Can Annuities Lose Money? When and How It Happens

An annuity represents a contractual agreement between an individual and an insurance company. The individual makes payments to the insurer, who then provides regular income payments, either immediately or at a future date. A common concern is whether annuities can lose value. This article explores when an annuity’s value can fluctuate, including potential for loss, and when they offer protection.

How Annuities Generate Returns

Annuities accumulate funds and provide income through various mechanisms. The simplest form, a fixed annuity, offers a guaranteed interest rate for a specified period, typically ranging from one to ten years. This rate is set by the insurance company and provides predictable growth, ensuring the principal and accumulated interest are not subject to market fluctuations.

Fixed indexed annuities link their returns to the performance of a specific market index, such as the S&P 500 or the Nasdaq 100, without directly investing in the market. Instead of earning direct market returns, these annuities apply a portion of the index’s gains to the annuity’s value, often through participation rates, caps, or spreads. A participation rate determines the percentage of the index’s gain credited to the annuity, while a cap sets the maximum interest rate that can be earned in a given period. A spread, or asset fee, is a percentage subtracted from the index’s gain before interest is credited.

Conversely, variable annuities allow individuals to invest their premiums in a selection of investment options, known as subaccounts, which are similar to mutual funds. The value of a variable annuity directly reflects the performance of these chosen subaccounts. If the underlying investments perform well, the annuity’s value increases, and conversely, poor performance leads to a decrease in value. This direct exposure to market performance means that the growth potential, as well as the risk, is significantly tied to the investment choices made within the subaccounts.

Factors That Can Reduce Annuity Value

Several factors can lead to a reduction in an annuity’s account value or its purchasing power, directly impacting the money an annuitant ultimately receives. Fees and charges represent a primary component that can erode an annuity’s value over time. Variable annuities, in particular, often carry a range of fees, including administrative fees, which cover the costs of maintaining the contract, and mortality and expense (M&E) risk charges, which compensate the insurer for guaranteed benefits. Additionally, fees for optional riders, such as income guarantees, and underlying investment management fees within the subaccounts further reduce the net return.

Surrender charges are another significant factor that can reduce the amount received if an annuity contract is terminated prematurely. These penalties are imposed when funds are withdrawn or the contract is canceled before the end of a specified surrender period, which can range from typically five to ten years. Surrender charges often decline over the surrender period, for example, starting at 7% and decreasing by 1% each year, but they directly reduce the principal amount received upon early withdrawal. Income earned within an annuity is generally tax-deferred until withdrawal, but withdrawals before age 59½ may be subject to a 10% federal income tax penalty in addition to ordinary income tax.

Inflation also poses a threat to the real value of an annuity, especially for those providing fixed payments over many years. While the nominal payment amount remains constant, the purchasing power of that money diminishes as the cost of goods and services rises. This means that over time, a fixed annuity payment may buy less, effectively eroding the true value of the income stream.

Annuity Types and Their Loss Potential

The inherent structure of different annuity types significantly influences their potential for principal loss or value fluctuation. Fixed annuities are generally considered to have the lowest risk of principal loss because they provide a guaranteed interest rate and their value is backed by the insurance company’s general account. The principal invested in a fixed annuity is protected from market downturns, ensuring that the initial investment, plus accumulated interest, is preserved, provided the contract is held until the end of the surrender period.

Fixed indexed annuities offer a layer of principal protection, often referred to as a “floor,” which typically guarantees that the account value will not decline due to negative market performance. This means that even if the linked market index performs poorly, the annuity’s value will generally not fall below the amount invested, excluding any prior withdrawals or fees. While principal is protected from market drops, the credited interest can be zero in years where the index performs poorly or does not meet the crediting method’s criteria.

Variable annuities carry the highest risk of principal loss among annuity types because their value is directly tied to the performance of the underlying investment subaccounts. If these subaccounts, which function similarly to mutual funds, experience negative returns, the account value of the variable annuity can decrease. This decrease can potentially lead to the loss of a portion or even all of the initial investment, making variable annuities susceptible to market volatility. The direct exposure to market risk means that the value can fluctuate significantly, both upward and downward, based on the performance of the chosen investments.

Principal Protection Features

Annuities can include various mechanisms and features designed to protect an individual’s principal or provide guaranteed income streams, offering a degree of security against potential losses. Many variable annuities offer optional riders, such as Guaranteed Minimum Withdrawal Benefits (GMWBs) or Guaranteed Minimum Income Benefits (GMIBs). A GMWB ensures that an individual can withdraw a certain percentage of their initial investment each year, regardless of market performance or account value decline, effectively providing a protected income stream. A GMIB guarantees a minimum income stream for life, often based on a benefit base that can grow independently of the actual account value, even if the underlying investments perform poorly.

These guaranteed benefits come with additional fees, typically a percentage of the benefit base, which are deducted from the annuity’s account value. It is important to consider these costs when evaluating the overall value of such riders. The financial strength and claims-paying ability of the issuing insurance company also play a significant role in principal protection. Annuities are backed by the insurer, so researching the company’s financial ratings from independent agencies provides insight into its ability to meet future obligations.

Furthermore, state guarantee associations provide a layer of protection for annuity contract holders in the event an insurance company becomes insolvent. These associations, established by state law, provide coverage up to certain limits for policyholders, typically ranging from $100,000 to $500,000 per contract holder, though these limits vary by state. This safety net offers some reassurance that a portion of the annuity’s value may be protected even in the rare instance of an insurer’s financial failure.