Can You Lose Money on an Annuity?

Annuities are financial contracts designed to provide a steady income stream, often during retirement. While frequently marketed for financial security and guaranteed income, specific circumstances can lead to a reduction in their value or even a loss of principal. This can occur due to fees, market fluctuations, or, in rare instances, the issuing insurer’s financial instability.

How Annuity Fees and Charges Affect Your Principal

Annuities come with various fees and charges that directly reduce the principal invested or the accumulated value. Understanding these deductions is crucial for assessing an annuity’s true potential return.

One significant charge is the surrender charge, applied if funds are withdrawn or the contract is terminated prematurely. These charges typically start high, often 7% to 10% of the amount withdrawn or contract value in the first year, then gradually decrease over a three-to-ten-year surrender period. Many contracts allow a penalty-free withdrawal of a certain percentage, commonly 10% of the account value, each year.

Administrative fees cover the costs of managing the annuity, including record-keeping and customer service. These fees can be a flat annual amount ($30-$50) or a percentage of the annuity’s value (0.3%-1% annually). Variable annuities also have mortality and expense risk (M&E) charges, compensating the insurer for guaranteed benefits like death benefits or lifetime income. These M&E charges generally range from 0.4% to 1.75% annually, deducted from the account value.

Many annuities offer optional riders for enhanced benefits, such as guaranteed lifetime income or death benefits. While valuable, these riders come with additional costs, typically 0.25% to 1.5% of the contract value per year. Variable annuities’ underlying investments, known as sub-accounts, also incur expense ratios (0.06%-3.26% annually), similar to mutual fund fees. These cumulative fees significantly impact an annuity’s net growth, especially with modest returns or early surrender.

Understanding Market Exposure in Annuities

Market fluctuations can limit growth or lead to losses in certain annuities. The degree of market exposure varies by annuity structure, as not all are designed to protect principal from downturns.

Variable annuities directly expose the invested principal to market risk. Funds within a variable annuity are typically allocated to sub-accounts, which are similar to mutual funds and invest in stocks, bonds, or other securities. If these underlying investments perform poorly due to market downturns, the annuity’s value can decrease, potentially leading to a loss of the original principal. Unlike some other annuity types, variable annuities generally do not have caps or floors on their investment performance, meaning both potential gains and losses are uncapped.

Indexed annuities offer a different approach to market exposure. While they link their returns to a market index, such as the S&P 500, they typically incorporate features designed to protect the principal from direct market losses. However, this principal protection often comes at the cost of limiting potential gains. These limitations are implemented through various crediting methods, including caps, participation rates, and spreads.

A cap rate sets a maximum percentage of index growth credited to the annuity, such as 2% to 5%. Participation rates determine the percentage of the index’s gain credited, often 50% to 90% of positive performance. A spread, or margin fee, is a percentage subtracted from positive index gains before interest is credited. While these mechanisms protect against market downturns, they can lead to a loss of purchasing power if credited interest fails to keep pace with inflation or if fees outweigh limited gains.

The Role of Insurer Financial Strength

The financial stability of the issuing insurance company influences an annuity’s security. An annuity is a contractual agreement, and its promises, including guaranteed payments and principal protection, are only as strong as the insurer. If an insurance company faces severe financial distress or becomes insolvent, it may be unable to meet its obligations to annuitants.

Independent rating agencies like A.M. Best, S&P, Moody’s, and Fitch provide financial strength ratings to assess an insurer’s stability. These ratings offer an opinion on an insurance company’s ability to pay claims and meet commitments. Reviewing multiple agency ratings provides a comprehensive picture of solvency. A strong rating indicates a higher likelihood the company will honor its contractual obligations.

If an insurance company fails, state guarantee associations provide a safety net for policyholders. These non-profit organizations exist in all states, funded by assessments on other insurers. While offering protection, their limitations must be recognized.

Coverage limits vary by state, generally ranging from $250,000 to $300,000 for the present value of annuity benefits per annuitant. Amounts exceeding these state-specific thresholds may not be fully covered. Payments from a state guarantee association may also be delayed while the insolvent insurer’s assets are liquidated and claims processed.