Many soon-to-be retirees turn to investments they believe are safe, like annuities, to protect and preserve their nest egg. Annuities can be an appealing option, thanks to their tax-deferred growth, guaranteed income payments and protection against market volatility.
But are annuities really as safe as they seem?
We’ll dive into what annuities are, how annuities work, the risks and benefits involved and whether these financial products are a good fit for your financial goals.
Here’s everything you need to know.
An annuity is a financial contract between you and a life insurance company. You pay a lump sum or series of payments to the insurer who, in turn, agrees to make regular payouts to you over a period of time, which could be a set number of years or the rest of your life.
These financial products are especially popular among retirees because annuities can help provide financial stability after regular income from work stops.
An annuity’s payout structure depends on the type of annuity you buy. After you make the initial deposit, the annuity company invests these funds. Over time, your money grows, contributing to the annuity’s eventual payouts.
Annuities can be immediate (payments begin right away) or deferred (payments begin later, often during retirement).
The annuity market offers several options, and each type comes with its own level of risk and potential growth.
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Fixed annuities: Offer a guaranteed minimum interest rate, providing stability with minimal risk. Some fixed annuities set a fixed interest rate for the entire contract term while others may adjust the rate periodically,
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Indexed annuities: Link their returns to a specific market index, such as the S&P 500. They offer the potential for some growth but there’s often a cap on returns. These annuities also limit market losses.
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Variable annuities: Returns depend on the performance of underlying investments (such as stocks and mutual funds), allowing for growth but also exposing your principal to loss.
Whether annuities are “safe” depends heavily on the type of annuity you’re considering, your own personal risk tolerance and the financial health of the insurance company issuing the contract.
Fixed annuities are considered the safest type of annuity because their returns are tied to a specific rate, usually the prevailing interest rate, and they offer a guaranteed minimum payout. However, these returns may not keep pace with inflation over time.
Meanwhile, variable and indexed annuities offer the potential for higher returns but involve more risk due to their link to market performance. They also tend to have higher fees than fixed annuities.
Since insurance companies underwrite annuities, the financial health of the insurer is essential. After all, insurance companies with high credit ratings and a stable financial history are much more likely to make good on decades worth of payouts.
When shopping for an annuity, look for companies with high ratings from reputable rating agencies such as A.M. Best, Moody’s and Standard & Poor’s.
Many annuities come with built-in guarantees designed to protect your principal investment.
Fixed annuities, for example, guarantee a minimum rate of return regardless of market conditions. Meanwhile, variable annuities usually offer optional guarantees through riders, like a guaranteed minimum withdrawal benefit, though these features come at an added cost.
Here are some other annuity guarantees typically offered as riders.
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Death benefit: Ensures that beneficiaries receive a payout after you die.
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Living benefits: Give you the ability to withdraw larger sums of money from the annuity penalty-free if you’re admitted to a nursing home or diagnosed with a terminal illness.
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Guaranteed minimum income benefit: Guarantees a minimum level of income, even if the underlying investments underperform.
Annuities are often appealing to people seeking predictable income and peace of mind, but they typically lack the growth potential of other investments, such as stocks and ETFs.
Fixed annuities are more secure but offer lower returns, which is why they’re often compared to certificates of deposit.
Variable annuities allow for more growth but, like stocks, can lose value when the market declines.
Similar to investments held within retirement plans, such as 401(k)s and IRAs, earnings within an annuity grow tax-deferred, allowing them to compound over time.
When comparing annuities to other investments like stocks, bonds, CDs or mutual funds, consider both the level of risk you’re willing to take and your need for liquidity, or easy access to your cash. Annuities have less liquidity than many other investments due to their withdrawal restrictions and surrender charges. This can make it difficult and expensive to get out of an annuity, especially after payouts begin.
While annuities provide a stream of income, they come with certain risks that you should understand before signing a contract.
Annuities are typically illiquid, meaning you’ll face penalties for early withdrawals.
This lack of liquidity makes it challenging — if not impossible — to access money if you’re hit with a major expense or simply want to shift your money to a different investment. This makes annuities better suited for investors who don’t anticipate needing immediate access to their funds.
The financial health of the insurance company issuing the annuity directly impacts the security of your investment. If the company goes bankrupt, it could put your payouts in jeopardy.
Remember: While an annuity may come with guarantees, these only hold up so long as the insurance company remains solvent.
To mitigate this risk, choose insurers with strong credit ratings and check to see how much your state’s guaranty association would cover in the unlikely event of insurer insolvency.
Variable annuities are subject to market risk since the value of the underlying investments can fluctuate.
This means that if investments in your annuity subaccounts underperform, your payouts will decrease. While variable annuities may offer higher growth potential, they can lead to losses, especially if the stock market nosedives right before you start receiving payments.
And since variable annuities come with higher commissions than other annuities, you also risk losing more of your money to administrative costs and other fees.
Annuities can provide several benefits, particularly for retirees concerned about outliving their savings.
The top benefits of annuities include:
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Predictable income: For fixed annuities, the income is predictable, helping you plan your finances with more confidence. Your annuity payments arrive on a set schedule, acting as a sort of “paycheck replacement” in retirement.
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Tax advantages: Tax-deferred growth can help maximize your investment returns. When you withdraw funds or begin receiving payouts, you’ll owe ordinary income tax on some or all of the money.
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Longevity insurance: Annuities offer peace of mind by delivering a steady income that can last a lifetime, helping retirees avoid the risk of outliving their savings — a top concern for many older Americans.
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Professional management: For people who want a “set it and forget it” income source, an annuity can free you up from investment decisions by shifting that responsibility to the insurer.
Deciding if an annuity is right for you hinges on your retirement goals, risk tolerance and financial situation.
If the thought of outliving your savings keeps you up at night, an annuity could offer peace of mind with a guaranteed income stream that, in some cases, lasts for life. If you prefer a conservative, low-risk approach to retirement planning, you’ll likely appreciate the stability that fixed annuities offer, especially if you value predictability over potential gains.
Retirees with other sources of income who don’t need immediate access to their cash are better suited to buy annuities. Since annuities lock up your principal, they work best if you have other assets you can tap for emergencies and day-to-day expenses.
However, annuities aren’t for everyone.
People who prefer flexibility in their investments might find the rigid nature of annuities restrictive. Annuities aren’t ideal if you think you may need access to your money in the near future since surrender charges and fees can eat into money you attempt to withdraw early.
Similarly, if you’re seeking higher growth in your portfolio, you’ll likely find better options elsewhere. Younger investors or those with a long time horizon might find annuities’ lower return potential limiting. These investors can likely achieve greater gains in the stock market or real estate, where their money can grow and compound more aggressively — and with fewer restrictions.
If you’re interested in buying an annuity but want to take a more diversified and balanced approach, consider making an annuity just one part of your overall portfolio, balancing it with other investments like stocks, bonds and real estate.
Annuities can be a valuable tool for retirement planning, but they’re not a one-size-fits-all solution. While some annuities, like fixed annuities, are relatively safe and low risk, other annuities, like variable annuities, carry market risk and high fees. And all annuities come with some level of credit risk tied to the insurance company’s stability.
Always research your options and speak to a financial advisor to ensure that any annuity you’re considering aligns with your long-term goals and financial situation.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
