Can Annuities Lose Money? Here’s How and When

An annuity is a contract between an individual and an insurance company, where the individual makes payments and, in return, receives regular disbursements, typically in retirement. While some annuities offer principal protection, others involve investment risk that can lead to a loss of the original capital. Understanding the structural differences among annuity types is important to assess their potential for principal erosion.

Annuity Types and Principal Risk

Fixed annuities generally offer the most straightforward principal protection, guaranteeing the initial investment and a specified interest rate over a set period. The insurance company assumes the investment risk, ensuring the principal does not decrease due to market fluctuations.

Variable annuities directly expose the invested principal to market risk. Funds are allocated to sub-accounts, similar to mutual funds, investing in stocks, bonds, or money market instruments. The value of these sub-accounts fluctuates with market performance, meaning that if underlying investments perform poorly, the principal can decrease. This direct exposure to market volatility makes variable annuities susceptible to significant principal loss.

Indexed annuities, also known as fixed indexed annuities, typically provide principal protection from market downturns. Their returns are linked to the performance of a specific market index, such as the S&P 500, without directly investing in the index itself. While the original principal is generally protected from market losses, potential gains are often limited by features like participation rates, caps, and spread fees. If the index performs poorly or if these limiting factors are significant, the annuity may yield zero returns.

Mechanisms of Principal Erosion

Various fees and charges can reduce an annuity’s overall value, potentially leading to a net loss or significantly lower returns. Surrender charges are common penalties applied if funds are withdrawn before a specified period, typically ranging from six to ten years. These charges often start high and gradually decline, significantly reducing the amount received.

Variable annuities often include mortality and expense (M&E) fees, which compensate the insurance company for insurance guarantees and administrative costs. Administrative fees cover general management and record-keeping. Fees for optional benefits, known as riders, can also apply. These cumulative fees can significantly erode returns, especially during periods of low market growth, potentially turning a modest gain into a net loss.

Market performance directly influences the value of variable annuities, as their sub-accounts are subject to the same fluctuations as broader financial markets. A sustained downturn in the stock or bond markets can lead to a direct reduction in the annuity’s principal value. For indexed annuities, low or negative index performance combined with caps on gains or high participation rates can result in minimal or zero interest credited.

Inflation risk poses a subtle yet significant threat to the purchasing power of annuity principal, even when the nominal amount is guaranteed. For instance, a fixed annuity guaranteeing a 2% return might provide a secure principal amount, but if inflation is 3% annually, the money’s ability to purchase goods and services decreases by 1% each year. This erosion means that while the dollar amount remains constant, its real value and buying power diminish over time.

Early withdrawal penalties and taxes can also reduce the net amount received from an annuity. The Internal Revenue Service (IRS) imposes a 10% penalty on withdrawals made before age 59½, in addition to regular income taxes on any gains. This penalty, combined with the taxation of earnings, means that even if the annuity has grown in value, a premature withdrawal can significantly reduce the accessible funds. These financial implications directly impact the amount an annuitant ultimately receives.

Features Protecting Annuity Principal

Certain features and riders available with annuities are designed to offer specific protections against principal loss or to ensure a minimum financial outcome. Guaranteed Minimum Benefits (GMBs) act as contractual safeguards. A Guaranteed Minimum Accumulation Benefit (GMAB) rider ensures that the annuity’s value will not fall below a certain percentage of the initial investment, or a specific growth rate, even if market performance is unfavorable.

A Guaranteed Minimum Withdrawal Benefit (GMWB) rider guarantees that a certain percentage of the initial investment can be withdrawn annually for life, regardless of how underlying investments perform or if the account value drops to zero. This feature protects the ability to recover the original principal over time through guaranteed income streams. Similarly, a Guaranteed Minimum Income Benefit (GMIB) ensures a minimum future income stream based on a protected value, providing a safeguard for retirement income even if the actual account value declines.

The financial strength and claims-paying ability of the issuing insurance company are paramount to the security of any annuity’s guarantees. Annuitants should research the insurer’s ratings from independent agencies like A.M. Best, Moody’s, and Standard & Poor’s. A highly rated company offers greater assurance that it will be able to fulfill its contractual obligations, including principal guarantees and benefit payments, over the long term.

A “free look” period is a regulatory provision that allows annuitants to review their contract and cancel it without penalty within a specified timeframe, typically 10 to 30 days after delivery. This period provides an opportunity to understand the terms, fees, and guarantees of the annuity. Utilizing the free look period helps ensure that the contract aligns with an individual’s financial goals and risk tolerance before it becomes a binding commitment.