“At the end of the day, the goals are simple: safety and security.” — Jodi Rell, former Governor of Connecticut
Pensions, once essential for retirement, have been steadily disappearing. Today, less than one-third of Americans (31%) are retiring with a defined benefit pension plan. If you are fortunate enough to retire with a pension plan, the median annual pension benefit is $9,262 for private pensions, $22,172 for government pensions, and $24,592 for railroad pensions.
But, that’s not all. Many of us are struggling to save for an uncertain future. Most recently, as an example, the COVID-19 pandemic forced people to cut back or tap into their retirement savings. There’s also the fear that Social Security will run out, as well as increasing medical costs.
As such, more than ever, we’re responsible for our retirement. Of course, this is no easy task. After all, you want to make sure that you have enough in your nest egg to cover essential expenses, while also having enough for unforeseen expenses. And, just to make ensure that you have nothing to worry about, it would be beneficial to have enough money stashed aside so that you won’t outlive your savings.
In many ways, annuities are among the best strategies for combating the challenges mentioned above. Nevertheless, as you find yourself entering the retirement stage and looking at multiple financial options, you may wonder, “Are annuities safe for retirement?” After all, annuities are complex, expensive, and risky, right?
As it turns out, while annuities aren’t flawless, they are quite safe. But, it will take some effort on your part to guarantee their safety.
Annuities: What Risks Are There?
As part of your retirement plan, you may be considering an annuity that will guarantee a constant flow of income for the rest of your life. And, it’s this advantage that may convince you into purchasing an annuity.
Nonetheless, you should consider that annuities also carry drawbacks and risks, whether they provide an immediate or deferred income. Fortunately, if you are aware of these dangers in advance, you can plan ahead and reduce them.
You die sooner than expected.
A fixed annuity, also known as an income annuity, generates a guaranteed stream of payments for a certain period of time. For example, a single-life payout, or a “life only” payout, provides you with monthly payments while you’re alive. But, if you die prematurely, payments will stop.
Because of this, it is important to choose the type of distribution carefully, as there are other distributions with death benefits. Essentially, a beneficiary can inherit the remainder of an annuity after the owner dies if the contract includes a death-benefit provision.
Illiquidity.
In most annuities, you’re committed to the contract after the initial “free look” period has ended. That means you will not be allowed to get a refund of your principal after this period has passed.
Although some companies permit one-time withdrawals with a limited discretion, the costs and penalties can be significant. One such penalty is the one imposed by the IRS is you make a withdrawal before the age of 59 ½ — which is 10% of the annuity’s value.
You’ll also have to deal with a surrender charge. In most cases, this depends on when you take the withdrawal and the amount of money you’re taking out. But, let’s say you’re in the third year of your contract and you withdraw $1,000. If the surrender charge is 5%, then you’ll have to pay $50.
In spite of this, it’s not uncommon for contracts to permit some type of fee-free withdrawal during the contract period. Usually, this is around 5% or 10% of the value of the account. And, in some cases, there are penalty-free withdrawals in certain situations, like having to pay for medical expenses.
The annuity company goes bankrupt.
Savings accounts and certificates of deposit are insured by the FDIC. In addition, the Financial Industry Regulatory Authority (FINRA) oversees the financial world. But, who backs and oversees annuities?
Well, annuities aren’t regulated by any federal entities. They’re actually backed by the companies who sell them. Therefore, if your insurer goes belly up, the federal government isn’t obligated to compensate you.
The good news? You aren’t totally up the creek without a paddle.
Despite the federal government’s inaction, your state government will act. State guaranty associations hold insurance companies accountable. In the incredibly rare event that your insurance company goes bankrupt, your losses will be covered up to a certain amount. Usually this is between $250,000 – $300,000, but some states may provide coverage up to $500,000.
Annuities grow slower than inflation.
A majority of annuities aren’t automatically adjusted for inflation like Social Security. This means that even when inflation rates go up, your annuity payouts will remain the same. Because of inflation, both immediate and deferred annuities suffer.
As an example, a deferred annuity’s rates are fixed for a set period of time and do not increase or decrease with inflation. As a consequence, the rate of interest credited to you may fail to keep up with inflation. It’s important to note, however, that inflation is not unique to annuities. All investments and savings funds are impacted by inflation.
Your best bet? Work with a financial advisor to develop a retirement plan to keep your rate of return above inflation rates. Also, consider adding an inflation rider so that rising inflation does not diminish your annuity payments. Just be aware that you will have to pay extra for this.
Interest rates are locked in.
Last but not least, there is the risk of losing an opportunity. When you sign your annuity contract, you lock in your crediting rate for a period of time, at least for fixed annuities. Despite stock market rate spikes after signing your contract, you will still be credited at the same rate. There is, however, a relatively small opportunity cost.
Also, if you’re playing the waiting game for a higher interest rate, I’ve got bad news for you. The growth in your annuity will not be possible. Besides, it’s not like you have a crystal ball to let you know when these rates are “just right.”
The Best Way to Minimize Annuity Risks and Keep Them Safe
You can avoid annuity risk just as you can with other investments by taking the following precautions. And, when you mitigate these risks, you can safeguard your annuity.
Learn the basics of annuities.
As a refresher, you enter into a long-term contract with an insurance company when you purchase annuities. In exchange for a lump sum of money, you’ll receive an income stream that lasts your entire life.
What’s more, annuities come in a variety of forms. And, each type of annuity carries various levels of risk.
The type of annuity matters.
With variable annuities, you can earn tax-deferred money growth by linking them to bonds or equity subaccounts. Invested premiums are actually directly invested in market-risk investments in these contracts. Your account balance can rise or fall based on the performance of those subaccounts since your money is subject to market fluctuations.
