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What Are the Risks of Annuities?

what are the risks of annuities

Annuities can help strengthen your overall retirement strategy with their unique guarantees.

From lifetime income to growth or protection, their contractual guarantees can help in many areas. But just like with any other instrument, annuities also have risks of their own.

What are these risks of annuities? What should you keep in mind as you consider an annuity contract for your retirement?

Here's a quick rundown of different risks of annuities and some other information that can help with your decision-making.

Some Risks of Annuities to Keep in Mind

Working through these factors before you commit to an annuity purchase can help you find the right annuity for you.

Here are some potential annuity risks that might occur. Your financial professional can walk you through these pros and cons so you can find an annuity contract that is a good fit for your situation.

Liquidity

Annuities offer relatively less liquidity than other assets do, such as stocks or equity funds. But they do come with some liquidity, via free withdrawal provisions, so you have some money access.

Most annuities come with back-end surrender charge schedules similar to mutual fund B shares. These schedules can last for up to 15 years in some cases, especially with indexed annuities. However, most contracts fall within a span of 10 years or less.

Many variable and fixed annuities also usually come with this length of surrender period. The key is to make sure that this maturity period lines with the timeline you have for your money and your financial needs.

Possible Opportunity Cost for Growth

With fixed-type annuities, you run the opportunity cost risk of missing out on growth potential for the money you put into the annuity.

The interest and principal are always guaranteed by the insurance carrier for fixed annuities. But in return for these guarantees, fixed annuities typically pay fairly low rates of interest.

However, they usually still pay higher rates than other guaranteed instruments, such as Treasury securities or CDs.

Fixed index annuities also guarantee your principal. But they don't guarantee the amount of interest that they will earn depending upon the movements of the underlying financial benchmark they are linked to.

Variable annuities have the greatest potential for growth. The money that is placed into them is invested in mutual fund subaccounts, which rise and fall in tandem with the markets.

But it's also possible to lose money in a variable annuity if the markets perform poorly. This is why indexed annuities are becoming more popular, because they constitute a happy medium between the other two.

In a low-interest rate environment, people are willing to forego the certainty of a guaranteed rate when indexed annuities have historically outpaced their fixed cousins in growth.

Tax Treatment of Annuity Withdrawals

Withdrawals from an annuity are taxable at ordinary income tax brackets. Annuities are one instrument that grows inherently tax-deferred with no limit to the amount that can be placed in them.

However, unless the annuity is purchased inside an IRA or a qualified plan, there is no tax deduction available for the money you put in it. Hence, there is no additional tax benefit for this.

Furthermore, there is no capital gains treatment available for annuity distributions. This is because annuity withdrawals are subject to income tax; they aren't treated as capital gains for tax purposes.

Annuity owners must pay tax at their top marginal tax brackets in order to remain in compliance with the IRS. That can increase your tax liability in some cases, especially for heirs who inherit large annuity contracts from a loved one.

With proactive planning, you can have more tax efficiency in your annuity income streams.

Non-qualified annuity withdrawals are now taxed in a way that dictates that a portion of each payment be considered a tax-free return of principal. If any earnings are left in the contract after all of the principal has been exhausted, they will be taxed as ordinary income.

One means to reduce your tax burden is the annuity exclusion ratio, especially when it's coordinated with other tax-advantaged vehicles such as Roth accounts.

Early Death

Annuity owners may die too early to enjoy the guaranteed income benefit that their annuity would have given them. The guaranteed income stream that the annuitant can't outlive does provide peace of mind.

But the trick is to live long enough to profit from it. For example, say someone purchases an annuity and then opts for a straight life payout. Then they pass away in an accident after receiving only four payments.

The insurance carrier will pocket the rest of that contract owner's money unless the contract owner had specified a beneficiary along with a payout option for their beneficiary. The same holds true for couples who choose a joint and survivor life option.

However, keep in mind this applies only to these payout options. In most cases, the remaining sum in your annuity will go to your heirs. Your financial professional can bring you up to speed on the payout options that will ensure this.

