Are annuities secure?

As you think about your financial options in retirement, you may be wondering if annuities are a Secure investment vehicle. Generally speaking, annuities can be a very Secure investment if you understand how they work and the associated risks—after all, like any investment, the more you know, the more comfortable you can be with your decision. Having said that, the most important risk-related considerations have to do with the type of annuity you choose and the company you purchase it from. This article can help you decide what's right by telling you about:

• What is an annuity and the different types you can buy

• Risks you need to be aware of

• How to protect against these risks

What an annuity is?

An annuity, one kind of which is an income annuity, is a financial product designed to provide a regular stream of guaranteed income payments to the purchaser of the contract, with terms spelled out in an annuity contract that you enter into with an insurance company:

• You can purchase your annuity with a single lump sum payment, or several premium payments over time, depending on the type.

• With an immediate annuity, your income payments start immediately. However, with many annuities, those payments are deferred, and your money either earns interest or is invested in variable funds (investment options within the annuity that are similar to mutual funds, allowing you to allocate your premium into various securities like stocks or bonds. The value of these funds can fluctuate based on market performance, offering the potential for higher returns but also carrying more risk compared to fixed-rate options).

• Once payments start, they can continue for a predetermined number of years (typically 10 or 20); or the annuity can be structured to provide income payments for the rest of your life.

If you’re seeking financial stability as part of your retirement planning strategy, an annuity can help by ensuring you don't outlive all your money. And in the years before retirement, annuities can help you save with valuable tax-deferral advantages, alongside any contributions you make to a 401(k) or an IRA.

Risks associated with annuities

While annuities are generally thought to be a conservative investment vehicle, there are risks associated with any investment. And, with certain types of annuities, you can lose at least part of your principal. Here are the more common risks associated with different types of annuities, and how to mitigate them.

1. Inflation Risk - Failing to keep pace with inflation is a common risk associated with fixed annuities because the money you invest grows at a fixed interest rate, like in a savings account. If inflation outpaces that interest, your annuity might lose purchasing power over time, i.e., the fixed amount you receive from an annuity could buy less in the future than it does today.

How to mitigate: Other types of annuities, such as fixed index annuities, are tied to market performance and traditionally outpace inflation over time. These annuities offer protection against market losses, but also cap total returns. An annuity may also offer an optional feature known as a Cost of Living Adjustment (COLA) rider that adjusts payouts in line with inflation. Also, most financial advisors will say that annuities should be just one component of a diversified investment portfolio and balanced against other investments with different profiles for risk vs. growth potential.

2. Market Risk - Similar to a brokerage account, variable annuities are invested in variable funds that you, the annuity owner, choose. So, like stocks and mutual funds, they carry the risk of market volatility and the possibility of losing principal, especially during a prolonged recession.

How to mitigate: Fixed index and Registered Index-Linked annuities (RILA) are two types of annuities that provide exposure to market growth potential while mitigating downside investment risk, and a fixed annuity eliminates market and investment risk altogether. However, as with investment risk, a diversified financial portfolio with a mix of investment products that balance risk and growth potential can help mitigate long-term market risk.

3. Liquidity Risk - Annuity contracts typically have stringent terms for early withdrawal, making it difficult to access your funds without facing penalties. Also, there can be tax implications and penalties for withdrawals made before age 59 ½. This lack of flexibility can be problematic if you suddenly need money for an emergency or a new investment opportunity.

How to mitigate: Before purchasing an annuity, understand the terms regarding withdrawal penalties, known as surrender charges. There is usually a period before these charges kick in, and they tend to decrease over time. Different annuities offer more flexible options for accessing funds should you need them, but the best way to mitigate liquidity risk is to ensure you have at least some other readily available assets, such as cash in savings accounts or short-term Certificates of Deposit (CDs). Also, the government will allow penalty-free withdrawals before age 59 ½ in certain situations, but you should consult a tax professional before proceeding.

4. Life Expectancy Risk -Life expectancy is a risk factor for most sources of retirement income, and impacts your choice of annuities in two ways. On the one hand, there's "longevity risk": the risk of outliving your savings, but it also applies to a fixed-term, 10- or 20-year annuity payout. A lifetime annuity eliminates longevity risk because it is structured to provide income for life; however, lifetime payments are typically lower than fixed-term payments because the insurance company has to account for the possibility of payments lasting indefinitely. But with lifetime annuities, there's also a risk of "leaving money on the table" if you pass in the first years after annuitization: the sum of payments received could be far less than you put in.