In short, variable annuities have the highest risk.
Fixed annuities, on the other hand, do not directly participate in any equity markets. Instead, they receive interest payments at a set rate. As an example, with a Due Fixed Annuity, you’ll always get 3% a month on your money. In turn, this makes fixed annuities the lowest risk.
With fixed annuities, there is another important distinction. Despite the fact that fixed annuities aren’t insured by the FDIC, state laws impose strict reserves on insurance carriers that issue them. A fixed annuity insurance company must have a cash reserve of one dollar for every dollar of the premium received.
If you invest in a fixed index annuity, your growth potential is linked to an external index, such as the S&P 500. In some cases, your money may grow at a rate based on an index growth percentage. However, if the index loses value, both the principal and credited interest will be protected, but do not earn any interest. Accordingly, the index can’t decrease your account balance making this a medium risk.
If you don’t understand an annuity, don’t buy it.
Never buy an annuity if its terms are too complicated, and your provider is unable to explain it clearly to you. At the very least, you should know;
- How much the annuity will cost
- The fees involved, such as
- The payout structure
- Penalties on early withdrawals
- Who gets the annuity when you die
Combine your annuity with other financial products and investments you own.
I’m positive that you’ve been told a million times, you shouldn’t put all your eggs in one basket. While a guaranteed annuity can provide an income for retirement, you still have to take into account factors like inflation, illiquidity, and missed opportunities. By diversifying your retirement plan so that it contains stocks, bonds, and cash, you can address these potential concerns, as well as balance out potential gains and losses. .
Choose a reputable insurer.
Perhaps the best way to ensure the safety of an annuity is to ensure that the insurer is financially sound. After all, the annuity your buy is only as good as the insurer that backs it up.
Thankfully, annuities historically have been a safer way to invest your retirement funds. In a 2012 Advisor Perspectives article, insurance actuary and Certified Financial Planner™ Joe Tomlinson explains:
“History shows that annuities have traditionally been an extremely safe investment. Insurance company insolvencies have been few, companies in trouble have often sold business to healthy insurers, and guaranty associations have provided an additional safety net.”
“In my review of the historical record, I could only find a few cases where annuity owners ended up with less than their insurer promised. One resulted from the 1983 bankruptcy of Baldwin-United, which involved a takeover by MetLife and a court-ordered reduction in benefits.”
“Another involved the 1991 failure of Executive Life, which continued to pay annuity benefits in state-managed rehabilitation mode until this year, when balance sheet deterioration led to liquidation. Going forward, owners of Executive Life annuities that exceed state guaranty caps will suffer losses…”
“Based on my own experience as a former insurance company actuary, I would say that the risk-based, balance sheet focus, and actuarial culture of insurance companies makes a difference.”
How else can you verify an insurance company’s finanical health? Check out the rating of the insurance from agencies like A.M. Best, Fitch, Moody’s, and Standard & Poors. Normally, an A+ is considered “Superior,” while a D is considered “Poor.”.
Ensure you’re the right candidate for an annuity.
Make sure you have a purpose and a plan before you purchase an annuity or any other financial product for that matter. You can have guaranteed income in retirement when you take out an annuity as part of your long-term retirement planning.
At the same time, if you believe that you’ll need money sooner than later, you should consider more liquid alternatives. These are investments that you can convert easily and quickly into cash, such as CDs, shares, or money market accounts.
Annuity Safety FAQs
1. Can annuities be trusted for retirement?
Investing in annuities is a safe way to accumulate retirement savings since they are purposefully designed for retirement. Even so, careful planning and diligence are still necessary to protect your long-term investment.
2. How risky are annuities?
Annuities pose a low risk when compared with other investments such as stocks and bonds. With their guaranteed income and fixed rates, annuities are considered relatively safe investments.
At the same time, this also depends on the type of annuity. Fixed annuities are incredibly low risk, while variable annuities are riskier since the value of your account can rise and fall with the market.
3. Can you lose money with an annuity?
Like with any other investment, it’s possible to lose money with an annuity.
As noted above, unless you purchase a guaranteed minimum income benefit (gmib) as a rider on a variable contract, market fluctuations can affect its value. The same is true of indexed annuities, which are linked to investment benchmarks like the S&P 500. And, although fixed annuities are generally the safer option, a market value adjustment (MVA) rider adjusts the fixed interest rate guarantee to rematch the going market rate.
You can lose money on an annuity if the insurer backing it goes bankrupt and fails to fulfill its obligations. There are steps that annuity owners can take to prevent this, but if it does occur, they may lose part of the value of their account. There is, however, some protection. State-backed insurance companies must join their states’ guaranty associations, which pay claims to member companies when they fail.
4. Who regulates and oversees annuities?
Annuities are regulated at the state level. And policy amounts are backed up by a guarantee fund in each state. For information on the specific levels in your state, visit www.nolhga.com. Why? Each state has a different dollar protection limit, and coverage is not uniform.
Thus, you should always consider the carrier’s ability to pay claims, not the state guarantee fund, when choosing an annuity. Please remember that state guarantee funds are separate from the FDIC and should never be compared to it.
5. What can you do to minimize annuity risk?
As with any other investment, you need to be thoughtful when purchasing an annuity. Despite being less risky than stocks and bonds, annuities are not risk-free investments. But, thankfully, there are ways that you can manage your annuity to reduce these potential risks.
Risk can be managed most effectively through diversification. In other words, annuities can be included in a well-balanced portfolio that contains other assets like cash, stocks, and bonds. You may even want to consider purchasing different types of annuities to provide additional growth and income to and through retirement.
And, above all else, do your homework by making sure that the company you buy the annuity from is financially strong so that they won’t become solvent.
