The Risks of Owning an Annuity

What Are the Risks of Owning Annuities?

As with any investments, annuities pose certain risks to the investor. Depending on the annuity, the level of risk can decrease or increase. The level of risk is contained within two general factors: the type of annuity it is and the solvency of the company issuing the annuity itself. Annuities aren’t the typical savings vehicle issued at a bank, for example. Rather, annuities are contracts purchased by an investor from an insurance company in exchange for payment on a specific date, over a specific period of time, and usually at specific rate of return.

It is important to note that annuities are not backed up by the FDIC and some may not be registered with the SEC.  However, certain states may have special annuity coverage funds if the company issuing the annuity goes under through “guarantee associations.” The amount of coverage varies depending on which state you live in. For example the state of Washington has the highest protection of $500,000. If the insurance company which the annuity was purchased from is not able to cover their obligations, usually other insurance companies step in and buy out the company and redeem some of the investments. This practice preserves the health of the entire industry.

A fixed annuity is a contract that determines a specific rate of return over a particular period of time. The level of risk may be considered lower than other annuities because its health is not necessarily based on market fluctuations, but rather more stable insurance pools. The drawback for some investors is that the Rate of Return for fixed annuities is not as dramatic as other investments.  A variable annuity on the other hand, allows the investor the ability to determine the level of risk.

By allowing the investor to determine the percentage of his payments into subgroups, the risk can either increase or decrease. For example, if you decided to purchase a variable annuity and place 75% of your payments into a higher risk mutual fund and the rest into a lower risk fund, the overall risk of that annuity may increase. The level of return would ultimately depend on the performance level for each of those funds chosen as a percentage of your portfolio. Variable annuities also allow you to invest a percentage of the funds into a fixed mutual fund as one would in a traditional fixed annuity account. This provides an increase level of freedom for the investor to diversify his portfolio.

Specifically, index annuities are based on the overall performance of the market. The level of return would essentially be based on whether the market goes up or down and would intrinsically have a more risk than a fixed-deferred annuity or a variable annuity. Yet, as other annuities, index annuities can provide good long term investments if we consider the historical levels of market performances that trend upward through the years.

With any financial instrument, a level of uncertainty will always exist. However, the amount of risk which is expected with annuities depends on the type of the annuity chosen by the investor and also includes the long term stability and health of the insurance company the investor is making the purchase from.

Nevertheless, seasoned investors find annuities as attractive saving instruments because they can survive through significant market upswings relatively unscathed, falling interest rates, and deferred tax obligations determined on any earnings due to interest over time. The best way to understand the risk associated with each annuity is to thoroughly read the issuing company’s prospectus.

Annuities are best suited for long term investors.  Any withdrawal prior to age 59 ½ is subject to a 10% tax penalty as well as regular income tax.  Annuities often also have a surrender schedule, meaning that withdrawals may be subject to a penalty by the insurance company if not left in for a predetermined amount of time.  Any guarantees on principal invested is based upon the claims paying ability of the underlying insurance company.