign your annuity contract, your crediting rate—at least for most fixed annuities—is locked into place for a period of time. Stock market rates may soar the day after you sign your contract, but your annuity crediting rate will stay the same. The opportunity cost, however, isn’t typically that dramatic. And waiting until rates are “just right”—which, come on, who really knows that?—has its cost, too: You’re missing out on potential growth in your annuity.

How Do Different Types of Annuities Rank by Risk?

One reason annuities get a bad rap is the confusion over the different types of annuities. Annuities don’t all work the same, and their differences affect their levels of risk. So, to set the record straight, here’s how the three major annuity types compare.

Variable Annuities (Highest Risk)

A variable annuity works like a mutual fund: Your premiums go into investments (called subaccounts), which impact your annuity’s rate of return. If these subaccounts perform well, you’ll see a high return. If they don’t, you’ll see a low return or a negative return.

The trouble with variable annuities? They don’t guarantee any earnings.

What’s worse: Variable annuities can have high fees, such as administration fees on all your subaccounts and commission paid to the insurance company agent who sold you the annuity. Because market volatility affects the value of a variable annuity, it is by far the riskiest of the three types.

Fixed Indexed Annuities (Medium Risk)

An indexed annuity also has market risk but in a different way. Your premiums are tied to an underlying index market, like the S&P 500, and your rate of return depends entirely on that market’s performance. At issue, you’re given a guaranteed minimum rate of return and a guaranteed maximum. Your guaranteed minimum protects you from losing money, while your maximum caps your earnings at a certain percent.

So if your minimum is 2% and the index that you’re annuity is tied to dropped to -25%, guess what? You’d get the 2%. Sounds safe, right? Well, minimum and maximum rates aren’t the full story. On a fixed indexed annuity gains may be more complicated than you think, too.

Insurance companies use what’s called a “participation rate” to determine how much of the gain you get. For instance, let’s say you have a participation of 55%. If the market jumps up to 20%, your rate of return isn’t the full 20%; it’s 55% of 20%, which comes out to 11%.

While you are taking some risk that you won’t be getting the entire upside of the market, you are protected against the downside. Fixed indexed annuities can not credit you less than 0% interest, meaning you do not lose principal when the index loses money.

This illustrates perhaps the biggest risk with indexed annuities: They can be complicated. Before you purchase one, make sure you consult a financial professional. Have them explain in plain English what you’re buying. You don’t want to invest in something you don’t understand.

Fixed Annuities (Lowest Risk)

Fixed annuities are the least risky annuity product out there. In fact, Fixed annuities are one of the safest investment vehicles in a retirement portfolio.

When you sign your contract, you’re given a guaranteed rate of return, which remains the same no matter what happens in the market. You know how much you’ll earn a year, and, unless you break your contract, your money will continue to grow at your fixed interest rate for the length of the guarantee term you choose.

Does a Recession Make Annuities Riskier?

A recession doesn’t make annuities riskier, though it may have an impact on the risks listed above. For example, the increased costs of living that come with a recession may tempt you to withdraw your money and pay surrender charges.

How Can You Manage Annuity Risk?

Like other investments, annuity risk can be avoided. Here are five ways to minimize the investment risks that come with an annuity.

1. Don’t Buy an Annuity You Don’t Understand

If your annuity is too complicated, and your provider can’t explain it in simple terms, don’t buy it. Period. You should know how your annuity works, what the payouts will be, who gets the annuity when you die, how much you’ll pay in fees, and what penalties you’ll face if you make early withdrawals.

2. Know How the Fee Structure Works

What's worse than locking into an annuity you don't understand? Locking into an expensive annuity with fees you weren't expecting.

Yes, if you're not careful, annuities can get costly. And we're not even talking about penalties and surrender charges either (though those can be hefty, too). Many annuities come with account fees, which can affect your rate of return and how much your annuity will cost in total. And if your annuity has underlying investments (like those on variable and indexed annuities), you'll have to pay fees on your subaccounts too.

Plus if you purchase a rider, there might be additional fees to pay. Always, always, always read the fine print on your contract. You should only feel confident buying an annuity when you know exactly how the fee structure works.

3. Make Your Annuity Work With Other Financial Products and Investments

You’ve heard it before but don't put all your eggs in one basket! Sure, an annuity can provide guaranteed retirement income. But to hedge the risk of inflation or cover unexpected expenses, consider diversifying your retirement plan with stocks, bonds, and cash.