Inflation and Purchasing Power

Your annuity's fixed payments may lose spending power as inflation grows over time. This is probably one of the biggest disadvantages of annuities.

While it's nice to be able to receive guaranteed payments for life, there is usually no adjustment for inflation with them. Some annuities in the past have offered riders that can add a COLA to the contract.

On the other hand, you can also keep some of your retirement nest egg in stocks or equity-based mutual funds. That way your portfolio can counter the impact of inflation on your money's changing spending power. These investments have typically outperformed inflation over time, despite their volatility.

You also have some strategies at your disposal in the annuity department. Laddering strategies or staggered payout strategies can help you manage inflation risk with your annuity payouts over time.

Life Insurance Companies and Institutional Risk

The company who issued your annuity contract has a risk of not being around to maintain its contractual guarantees to you. Historically, the good news is this hasn't happened to that many life insurance companies.

Part of this is due to their unique risk-managing capability and how they are regulated. As financial industry history shows, life insurers have a pretty strong record as annuity guarantors.

If you are buying an annuity with an insurance carrier that has a financial rating below B+ or BBB, then you may be asking for trouble. The various credit agencies (like A.M. Best) assign ratings based on the insurance carrier's financial strength and stability.

So, any company rated below investment grade is suspect. If you do have an annuity with an insurer that has become financially insolvent, then you still have some protections in place.

State reinsurance firms will step in and reimburse you for your losses up to a fairly high amount, such as $300,000. This amount can vary from state to state, so check with your state's department of insurance for more information.

That said, it could take a long time for them to get you your money. Again, most life insurance companies don't have this problem with solvency, but this is still good for annuity policyholders to know.

Interest Rate Conditions

Annuities are susceptible to interest rate risk. Annuity payouts are largely determined by long-term bond yields, such as the 10-year and the 30-year bonds.

Why? Because insurance companies put the bulk of fixed annuity premium dollars into investments like these. In turn, these holdings help the insurers maintain their contractual guarantees to you and other policyholders.

Interest rates going up or down can affect the value of these underlying assets. So, what your annuity actually pays you can change depending on what interest rates are doing when you buy your contract.

Even so, insurance companies protect against this risk with annuities better than what you might see in bonds or other fixed-interest assets. They accomplish this by including life expectancies and estimates for their payments to every policyholder in their payout calculations.

Not only that, mortality credits, or leftover annuity payments for policyholders who died earlier than expected, goes into a pool of money. This pool of money is then used to pay lifetime income to those who outlive their life expectancy.

Annuity Fees and Expenses

Some annuities can come with high fees, but not all do. There are annuities out there that charge as much as 3% per year in order to maintain the contract.

These fees, applicable primarily to variable annuities, include an annual mortality and expense fee, a contract administration fee, and mutual fund subaccount management fees.

Then there can be additional fees for income riders -- or death benefit riders that guarantee at least a certain amount of money will be distributed to the annuitant's beneficiaries.

This fee and expense risk is seen moreso in variable annuity contracts. However, some fixed-type annuities can also have fees when more bells and whistles -- i.e., rider benefits -- are attached to the contract.

Be sure your annuity contract doesn't have additional rider benefits that you might not need. Otherwise you are essentially paying more costs for excessive benefits that you won't use -- and that reduce your money's value.

Finding the Right Annuity Guarantees for Your Plan

Consult with your financial advisor for more information on the advantages and disadvantages of annuities.

When used properly, annuities can bring great value and predictability to an overall retirement strategy. By identifying gaps in your plan and some specific financial needs, the right annuity can solve for those problems and bolster your retirement foundation.

If you are looking for a financial professional who can help you with annuities and with retirement strategies in general, help is just a few clicks away. Many financial professionals are available to assist you at SafeMoney.com.

Use our "Find a Financial Professional" section to connect with someone directly. Should you need a personal referral, please call us at 877.476.9723.

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