Can You Lose Your Money in an Annuity?

An annuity is a financial contract between an individual and an insurance company. The individual makes payments, either as a lump sum or a series of contributions. In return, the insurance company agrees to provide regular payments to the individual, often during retirement. This arrangement involves two main phases: an accumulation phase, where contributions are made and the money potentially grows, and a payout (or annuitization) phase, when the individual begins receiving income. Annuities are designed to offer a steady income stream, particularly for retirement planning, addressing concerns about outliving one’s savings.

Understanding Annuity Types

Annuities come in different forms, each with distinct characteristics that influence potential returns and risks. A fixed annuity offers guaranteed interest rates on contributions and provides predictable income payments once annuitization begins. The principal invested in a fixed annuity is generally protected, and the payments remain consistent, providing stability.

A variable annuity allows the contract holder to invest in various sub-accounts, which are similar to mutual funds. Their value fluctuates with market performance. While variable annuities offer the potential for greater growth through market participation, they also carry the risk of investment losses. Earnings in a variable annuity grow tax-deferred, and the payouts can vary depending on the performance of the chosen investments.

Indexed annuities, also known as fixed indexed annuities, combine features of both fixed and variable annuities. Their returns are linked to the performance of a market index, such as the S&P 500. They typically include a minimum guaranteed interest rate or principal protection. This structure aims to provide market-linked growth potential while limiting downside risk, though gains are often capped.

Ways Money Can Be Lost

While annuities can offer financial security, several factors can lead to a reduction in value or purchasing power. The performance of underlying investments can directly impact the value of a variable annuity. Losses in the chosen sub-accounts will reduce the overall account value, meaning the amount accumulated or paid out could be less than anticipated.

Inflation poses a significant risk, particularly for fixed annuities that provide predetermined payments. Over time, a fixed income stream may lose purchasing power as the cost of living increases. This diminishes the real value of the annuity payments, making it challenging for annuity holders to maintain their standard of living in retirement.

Annuities often come with various fees and charges that can reduce the net return or account value. Administrative fees cover record-keeping and maintenance, typically ranging from a flat annual fee of $30 to $100 or a percentage of the contract value, often around 0.10% to 0.50%. Variable annuities also incur mortality and expense (M&E) charges, which compensate the insurance company for insurance risks and guarantees, usually 0.5% to 1.80% annually of the account value. Investment management fees for variable annuity sub-accounts can range from 0.25% to 3.26% annually.

Optional riders, which provide additional benefits like guaranteed income or death benefits, come with their own fees, typically ranging from 0.25% to 1.5% of the contract value per year. Surrender charges are penalties for withdrawing funds early from an annuity, often within the first 5 to 10 years of the contract. These charges can be substantial, beginning as high as 7% to 10% in the first year and gradually declining over the surrender period. Additionally, a 10% federal income tax penalty may apply to withdrawals made before age 59½, in addition to regular income taxes on the earnings.

Although rare, the insolvency of an insurance company can impact annuity holders. If the issuing company fails, policyholders may face delays or reductions in payments. A lack of understanding of the annuity contract terms can also lead to unexpected outcomes, such as reduced benefits or losses not foreseen by the annuity holder.

Protections for Annuity Holders

Several safeguards are in place to help protect annuity holders, mitigating some of the risks involved. State guarantee associations provide a safety net for policyholders in the unlikely event that an insurance company becomes insolvent. These non-profit organizations, established at the state level, are funded by assessments on other solvent insurance companies licensed in that state. While coverage limits vary by state, typical protection for annuity contracts ranges from $250,000 to $300,000 in accumulated value.

Before purchasing an annuity, it is prudent to review the financial strength ratings of the issuing insurance company. Independent rating agencies such as A.M. Best, S&P, Moody’s, and Fitch assess an insurer’s ability to meet its financial obligations. A higher rating indicates a stronger financial position and a lower risk of default.

Many annuity contracts include built-in guarantees or offer optional riders designed to provide protection against market volatility or longevity risk. Fixed annuities inherently guarantee the principal and a set interest rate, offering predictability. For variable and indexed annuities, optional riders like Guaranteed Minimum Withdrawal Benefits (GMWB), Guaranteed Minimum Accumulation Benefits (GMAB), and Guaranteed Minimum Income Benefits (GMIB) can be purchased for an additional fee. A GMWB allows the holder to withdraw a specified percentage of their initial investment annually, regardless of market performance, often 5% to 10%. GMABs guarantee a minimum account value after a certain period, while GMIBs ensure a minimum income stream once payments begin, even if the underlying investments perform poorly.

Making Informed Decisions

To minimize potential risks and ensure an annuity aligns with financial objectives, careful consideration and due diligence are important. Understanding personal financial needs, including risk tolerance, liquidity requirements, and long-term income goals, is a foundational step before committing to an annuity. Annuities are generally considered long-term investments, and funds may be illiquid with penalties for early withdrawal.

Thoroughly reviewing the annuity contract is necessary to comprehend all terms, conditions, fees, and guarantees. This includes understanding administrative charges, M&E fees, investment management fees, and the surrender charge schedule. Asking specific questions about how each fee impacts the overall return and how guarantees function under various market conditions helps clarify expectations.

Seeking guidance from a qualified financial advisor who understands annuities is also beneficial. An advisor can help assess suitability, explain the complexities of different annuity types, and ensure the product chosen aligns with an individual’s broader financial plan. They can also clarify the tax implications of annuity payments and withdrawals, which are generally taxed as ordinary income.

Periodically reviewing the annuity’s performance and terms against changing personal circumstances or market conditions is a proactive measure. This ongoing evaluation allows for adjustments or further discussions with a financial advisor to ensure the annuity continues to meet evolving financial needs and goals.