4. Choose an Insurer in Good Standing

Before you sign your contract, make sure the insurance company providing your annuity will actually be around when it comes time to pay you. How can you know that? One way is to use an independent credit rating agency to assess their financial strength.

Agencies like Standard & Poors, Moody’s, Fitch, and A.M. Best will give you an unbiased rating on your insurance company, helping you decide if the insurer is secure enough to entrust with your money.

5. Make Sure an Annuity Is Right for You

Before you buy an annuity or any financial product for that matter, make sure you have a purpose and a plan. An annuity is a great long-term retirement planning strategy that gives you guaranteed income in retirement. But if you think you’ll need a lot of cash for expenses in the near future, you probably want to keep your money liquid and not purchase anything that could restrict your access to the money you need.

What Are the Advantages of Having an Annuity?

Once you understand and know how to manage the risks, it’s time to consider if an annuity purchase is right for you. Annuities can be a great way to build retirement income, and the fact that they can also offer guaranteed lifetime income should get you excited. Here’s why you may want to include one in your retirement planning strategy.

1. Guaranteed Income for the Rest of Your Life

An annuity is designed to take the risk out of retirement. You buy one because the risk of not having one (that is, depleting your retirement savings earlier than expected) is greater than all the small, manageable risks listed here. If you’re worried you’ll run out of money in retirement, annuities can give you peace of mind and security, knowing you’ll have payouts coming to you.

2. Contributions Grow Tax-Deferred

Annuities give you something that certificates of deposit (CDs) and savings accounts can’t -- the power of tax-deferral. That means you won’t pay taxes on annuity earnings until you start getting payouts.

3. No Contribution Limits

You can typically put as much money in an annuity as you want. Unlike other forms of retirement savings, there aren’t contribution limits. That makes annuities especially useful if you’ve maxed out other retirement accounts, like 401(k)s and IRAs.

Some insurance companies may limit the total amount you can invest, so be sure to ask.

4. Guaranteed Rate of Return with Fixed Annuities

In any given year you may earn a negative rate of return on a variable annuity and a 0% return on a fixed indexed annuity, but there is a type of fixed annuity called a MYGA (multi-year guaranteed annuity) that offers you a guaranteed crediting rate for any term length you choose.

This fixed crediting rate can not only help you predict how much you’ll earn on your annuity, but you can continue to earn a steady rate even if the stock market declines.

Want an Annuity with Minimum Risk?

If you're wary of more risky annuity products like variable and indexed annuities, then we’ve got good news—there are low-risk annuities out there. At Canvas, our annuities are designed to be simple, straightforward, and people-first.

We offer fixed MYGA annuities with a guaranteed crediting rate that you fund with a single premium with qualified or non-qualified funds. Canvas annuities are backed by the Puritan Life Insurance Company of America, a company rated B++ by A.M. Best.

With penalty-free withdrawals of up to 10% of your account value each year or for qualifying medical emergencies, our annuities are flexible, helping you deal with life when it happens. And the best part? You can buy our annuities directly online, meaning you don't have to work with an agent.

Taking out the middleman gives our annuity products highly competitive interest rates—not to mention no commission, account, or annual fees. Ready to get started? See which Canvas annuity is right for you, and we can help you get it up and running today.

Citations

1. Blueprint Income (2018, March 9). State Guaranty Associations for Annuity Contracts. Retrieved from https://www.blueprintincome.com/resources/annuity-basics/state-guaranty-associations-annuity-contracts/

2. Caplinger, Dan, Selena Maranjian, and John Maxfield (2015, July 15). 3 Hidden Risks of Buying an Annuity. Retrieved from https://www.fool.com/retirement/general/2015/07/15/3-hidden-risks-of-buying-an-annuity.aspx

3. Hawley, Craig (2018, October 6). 5 questions you should ask before buying an annuity policy. Retrieved from https://www.marketwatch.com/story/5-questions-you-should-ask-before-buying-an-annuity-policy-2018-10-03

4. Konish, Lorie (2020, January 9). These are the key questions to ask before buying that annuity. Retrieved from https://www.cnbc.com/2020/01/09/these-are-the-key-questions-to-ask-before-buying-that-annuity.html

5. Mercadante, Kevin (2020 December 29). What the FDIC, SIPC and FINRA Mean For Your Investments. Retrieved from https://investorjunkie.com/investing/fdic-sipc-finra-investments/

6. Parrish, Steve (2019, June 17). Taming the Inflation Risk In Annuity Payouts. Retrieved from https://www.forbes.com/sites/steveparrish/2019/06/17/taming-the-inflation-risk-in-annuity-payouts/?sh=32039b82206c