How to mitigate: Many or most lifetime annuities offer the option of providing a death benefit to your heirs. It can be structured in a number of ways but typically ensures that the total paid out is equal to the principal paid in (less certain fees).

5. Issuing Company Risk -There's a risk (albeit slight) that the insurance company from which you purchase an annuity could encounter financial difficulties that affect the company's claim-paying ability—or fail altogether. While the insurance industry and state regulators have a number of secure guards in place to minimize the possibility of losing all your money, such an event could undoubtedly disrupt the steady flow of income payments.

How to mitigate: Choose an annuity from a financially stable and highly-rated life insurance company to minimize the risk of claims-paying ability impacting your income stream. Independent rating agencies such as Moody's, AM Best, Standard & Poor's, and COMDEX use a unique letter grading system to rate the financial health of insurance companies, which helps you gauge the risk involved in purchasing policies or annuities from them. You can see Guardian’s ratings here for an example of what to look for.

Companies offer riders designed to manage annuity risks

Look into different types of riders offered by the issuing life insurance company. While they often come with extra fees, the added protection may be worth it. Riders to look for include:

• Guaranteed Minimum Income Benefit (GMIB)- A GMIB ensures you receive a guaranteed minimum income, even if the annuity's account balance falls due to poor investment performance.

• Guaranteed Minimum Withdrawal Benefit (GMWB) -A GMWB allows you to withdraw a certain annual percentage of your investment, regardless of the annuity's market performance.

• Death Benefit Rider- Provides a death benefit payout to your beneficiaries if you pass away before a certain level of funds have been paid out.

• Market Value Adjustment (MVA) Rider -An MVA rider impacts the surrender value of your annuity, which is the amount of money you can receive if you decide to terminate your contract before it matures. Essentially, the MVA can either increase or decrease the surrender value based on certain economic factors, as compared to the same factors at the time you purchased your annuity. If the factors have risen since the purchase, the surrender value may decrease; conversely, if factors have fallen, the surrender value could increase. You might want to consider an MVA rider if you think you might need to withdraw your investment prematurely.

There are costs and fees associated with annuities

Costs and fees can impact growth potential and, ultimately, the amount of money you get out of your annuity. Before investing, make sure to ask about all the costs involved, in particular:

• Administration fees: Annuities often come with a range of fees, including management fees, mortality and expense risk charges, and administrative fees, which, over time, can detract from the value of your investment.

• Surrender charges: If you decide to withdraw money from your annuity before the specified period, you may incur surrender charges. These charges may impact any gains earned.

• Optional rider fees: Annuities may offer additional features or benefits, known as riders, which can be added to your contract for an extra cost. These riders, such as guaranteed lifetime withdrawal benefits or enhanced death benefits, provide additional protection or income options but come with their own fees that can reduce your overall returns.

Understanding these fees and risks, discussing them with a financial professional, and asking the right questions when reviewing annuity options are the best ways to ensure your annuity meets your needs and expectations.

The different kinds of risk associated with different types of annuities

Comparing the risks of annuities to other types of retirement savings vehicles

It’s important to note that none of the vehicles described below is designed to turn your retirement nest egg into a stream of income – you have to do that on your own. Also, none can address longevity risk the way a lifetime annuity can. Having said that, the simplest alternative to investing in annuities is to leave your money in a traditional savings account or open a certificate of deposit (CD). CDs and annuities generally yield higher returns than traditional savings accounts. However, you must agree to lock in these funds for a certain period, so there is some liquidity risk. Your money is more accessible in a regular savings account, but lower rates mean greater exposure to inflation risk.

Mutual funds offer the opportunity to invest in a balanced portfolio of stocks, bonds, or other securities managed by professionals. Mutual funds can provide higher potential returns than CDs with lower fees than annuities. However, there are no minimum performance guarantees, like with a variable: you assume all market risk and can lose money in a market downturn.

Individual Stocks have the potential for high returns, but also a higher risk of volatility and losses resulting from market conditions, company performance, and broader economic factors. As with mutual funds, you assume all investment risk and must be comfortable weathering the ups and downs of the financial markets.

Bonds offer a middle ground between the security of CDs and riskier stock market investments. By purchasing government or corporate bonds, you lend money in exchange for possible regular interest payments and the return of the bond's face value at maturity. Bonds range in security from ultra-secure Treasury bonds to higher-yielding, riskier corporate bonds that can lose money. There is also liquidity risk with bonds, as only some bonds are tradeable, and those that are may only sometimes have a market.