Are Annuities Safe?

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Annuities are a popular component of many retirement strategies, particularly with increasing U.S. life expectancy. But how safe are they?

Annuities have come through for Americans for many years. They're generally low-risk but not entirely risk-free. Risk depends on the type of annuity you choose and which issuing company you select.

Can you lose money in an annuity?

An annuity is a contract between an individual and an insurance company. You, the owner, can buy an annuity with either periodic payments or a lump sum. They come in two basic types: fixed and variable.

With fixed annuities, the owner will receive either a guaranteed monthly income stream starting immediately or at a future date, or a guaranteed return of their money at a fixed or fluctuating interest rate.

In contrast, with variable annuities, the money you use to fund the account is invested in subaccounts that can be affected by market fluctuations.

The subaccounts are much like mutual funds that can be invested in stocks or bonds. If the stock or bond market rises, your annuity value increases.

However, if the market drops, you could lose a significant amount of your investment.

Variable annuity riders (optional add-ons) may be touted as protecting against market downturns. For an additional fee, they can help protect your investment from some, but not all, downside risk.

With variable annuities, you assume at least some of the risk and volatility. That may be OK, but you must go into it with your eyes open.

Fixed annuities, in contrast, do protect against market risk because the insurance company assumes the risk. Your principal, interest and future payments are guaranteed — provided the company remains solvent.

While annuity companies can become insolvent, it's rare for highly rated medium to large life insurance companies to fail. Regulators in the state where the company is domiciled watch over insurers for signs of potential weakness and work hard to make sure insurers in their state stay healthy.

Financial-rating companies such as AM Best, Standard & Poor's and Moody's also monitor insurers closely.

The best way to reduce the risk of insolvency is to choose a financially strong insurer. I recommend buying only from a company rated at least B++ by AM Best.

If you're more cautious, you may want to go with an A- or higher, especially when choosing a lifetime-income annuity.

Consider purchasing annuities from two or more insurance companies to mitigate the risk of default, especially if you're making a large purchase at once.

If you buy annuities at different times, this will probably happen on its own because the insurer offering the best deal today is rarely the market leader next year.

Inflation and purchasing-power risk

Inflation is another risk to consider when planning for retirement. With rising inflation, purchasing power gradually decreases. This concern also applies to annuities that provide a fixed interest rate or income stream, such as fixed annuities.

For instance, if you receive $3,000 per month from your income annuity over many years, your money will lose its value over time because of inflation. Keep this in mind when planning for long-term retirement income.

Some companies offer an optional inflation rider on immediate and deferred income annuities. The rider guarantees a higher future payout.

For example, you may buy a rider that increases future payments by 1% to 3% annually. The downside is that the rider is not free; you must make a larger deposit to get the same initial income.

The multi-year guarantee annuity, or MYGA, known as a fixed-rate or CD-type annuity, is popular. These annuities provide a guaranteed interest rate for a specified period (typically two to 10 years).

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.

Today, MYGA rates are historically high. There's no guarantee inflation won't roar back, but current rates typically exceed the rate of inflation.

Variable annuities invested in stock accounts can potentially beat inflation, but expose you to market risk. However, there is a fixed-annuity type that provides powerful inflation-fighting potential with much lower volatility.

It's called the fixed indexed annuity. It credits interest annually to your account based on annual changes to a market index, such as the S&P 500 or Dow Jones Industrial Average. You receive an interest credit when the index value increases.

Nearly all indexed annuity interest-crediting-formulas have limits, so interest earnings will usually be based on only a portion of the change in the market index over each index-crediting term (usually one year).

In exchange for the added guarantees and principal protection, you may not receive 100% of the index market gains.

During down years, you typically receive no interest, but you don't lose anything. Your principal and all previously credited interest can never be lost and are always protected, even if the stock market crashes.

In effect, you can have your cake — part of it, anyway — and eat it, too. The product offers an appealing combination of low risk coupled with higher potential returns.

It is complex, however, and choosing the right one takes considerable thought.

You must be willing to accept a fluctuating interest rate that may be as low as zero some years. If you're relying entirely on your annuity to produce predictable income, this type won't work for you unless you add an optional income rider.

You can mitigate risk by splitting your annuity assets among multiple types — fixed-rate, fixed indexed, variable and income annuities.

The risk of not being able to access your money — liquidity

It's possible that you may not be able to access your annuity funds when you need them. Annuities are somewhat illiquid, meaning they often may not be fully converted into cash without penalty.

Almost all deferred annuities, whether variable or fixed, include "surrender periods" during which withdrawals may result in penalties.

However, many, especially MYGAs, offer penalty-free withdrawal provisions, usually allowing up to 10% of the contract value to be withdrawn annually.

Any interest withdrawn from a nonqualified annuity (one that's not in an IRA or Roth IRA) is normally subject to a 10% IRS penalty if you're younger than 59½. That penalty is waived in the case of permanent disability.

You can avoid surrender penalties and liquidity risk by not putting any money you need for short-term needs in an annuity.

This is especially true for income annuities. They typically have no cash value. Once you've bought one and gotten past the free-look period, you can't take withdrawals. You can only receive the periodic payments as specified in the contract.

Managing death risk

MYGAs, fixed-indexed and variable annuities will usually pass intact to your spouse as the primary beneficiary if you, the owner, should die. Assuming your spouse keeps the annuity, the guarantees, value, interest rate and term will remain the same.

If your primary beneficiary is not your spouse, most of these products will allow a full surrender of the annuity without penalty, even if the death occurs during the surrender-penalty period.

With life-only income annuities, it's different. If you pass away before the full amount deposited into your annuity has been paid out, the insurance company can keep the remaining balance.

Most income 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.

Here, the lifetime payments will continue as long as one spouse is alive. Most married individuals choose this option.

Another popular option is to add an installment refund provision to ensure your beneficiaries get back at least the amount you originally put in.

Annuities are a popular and reliable option for many individuals saving for retirement. If you take a little time to understand the risks and benefits, you'll make informed decisions to ensure they align with your long-term financial goals — and you'll avoid any unpleasant surprises.

Ken Nuss is the founder and CEO of AnnuityAdvantage, a leading online provider of fixed-rate, fixed-indexed, and lifetime income annuities. Ken is a nationally recognized annuity expert and widely published author. A free rate comparison service with interest rates from dozens of insurers is available at www.annuityadvantage.com or by calling (800) 239-0356. The firm also offers an income-annuity quoting service. There are no fees or charges for the firm's services; 100% of the client's money goes to work for them in their annuity.

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.