Why Is My Annuity Losing Money? Key Factors to Consider

Annuities are financial tools for retirement planning, offering tax-deferred savings and potential income streams. Some annuity holders become concerned when their annuity appears to lose money or not grow as expected. Understanding these products’ mechanisms and characteristics clarifies why such perceived losses occur.

Understanding Your Annuity’s Basic Function and Guarantees

Annuities are contracts between an individual and an insurance company, where the individual makes payments and, in return, the insurer agrees to make periodic payments back, either immediately or at a future date. The function and guarantees of an annuity depend on its type. There are three primary types: Fixed, Variable, and Fixed Indexed Annuities.

Fixed annuities offer a guaranteed interest rate for a specified period. The principal is protected and grows predictably without direct market exposure. This predictability means they are less susceptible to “losing money” in nominal terms, as the interest rate is declared in advance. Variable annuities invest premiums into underlying sub-accounts, similar to mutual funds, which can include stocks, bonds, or money market instruments. The value of a variable annuity directly fluctuates with the performance of these chosen sub-accounts. If these investments perform poorly, the annuity’s account value can decrease, leading to a loss of principal.

Fixed indexed annuities (FIAs) combine features of both fixed and variable annuities. They offer principal protection from market downturns but provide growth potential linked to a market index, such as the S&P 500, without directly investing in it. Interest is credited based on the index’s performance, but this growth is often subject to participation rates, caps, and spreads. While FIAs protect against market losses, their growth is limited, which might make them seem to underperform in strong bull markets compared to direct market investments.

The Impact of Annuity Fees and Charges

Annuities, like many financial products, come with various fees and charges that can reduce their growth or even erode the principal. Understanding these costs is important for evaluating the true return on an annuity.

One common fee is the surrender charge, a penalty imposed if funds are withdrawn from the annuity beyond a certain limit or before a specified surrender period, typically ranging from 3 to 10 years. This charge is often calculated as a percentage of the amount withdrawn or the premium, and it typically decreases over the surrender period. For example, an annuity might have a 7% surrender charge in the first year, declining by 1% annually until it reaches zero.

Administrative fees cover the costs of managing the annuity contract, including record-keeping and customer service. These fees can be a flat annual charge, such as $30 to $50, or a percentage of the annuity’s value, often ranging from 0.10% to 0.60% annually. For variable annuities, mortality and expense risk (M&E) charges are levied to compensate the insurance company for the insurance risks it assumes, such as guaranteed death benefits or lifetime income. These charges typically range from 0.20% to 1.80% annually and are deducted from the investment sub-accounts.

Additionally, variable annuities incur investment management fees for the underlying sub-accounts, similar to those found in mutual funds. These fees cover the costs of buying and selling securities and managing the investments, and they can range from 0.15% to 3.26% annually. Optional riders, which provide additional benefits like guaranteed lifetime income or enhanced death benefits, also come with separate fees, usually ranging from 0.25% to 1.5% of the annuity’s value per year. All these charges directly reduce the annuity’s value, impacting its potential for growth.

Market Fluctuations and Investment Performance

The performance of an annuity is significantly influenced by market fluctuations, especially for variable annuities and, to a lesser extent, fixed indexed annuities. Variable annuities invest in underlying sub-accounts, which are directly exposed to the stock and bond markets. If the chosen investment options perform poorly due to market downturns, the value of the variable annuity will decrease, potentially leading to principal loss.

Fixed indexed annuities protect principal from market losses but link interest crediting to a market index. The amount of interest credited is determined by factors including caps, participation rates, and spreads.

A cap rate sets the maximum interest that can be credited to the annuity, even if the index performs above that limit. For instance, if an annuity has a 5% cap and the index gains 7%, only 5% interest will be credited. A participation rate determines the percentage of the index’s gain that will be credited, such as 80% of a 10% gain resulting in 8% credited interest. Spreads are percentages subtracted from the index’s gain before interest is credited. These mechanisms limit the upside potential during strong market performance, which can lead to a perception of “losing money” compared to direct market investments, even though the principal remains protected.

The Effect of Withdrawals and Surrender Penalties

Taking withdrawals or surrendering an annuity before its intended term can directly reduce its value and lead to significant financial consequences. Annuities are designed as long-term financial instruments, typically for retirement planning. Insurance companies and the federal government discourage early withdrawals through various penalties.

Surrender charges are fees imposed by the insurance company if funds are withdrawn during the surrender period, which can last anywhere from three to ten years. These charges are typically a percentage of the amount withdrawn and often decline over time. For example, a surrender charge might start at 7% in the first year and decrease by one percentage point each subsequent year. If an annuity holder withdraws $10,000 in a year with a 5% surrender charge, they would pay $500 in fees.

Many annuity contracts include a “free withdrawal provision,” allowing the withdrawal of a certain percentage of the account value, commonly up to 10% annually, without incurring surrender charges. However, exceeding this provision will trigger the applicable surrender charges. Beyond insurer-imposed surrender charges, the Internal Revenue Service (IRS) imposes an additional 10% early withdrawal penalty tax on the taxable portion of withdrawals made before age 59½, unless an exception applies. This penalty is in addition to ordinary income taxes that apply to the earnings portion of the withdrawal. For non-qualified annuities, earnings are generally considered to be withdrawn first, making them subject to this penalty.

How Inflation Erodes Purchasing Power

Inflation, while not directly causing an annuity’s nominal account value to decrease, significantly reduces the purchasing power of the money held within the annuity over time. An annuity’s value might appear stable or even grow modestly in nominal terms, but if its growth rate does not keep pace with the rate of inflation, the real value of the money diminishes. This means that the annuity holder can buy fewer goods and services with the same amount of money in the future than they could today.

For example, if an annuity guarantees a 2% annual return and inflation is 3%, the annuity holder is effectively “losing money” in real terms, as their purchasing power declines by 1% each year. This erosion of purchasing power is particularly noticeable with fixed annuities that offer predetermined, unchanging interest rates. Even with principal protection, the real return on investment can be negative during periods of high inflation.